Federal Reserve chairman Ben Bernanke has given a little bit more guidance on where the Fed is headed with its plans for unwinding mortgage-backed securities purchases and while they may start to slow by mid-2014, imminent sales look less likely, giving some analysts hope.
Potential sales as the Fed unwinds have been “a risk that has hurt MBS since discussion of an exit started in January,” Steven Abrahams, a residential MBS researcher at Deutsche Bank, noted in a report on the agency MBS sector last week. “If the Fed rewrites its playbook and delivers on the promise of holding MBS rather than selling, that could provide major support for MBS spreads for the first time this year,” he said.
“The biggest lift would come from having nearly 30% of outstanding agency MBS taken out of the public market. That assumes the Fed ends up with an MBS portfolio of roughly $1.5 trillion. The MBS would likely return through prepayments. But slowly. Less than 10% a year,” said Abrahams.
“In the meantime, the bulk of the MBS would stay in most major MBS market indices. And beyond indexed portfolios, others would likely still have demand for a spread asset with limited credit risk. Basel III liquidity requirements and risk weights encourage that. Margin requirements for derivatives do, too. With higher agency guarantee fees likely to curtain public supply rather than add to it, the net result should be tighter spreads.”
Abrahams said he still has some concerns about reverse repos, which have been considered a possible alternative to sales, but he added that there may be ways to execute them that make “the risks to the market...increasingly look manageable.”
He said that while “the Fed could crowd most private portfolios out of the MBS repo market, potentially creating a two-tiered market with private portfolios paying a punitive repo rate,” it has started to look at ways it “could do reverse repo without disrupting other investors that need MBS repo funding—brokers and REITs above all. Among the possibilities, the Fed could create lending facilities similar to ones created after the 2008 crisis, facilities that could offer funding against agency MBS at a rate aligned with the target fed funds rate,” he said.
As to whether this all could make MBS more attractive to investors, Abrahams noted, “Any Fed promise to hold and not sell obviously will have to be credible and material, although it almost surely will short of unequivocal. The holding period should be long. The bar to selling should be high. But the Fed will have to allow that unacceptable levels of inflation could break the promise. Monetary policy will always come before market function.” With this caveat his recommendation is, “If the Fed promises to hold 'em, then buy them.”
As far as more immediate recommendations in reaction to Bernanke’s comments last week, the view of Credit Suisse researchers Mahesh Swaminathan, Qumber Hassan and Vikram Rao at deadline last Thursday was to remain neutral on MBS for the time being as “spreads are biased wider near-term, until somewhat higher and stable yields encourage bank demand,” something they stress “rate stability is a pre-condition for.”
They said banks may be drawn to mortgage-backed securities if, among other things, rates stabilize, the yield remains relatively high and loan growth stays tepid.
In the meantime, as the nonagency residential MBS market in the past week has continued to slowly grow with a new issuer putting its first deal in the pipeline, ratings agencies are saying they are being cautious about sizing up the credit risk of originators that have what they consider a limited track record, even if the performance of their loans to date has been pristine. Although Moody’s, for example, found that based on loan-level information from the new player, Shellpoint/New Penn, “none of the approximately 158 jumbo and non-GSE loans [New Penn] originated between Jan. 1, 2011 and Dec. 31, 2012 had become 60-plus days delinquent within 24 months of origination,” it considers “the number and seasoning of the loans are insufficient for Moody’s to give any weight to New Penn’s early loan performance at this time.”
