Analysts Warn MBS Supply May Outstrip Demand With Fed Paydowns

The Federal Open Market Committee (FOMC) said this week it plans to reinvest proceeds of maturing mortgage-backed securities (MBS) held by the US central bank into long-term Treasurys. Analysts are warning that the paydowns will in the long run boost supply of MBS, while demand may lag behind in the absence of the Federal Reserve‘s purchases — which ended in March. Capital Economics senior US economist Paul Ashworth calls the Fed’s plan to reinvest paydowns into Treasurys a “largely symbolic gesture, designed to reassure the markets rather than boost the economy.” After all, he writes in commentary this week, a cooling off of economic recovery has not yet warranted a resuming of the Fed’s asset purchase program. Such an additional round of quantitative easing would require a severe economic slowdown, which Ashworth notes is not being seen currently. Rather, the economy is likely to endure a prolonged period of “disappointing” economic growth, but should still avoid a double-dip recession. “Interestingly, as suspected the Fed will be buying Treasury securities rather than reinvesting in newly issued MBS,” Ashworth writes. “This itself is symbolic because [secretary Ben] Bernanke always couched the Fed’s asset purchase program as ‘credit’ easing, designed to target lower long-term rates for private sector borrowers rather than more traditional quantitative easing, which focuses on the specific size of the monetary base. Now the semantics have been tossed aside and the Fed is specifically targeting the quantity of money.” Although Ashworth hails the move as “symbolic,” it is bound to have a significant effect on the mortgage bond market. According to Deutsche Bank commentary today, the Fed’s MBS portfolio will likely return to hundreds of billions of dollars in principal in the next year due to paydowns, fueling the demand for Treasuries. The outlook depends on the movement of interest rates. As rates move lower, Fed MBS prepayments will rise, creating more demand for Treasuries and pushing rates down further, creating more prepayments and follow-on demand, Deutsche Bank analysts say. If rates increase, Fed MBS prepayments should drop and reduce demand for Treasuries, pushing rates up even further. Although Steven Abrahams of Deutsche Bank’s residential MBS research team notes that “the Fed looks like it’s a long way off from raising rates” — suggesting the former rate scenario could be likely — the Fed did not say it would buy MBS. “If the Fed’s portfolio does generate hundreds of billions of dollars of prepayments in the next year, that will be a transfer of new floating supply into the private market,” Abrahams writes. “Add that supply to the roughly $160bn in MBS mandated to roll off of GSE portfolios in 2011.” In short, it is possible supply could outstrip demand in the next 12 months, as the Fed’s current policy does not call for additional MBS purchases. The re-emergence of overseas demand for MBS and the continued scarcity of new issuance has tightened the mortgage basis to levels last seen during the Fed’s MBS purchase program, according to analysis by Barclays Capital today: But with the Fed reinvesting paydowns into Treasuries, mortgages could widen to Treasuries, BarCap analyst Nicholas Strand says. With a current estimated no-point mortgage rate of 4.6%, he expects the Fed MBS portfolio paydowns to be running at around $270bn over the year: “In addition to mortgage paydowns, there is an additional $50bn in maturing agency debt, which pushes the estimated amount of reinvestment in Treasuries up to $320bn,” he writes. “Although this number accounts for about 15% of expected Treasury coupon issuance, Fed purchases are likely to be more concentrated in the 5-10y sector. With strong support in the long end of the curve for treasuries, lower coupons are likely to be most effected.” Write to Diana Golobay.