Problems Pile Up in Agency MBS Market

(Update 1: updated mortgage rate discussion for clarity, corrected initial discussion of primary dealers to focus more directly on bank holdings) Despite the U.S. government’s takeover of both Fannie Mae (FNM) and Freddie Mac (FRE) in September — designed to bolster confidence both within the U.S. and abroad — investors have been anything but heartened when it comes to either agency’s debt or mortgage-backed securities as of late. In fact, agency MBS spreads are creeping upwards again, nearing levels last seen in March ahead of the Bear Stearns collapse. Bloomberg News reported that the spread between Fannie’s current-coupon 30-year fixed-rate mortgage securities and 10-year U.S. Treasuries gapped out to 213 basis points Monday afternoon, continuing a trend that began late last week. The spread had been at 162 basis points on Oct. 20, according to Bloomberg’s data, and show just how unnerved much of the MBS market has become — even for agency securities, once seen as the lone remaining source of liquidity for the mortgage market. For those in the primary mortgage markets, such widening spreads usually portend higher mortgage rates for borrowers. Part of the problems in the agency MBS market can be attributed to simple supply and demand factors, as you’d expect to see in any market. Investors are being faced with a wide expansion of the government-backed and agency MBS market, for one thing — some (like Ginnie Mae) with an explicit government guarantee, others with what Federal Housing Finance Agency director James Lockhart intended to call an “effective” guarantee in Congressional testimony last week (he mixed his words in testimony, but that’s the subject for another story). The “explicit guarantee” crowd got bigger in the past few weeks, too, with the FDIC saying it would guarantee all forward issuance of debt by insured U.S. commercial banks. On the demand side, more than a few banks have leveled off MBS holdings, and most don’t exactly have much room to play with on their balance sheets, either. Which in a nutshell means that the supply of agency MBS is consistently expanding, while demand has generally been contracting. Market imbalances notwithstanding, HW’s sources have been far more concerned lately about a separate development: the dearth of overseas buyers for agency MBS in recent weeks. Foreign central-bank holdings of agency debt and agency mortgage bonds fell $47 billion to $923.4 billion in the four weeks ended Oct. 22, according to data released by the Federal Reserve; more than a few media reports have suggested in recent weeks that the flight of foreign money out of the agency MBS market reflected some fundamental concern over credit. Not so, according to many of HW’s sources. Instead, we were told, at issue is liquidity and a crisis that has now expanded well beyond U.S. borders — foreign governments, much like any private corporation, are looking to put themselves into the most liquid position possible to ensure they can bail out their own banks, we’re told. And, sort of in an unintended consequences sort of way, the U.S. government’s own actions to bail out the banking sector have made agency MBS less liquid than other potential investments. “In times of crisis, you’ve got to be in the most liquid position possible, and you don’t want to trade risk for return,” said one source, a banker that asked not to be named in this story. “If you can be in highly liquid debt backed directly by the U.S. government, that carries a risk weighting of zero, you’re better able to step in where needed, if needed.” Sources confirmed a similar sentiment to Bloomberg, as well. “People have developed a lot more of their own problems in the last six weeks, than they had three months ago,” Jamie Jackson at RiverSource Investments told the news agency. “Countries, really just like banks, need to hold liquidity to prop up their own financial well-being and they’re not going to lend that out to other people.” All that said, more than a few portfolio managers that spoke with HW dismissed the notion that agency MBS were lacking in bids for the long-term. “It’s a short-term problem, at best,” said one manager, on condition of anonymity. “Let the yield on agency MBS gap out enough, and the Treasury and Fannie and Freddie will come riding in. That gap will close quickly.” Indeed, both GSEs have the capability to buy more than $200 billion in mortgages before hitting their $850 billion annual portfolio cap, and with Freddie a net seller of MBS in recent months, many are looking to the GSEs to pick up the purchasing pace heading into the last two months of the year. Send an email to Paul Jackson at [email protected].