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Agency MBS weathers S&P downgrade

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Mortgage-backed securities sponsored by Fannie Mae and Freddie Mac rallied back from a recent downgrade from Standard & Poor's and may actually be spurring demand. S&P downgraded the U.S. debt on Friday. Investors responded on Monday by flocking to Treasurys as stocks spiraled down to the sixth worst trading day in the history of the Dow Jones Industrial Average. S&P downgraded the government-sponsored enterprises on Monday, initially sparking a marginal widening of spreads, according Chris Killian, vice president of the securitization group at the Securities Industry and Financial Markets Association. But it has since rallied back, he added. "On Monday, there was marginal widening but nothing extreme and then (it) continued overnight as the stock market did what it did. Tuesday, things were tightening as investors waited for the Federal Reserve announcement," Killian said, referencing the Fed announcement of extended low rates until mid-2013. "Once it came out, I think there was a pretty tremendous rally in the agency MBS market that continued after close. On Wednesday, we're seeing marginal tightening and a rally continuing." Chris Flanagan, head of U.S. mortgages and structured finance research at Bank of America Merrill Lynch, said some agency MBS yields are sitting 350% higher than five-year Treasurys and 150% higher than 10-year Treasurys. "The risk aversion trade and Treasury rally appears likely to have peaked in the wake of the Fed decision," Flanagan said. "In the aftermath of the breathtaking Treasury rally, the overwhelming yield advantage of agency MBS over Treasurys and swaps, as measured by yield ratios, argues for an overweight of agency MBS. Some residual spread volatility is likely, but we think we have seen the worst." Agency MBS could even see a widening demand among real estate investment trusts, he said. "We look for REIT demand for MBS to increase, helping to stabilize valuations," Flanagan said. Killian said it was unjustified to "draw a parallel" between the volatility seen during the financial crisis of 2008 and what is happening now in the markets, specifically MBS. He said macroeconomic factors such as unemployment, a slowing economy and unpredictable policies, are pushing the current downturn. Before, Killian said it was a matter of investors waking up and realizing their triple-A holdings were not triple-A and that losses were going to balloon past their estimates. "It's natural when the stock market drops there is some risk aversion, but things were better on Tuesday than they were on Monday," Killian said. "I don't think it's quite right to draw a parallel back to 2008 when things just sucked." Write to Jon Prior. Follow him on Twitter @JonAPrior.

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