The scarcity of agency mortgage-backed securities intensified by the Federal Reserve third round of quantitative easing is adding momentum to the non-agency subprime MBS sector rally.
Bank of America Merrill Lynch (BAC) MBS strategist Chris Flanagan says the impact of QE3 on securitized products is that the “rich get richer.” Portions of the market saw valuations stretched even prior to the Fed announcement, and “QE3 will suck out an enormous supply of bonds from the market,” he says.
Agency MBS spreads were already at historically tight levels, and one week later QE3 has dramatically enriched the agency MBS market: the current coupon spread to the 10-year treasury has declined by 54 basis points to an all-time tight of 6 basis points.
Unlike the significant tightening in agency MBS, the spillover to other sectors such as non-agency MBS was a less expected outcome of QE3. In fact, Flanagan points out, the non-agency MBS sector has been in major rally mode since May.
BofAML analysts attribute the non-agency rally to many factors, including the sale of the Maiden Lane non-agency MBS portfolio in the spring, the announcement of more favorable capital treatment for broker/dealers for non-investment grade non-agency MBS, and strengthening home prices.
Annualized monthly home prices saw gains in April, May, June and July of 31.5%, 34.6%, 25.7%, and 16.3%, respectively. Investors are recognizing that non-agency MBS, and subprime in particular, are an effective means of gaining exposure to home price recovery.
“Given our own belief that home prices will continue to recover, we think the housing data will continue to attract investors to the non-agency market,” says Flanagan, who maintains his preference for last cash-subprime, which “we believe offer attractive fundamental value given the improving housing picture.”
BofAML anticipates further tightening and that agency valuations will get richer as the Fed continues its buying spree for what he thinks will be up to two years.
Analysts expect $1.4 trillion in gross agency MBS originations in 2012 and that the Fed will buy agency MBS at a gross annualized rate of about $850 billion per year, or roughly 60% of all new originations.
Last week “showed us that it is officially game on in terms of access to supply,” Flanagan says.