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Agency MBS market is facing a supply-side threat

Despite declining MBS net issuance, Federal Reserve's pull-back from the market is expanding supply, propelling wider spreads

Issuance of agency mortgage-backed securities (MBS) is projected to contract significantly over the next two years in the face of a housing-market contraction, but the actual supply of MBS available for purchase in the private market is expected to swell to record levels over that period.

That’s the takeaway from a recent market report by The Amherst Group, a real estate investment firm based in Austin, Texas. The major contributor to the projected elevated MBS supply, according to the report, is the Federal Reserve and its monetary-tightening policy. 

Part of the Fed’s strategy to beat back inflation includes raising the benchmark interest rate, which is now in the 4.5% to 4.75% range, up from 0.25% a year ago. That interest-rate tool is coupled with another lever known as tapering, which involves the Fed orchestrating a major retreat from the agency MBS market by allowing assets to run off its $2.6 trillion MBS portfolio as the securities mature or prepay. 

That tapering, for now, is being accomplished by not replacing those MBS assets — with the Fed’s run-off cap set at $35 billion per month.

“When I look out over the next six months, 12 months, 18 months, I do see this big overhang of [MBS] supply that needs to be absorbed on the agency side, and spreads definitely need to be wider,” which likely translates into upward rate pressure for the mortgage market, explained Sandeep Bordia, head of research and analytics for The Amherst Group. 

Bordia added that the pace of Fed MBS run-off, including prepayments slowed by a lack of refinancing, is now “only around $15 billion to $20 billion [per month].”

“So, they [the Fed] would really need to get into selling MBS actively to reach that $35 billion cap, though they have suggested that they are not inclined to do that.”

The Amherst report forecasts that the net issuance of MBS, which includes Fannie MaeFreddie Mac and Ginnie Mae securities, is projected at $325 billion in 2023 and $375 billion for 2024. That reflects a substantial reduction in new and existing-home sales and refinancing. 

By comparison, agency net MBS issuance in 2021, when interest rates were half of what they are today, came in at $870 billion. Net issuance represents new securities issued less the decline in outstanding securities due to principal paydowns or prepayments.

In 2021, however, the Federal Reserve was a major purchaser of MBS, to the tune of $475 billion, according to the Amherst report. Last year, net agency MBS issuance dropped to $530 billion. 

In 2022, the Fed began employing its tapering tool in stages, a strategy that expanded the effective MBS supply in the market by some $80 billion last year, Amherst reports.

“There’s been a broader rise in interest rates but, in addition, the MBS market had the rug pulled out from under it [last year] by losing the main buyer with the Fed,” said Sean Banerjee, co-founder and CEO of ORSNN, a Seattle-based fintech that operates a cloud-based trading platform.

Over the next two years, the Fed’s monetary tightening policies are projected by Amherst to add a total of at least $450 billion in new MBS supply based on its existing run-off strategy. So, even though agency net MBS issuance is projected to decline from $530 billion in 2022 to $325 billion this year and $375 billion in 2024, the added MBS supply created by the Fed’s quantitative tightening will effectively increase the overall supply of MBS that needs to be absorbed by the private market, compared with even the banner year of 2021. 

The agency MBS market is immense and expanding, with some $8.1 trillion in outstanding debt at the end of 2021, a figure that jumped to an estimated $8.6 trillion last year, the Amherst report shows. By yearend 2023, according to the report, the size of the agency MBS market is projected to jump to $8.9 trillion and to nearly $9.3 trillion by the close of 2024. By comparison, in 2013, outstanding MBS debt stood at about $5.4 trillion.

Agency MBS trading activity also “dwarfs the other segments of the market, with $288 billion of daily trading volume,” according to a recent report from the Federal Reserve Bank of New York. That compares to daily trading volume of $2.7 billion for commercial mortgage-backed securities (CMBS) and only $500 million for nonagency residential MBS.

“The effective supply the private market sees is organic net issuance plus Fed runoff/sales,” the Amherst report states. “The amount of supply that the market needs to absorb over the next couple of years is close to all-time highs, likely around $1.2 trillion.” 

The report adds that because of the high interest-rate environment, which reduces mortgage prepayments via refinancing, the Fed is not likely to reach its monthly $35 billion run-off cap any time soon. The Fed’s monthly run-off pace is estimated at about $20 billion currently, or about $225 billion annually. 

