DEC 20, 2012 11:22am ET

Lenders Feeling the Heat From Federal Reserve On MBS Buys

DEC 20, 2012 11:22am ET
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Community banks are growing increasingly uncomfortable with the Federal Reserve Board’s efforts to stimulate the economy.

Quantitative easing, particularly the Fed’s ongoing effort to buy mortgage-backed securities, has frustrated a number of institutions that are also in the market for such assets. The initiative is driving up prices for MBS at a time when smaller banks have been stockpiling such securities.

Bankers view securities as one of few viable ways to stash cash—and bring in some yield—as loan demand remains elusive. In recent years, banks have been regularly putting mortgage-backed securities on their books.

There are signs that small and midsize banks are struggling to keep the trend going. Excluding the 25-biggest U.S. banks, mortgage backed-securities fell 1% between Oct. 1 and Nov. 28, based on Fed data compiled by Sterne Agee. MBS at those banks made up 10.8% of total assets at Nov. 28, compared to 11% in early October.

Bankers such as Eric Nadeau, the chief financial officer at $1.1-billion-asset Home Federal Bancorp, wonder if the Fed is aware of the trouble that quantitative easing is causing his industry.

“It’s definitely creating inflation in the fixed-income markets,” Nadeau says. “Community banks that don’t have the ability to do hedging, or have other sources of income to make up for tightening margins, are disproportionately impacted.”

The Fed’s purchases of mortgage-backed securities are “taking away a significant opportunity from the banks they are trying to help,” says Joshua Siegel, managing principal at StoneCastle Partners. “They are penalizing the industry.”

Barbara Hagenbaugh, a Fed spokeswoman, declined to comment.

Economic factors had already forced banks like Home Federal to redirect far more of their assets out of loans and into securities than they would prefer. When regulators visited Home Federal’s headquarters this week, Nadeau joked that the examiner assigned to the securities portfolio had a tougher job compared to the staffer going through the loan book.

Securities made up 41% of the Nampa, Idaho, company’s total assets at Sept. 30, compared to 30% at the end of 2010. Loans comprised 40% of total assets at the end of the third quarter.

Bankers would undoubtedly prefer making loans over MBS investments. Margins on 15-year mortgage-backed securities, often viewed as the typical MBS investment for small banks, are “lousy” right now, says Kevin Cavin, a mortgage strategist at Sterne Agee. “Spread levels in the MBS market are very, very low, historically speaking,” he says.

It’s not just mortgage-backed securities that have become more expensive. Other securities have risen in price after the Fed launched its latest round of stimulus.

“It’s a pool of assets out there,” Nadeau says. “If folks aren’t buying mortgage-backed securities because they are overpriced, they’ll buy other securities, driving those prices higher as well.” Banks are desperate to find securities with higher yields to bolster thinning net interest margins, which are a by-product of artificially low interest rates.