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Tags: Banks | Fed | Mortgage | securities

Banks Won't Be Able to Clean Up Fed's Mortgage Mess

Friday, 05 February 2010 04:13 PM EST

Don't count on banks to rescue U.S. mortgage securities once the Federal Reserve leaves the market this spring.

Banks are typically massive buyers and a key support system for the $5 trillion agency mortgage-backed securities (MBS) market but are in no position to step up purchases this year, most strategists agree.

The Fed's $1.25 trillion MBS buying began in January 2009 to help cut borrowing costs, revive housing and the economy.

Without a new lifeline, mortgage rates could rise, crimping demand in a housing market still groping for solid ground.

Fewer players, a push to mend balance sheets and an Obama administration plan to limit bank risk-taking could put the lid on bank MBS buying.

"The banking system is not capable of assuming the burden of supporting the mortgage market when the Fed stops doing it," said Mustafa Chowdhury, head of U.S. rates and MBS strategy at Deutsche Bank in New York.

The number of banks reporting financial results to the Federal Deposit Insurance Corp fell to 8,099 at the end of the third quarter in 2009, compared to 8,533 at the end of 2007.

Banks load up MBS when yields on these long-term assets are high relative to short-term funding costs. Typically there is more cash to invest to enhance earnings when lending is light.

But with the number of banks down on several mega-mergers at the height of the financial crisis in 2008, and ongoing failures, their buying cannot be counted on to fill the Fed's shoes. Those still standing are focus on rebuilding capital.

"The banking sector in the U.S. has been heavily consolidated in the past 1-1/2 years because of all of these mergers," Chowdhury said. "The top four U.S. banks already own a gigantic portion of the total MBS and whole loan portfolio."

U.S. commercial banks owned $1.2 trillion in total mortgage bonds at the end of 2009, up from $1.07 trillion a year earlier and $929 billion two years ago, based on Fed data.

But in January, banks shrank mortgage bond holdings by $26 billion, Barclays Capital said.

Any fresh barriers to investment in the bonds used as a peg for home loan rates could destabilize the markets.

The Fed's exit as the biggest buyer of bonds issued by Fannie Mae, Freddie Mac and Ginnie Mae will contribute to a percentage point jump in average 30-year mortgage rates to 6 percent this year, according to Freddie.

President Obama's plans to limit banks' financial risk-taking could be another such hurdle.

"The administration is trying to target the compensation and risk-taking" at banks, not harm housing as it tenuously emerges from the worst slump since the Great Depression, said John Canally, LPL Financial economist in Boston.

"But the banks are generally a natural buyer of these bonds and if it becomes clear that they are being incented not to buy then some changes will have to be made," he added.

"It's another one of those unintended consequences of intervention in the markets by the government."

Few, to be sure, are relying on banks to pick up all of the slack when the Fed exits. Money managers are the prime candidate, with many underweight and eager for discounts.

Risk premiums on agency MBS need to jump 10 to 30 basis — after falling by nearly 70 basis points last year — to lure fund managers and others, strategists agree.

Weakness could be more pronounced if a big buyer segment such as banks fades.

Fannie Mae and Freddie Mac also have room to buy MBS after the government relaxed rules for mandatory downsizing. But their combined mortgage portfolios currently total $100 billion below their allowable year-end levels.

Still, no one expects the MBS market to return to levels anywhere near where they were before the Fed got engaged.

With new mortgage creation light as housing struggles, the supply of bonds backed by those loans will stay low. That will also contain market erosion if buyers are slow to return.

JPMorgan expects net agency mortgage bond issuance to fall to about $300 billion from around $435 billion last year.

"If banks extend net MBS holdings by about 8 to 10 percent that will bring supply and demand on a gross basis roughly in balance," said Mahesh Swaminathan, Credit Suisse mortgage strategist. "If they don't buy, then that leaves that gap and somebody else will have to step in."

The carry — borrowing short-term to buy long-term assets — remains high historically and should spur banks to grow their net MBS holdings by up to 10 percent, similar to the modest 2009 pace, the firm projects.

"These things are not cheap enough that they would just blindly pile in, but at the same time there is enough of a carry advantage versus their funding costs that they would take advantage," said Swaminathan.

"Banks will step away from buying MBS when loan growth resumes, and that's quite some way away yet," he said.

© 2022 Thomson/Reuters. All rights reserved.

Don't count on banks to rescue U.S. mortgage securities once the Federal Reserve leaves the market this spring. Banks are typically massive buyers and a key support system for the $5 trillion agency mortgage-backed securities (MBS) market but are in no position to step up...
Friday, 05 February 2010 04:13 PM
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