If the central bank decides to actively sell MBS to make up the difference, the Amherst report estimates that the effective supply of MBS created by such a move would increase to $420 billion a year over the next two years — or roughly $840 billion. That’s in addition to projected agency net issuance over the two-year period of about $700 billion.

MBS sales?

Mortgage data-analytics firm Recursion, which specializes in the MBS market, reports that the bulk of the Federal Reserve’s MBS portfolio is backed by mortgage collateral that is well-below prevailing market rates, which further complicates the scenario in which the Fed might start actively selling its MBS assets.

“Outright sales of 2% and 2.5% coupons will likely impact the market quite differently from a situation in which a low-coupon mortgage is extinguished” via a run-off strategy, Recursion states in its market-analysis blog. “As outright sales have not been used up to this point, it seems clear that caution needs to be employed when considering such an action.”

In a press conference this past fall, Fed Chair Jerome Powell said MBS sales were not “under consideration ‘anytime soon’, making run-off our base case,” the Amherst report concludes.

Regardless of the approach, the net effect of the increased MBS supply due to the Fed’s monetary-tightening policy is to put continued upward pressure on interest rates. Spreads are projected to widen by another 10 basis points through June of this year and another 17 basis points through June of next year, according to the Amherst analysis.

So, as the mortgage market weakens as projected, driven by a Federal Reserve policy, MBS coupon rates for new issuance are expected to rise due to the perceived risk to the underlying collateral (mortgages) as well as the increased MBS supply relative to demand. At the same time, the coupon rates for benchmark Treasury bonds are expected to face downward pressure as investor demand rises for secure investments like U.S. government-backed notes — further widening spreads. 

Those widening spreads, in turn, put upward pressure on primary mortgage rates, given home loans are the collateral behind MBS. 

“If the Fed was to sell MBS, we would expect spreads to widen 20 basis points through June 2023 in OAS [option-adjusted spread] terms,” the report states. “We would expect a further 27 basis-points widening through June 2024.” 

That’s the bad news for prospective homebuyers and lenders. The good news for investors is that there will be plenty of attractively priced MBS available to purchase over the next few years as supply expands. 

Who will buy these assets? The Amherst report indicates that it’s not likely to be banks, who are coping with falling reserves and were net sellers of MBS in 2022 — around $200 billion in total. The volume of MBS assets that can be retained by Fannie and Freddie is now capped, effective the end of 2022, at $225 billion each, so Amherst expects their MBS holdings to remain flat. 

Likewise, the report says foreign-currency hedging issues are likely to keep many overseas investors on the sidelines with respect to MBS market. In addition, a number of real estate investment trusts (REITs) are struggling with lower capital positions now “and absent meaningful equity raises, should have limited capacity for further addition” of MBS assets.

“We buy agency securities to hedge our MSR [mortgage-servicing rights] portfolio and, without a doubt, agency spreads are wider than they have been historically,” said Nick Smith, founder and CEO of Minneapolis-based private-equity firm Rice Park Capital. “…And there’s still subdued demand from the traditional buyers of MBS.

“Traditionally, banks have been a huge buyer of agency MBS, and there’s some structural reasons why they just aren’t buying as much. One of them is they have big portfolios and the prepayment speeds have slowed down so much [due to a drop-off in mortgage refinancing) that they just don’t have a lot of organic cash-flow that has been created to reinvest in the agency market.”

The big buyer going forward, though, according to Bordia and Amherst’s report, is expected be money managers, also known as portfolio or investment managers. Examples of leading money managers include Pacific Investment Management Co. (PIMCO), Vanguard Group Inc., Fidelity Investments Money ManagementBlackrock Fund AdvisorsJ.P. Morgan Asset Management as well as individual money managers like Warren Buffett of Berkshire Hathaway.

“We believe that most of this elevated [MBS] supply is going to be absorbed by money managers, and given how bearish and sensitive they are, it is likely that spreads remain somewhat on the wider side to the extent that they have to absorb the significant amount of supply.” Amherst’s Bordia said. “…But there is a lot of money waiting on the sidelines.”

Bordia added that 2022 was a challenging year for the mortgage market, marked by a “lot of surprises on the inflation front and coming from the Fed.”

“I would like to think that there would be fewer surprises this year but, again, I think given where we are, it’s really, really hard to make that call,” he stressed. “So, if I were to be put on the spot, I would say I think [2023] is going to be similarly interesting like last year.”

Comments

  1. Excellent article, Bill. You did a great job unpacking a very complicated and multi-layered topic.

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