With the recent bull flattener trade, investors have become more concerned about reduced bank demand for mortgages because lower yields and the flatter curve will put pressure on net interest margins.

However, despite these concerns, market observers expect bank demand to remain robust in the near term because of several factors. For instance, in a recent report, Credit Suisse First Boston noted the trend of continuing weak Commercial and Industrial (C&I) loan demand from the business sector, citing data from the quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices published by the Federal Reserve.

"This is noteworthy for mortgage investors because when banks are not making loans they buy securities," wrote CSFB. The firm further noted that in terms of securities, residential MBS are considered the preferred asset class because of their yield advantage over Treasurys, Agencies and swaps.

CSFB also said that the relative larger share of mortgage securities could be justified by the prevailing bullish view on rates. This view favors securities over loans to take advantage of potential capital appreciation. On the other hand, a bearish view would lean toward loans to avoid mark-to-market losses.

CSFB does not expect a shift out of MBS into Treasuries or Agencies because of the yield give-up consideration. The report also stated that banks are major buyers of front-end cash flows on CMOs, which are the first in line to get prepayment cash flows. "The need to reinvest these cash flows is likely to further support MBS," said CSFB.

Lehman Brothers said in a recent report that bank appetite for mortgages will stay very strong in the coming months. Analysts said that the recent dip in bank demand is more due to choppy markets than to any fundamental shift in their MBS outlook.

The report explained that a bull flattener curve can impact the existing securities portfolios of banks. As the market rallies and mortgage holdings prepay, banks need to reinvest the cash proceeds in a lower yield environment. However, while reinvestment of paydowns at lower yields may be a cause for concern, investors should remember that some of this would be offset by the overall duration exposure of these institutions, Lehman said. Additionally, banks are usually net long duration, and their duration gains in the market rally have apparently lessened losses from being short convexity.

In terms of reinvestment, the gains suggest that banks will not really be against bearing incremental duration and convexity exposure for incremental yield. Researchers said that it would take at least a 100 basis point rate backup for banks to begin booking losses on their securities portfolio. Further, with outlook for loan growth remaining very weak, investment alternatives are limited and banks would have to go back into MBS. Lehman predicts roughly $70 billion per month in paydowns on bank-held MBS (domestically chartered).

Marginal bank demand is also a major issue for mortgages. This issue is particularly relevant in the current environment considering the potential surge in deposits. With this, a flatter curve would definitely curb net interest margins as the spread between asset yields and funding would also be less. However, Lehman said that the curve has not really flattened enough for it to be an immediate concern. Since the end of last year, banks have had to extend less than a year to maintain margins.

Art Frank, head of mortgage research at Nomura Securities International, said that the curve is still steep enough to maintain the current high level of bank CMO demand. "We still have a yield spread of 120 basis points between the 6-month T-bill and the 5-year T-note, and I think that is steep enough to maintain bank demand for CMOs at a fairly high level," said Frank. "The risk is that if that spread would dip significantly below 100 basis points, and remain there for some time, bank CMO demand would likely diminish considerably."

A less publicized factor hindering the need to extend out the curve is the cheapening in option prices. On an aggregate portfolio basis, Lehman said that banks often hedge their duration/convexity exposure by buying options. Different than dedicated option players, banks would usually hedge relative to spot rates than forward rates. When the curve flattens, analysts explained that forward rates usually rally more than spot rates and an option that has a fixed strike relative to spot rates would "cheapen" on a nominal dollar price basis.

From a bank's view, the "cheapening" of options means it can buy more protection for the same fixed dollar amount. So even if a flatter curve suggests the need to buy more duration and/or sell more convexity, this can be partly mitigated since banks can also buy more options. Lehman estimates that for the typical options that banks buy, they can purchase 20% more options for the same premium with the flatter curve.

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