Fannie Mae announced recently that its retained portfolio grew at about a 20% annualized rate -- which analysts said is about twice the pace of the MBS market. This and other factors point to an intensifying supply/demand imbalance for mortgage-backeds, they stated.

Fannie's net purchases of around $10.6 billion were similar to the net growth in the FNMA MBS market, according to a report by Credit Suisse First Boston. Analysts said, however, that it seems like approximately 40% of the net purchases were not in FNMA MBS. They anticipate net MBS production to continue to drop. Further, they said that it is becoming apparent that the amount of equity-take-out is declining and average loan balances on 2002 originations may be lessening compared to last year.

"We are still positive on mortgages though we think there is somewhat of an imbalance as production declines," said David Montano, a director of mortgage research at CSFB. "There is generally strong demand for mortgage products; while the supply has declined the demand does not seem to be dropping. There are only a few more attractive investment alternatives at this point."

Opportunistic buyers

The accelerated growth rate of the GSEs is certainly not a new trend. In 2001, for instance, they both steadily built their mortgage portfolios at the rate of about $20 billion per month. Recently, Fannie Mae's mortgage portfolio had exceeded $700 billion while Freddie Mac had topped $500 billion.

In fact, because of their rapid expansion, they have gotten some bad press lately. The president's budget for fiscal year 2003 had indicated that the GSEs' large size may present a "potential problem" (see ASR, 02/11/02, p. 24) and Wednesday's edition of The Wall Street Journal (see story on page 1) printed an editorial comparing the two agencies to Enron.

Despite the fact that the agencies are growing at a much faster pace than the mortgage market, this is not a negative for the MBS market. Art Frank, director of mortgage research at Nomura Securities, said that GSE purchases tend to stabilize spreads especially when there is a high volume of issuance.

"We saw in 2001 that despite the large issuance volume the standard deviation of daily spread of the current coupon to the 10-year Treasury was the lowest it's been in four years," said Frank. "So rather than making mortgages expensive per se, I think the agencies tend to be a stabilizing force by the manner in which they buy. They tend to make spreads more stable than they would otherwise be."

Fannie and Freddie are typically considered to be opportunistic buyers. They buy mortgages when their model indicates that mortgages are on the cheap side of fair value given where agency debentures are and where implied volatility is. On the other hand, they tend to back away from buying if mortgages get a little on the rich side.

In a recent Merrill Lynch report, analysts said it would be reasonable to assume that Fannie and Freddie increased their holdings of agency mortgages by about $125 billion out of their total growth of $205 billion. Between the two of them, the agencies probably took down 43% of mortgage net supply, or $125 billion out of $291 billion.

However, Fannie and Freddie may not grow at the same pace this year, they now have a larger base portfolio, which jointly adds up to $1.2 billion.

Both agencies grew by about 20% last year. Merrill says that even if Fannie and Freddie were to grow by only15% this year, this would still mean that they would have to purchase about $180 billion of net securities. Though not all of this number would come from the agency fixed-rate mortgage market, the agency purchases would amount to about $110 billion, or 46% of net issuance of about $240 billion.

Banks pick up supply

Aside from the agencies, banks also accounted for a large percentage of the supply last year. According to Merrill, the banks took down about 33% of the net fixed-rate mortgage issuance, or $95 billion out of $291 billion. The firm also said that these financial institutions added $135 billion of securitized MBS in total to their portfolios.

However, there is a big question as to whether banks would continue to buy mortgages at the same rate as they have been.

With loan growth rather slow and banks continuing to tighten their credit standards, they will most likely continue to be active in the mortgage market. However, this would all depend on economic factors.

"Banks are the wild card because if the economy recovers and banks start lending out to corporate America again, then you are going to find that they would not be as interested in buying mortgages," said Akiva Dickstein, a director at Merrill.

Another possible factor that could lead to banks actually selling mortgages could be a desire to take earnings gains to offset credit losses or, alternatively, to raise cash in order to finance companies that are drawing on their bank lines because their access to commercial paper market had been limited.

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