Investors Worry About Potential Bank Sales of Mortgage Bonds
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After tightening most of August and early September, risk premiums for mortgage bonds have started to widen again as investors grow concerned that conditions are ripe for American banks to sell some of their vast holdings.
American banks have a lot of weight in the mortgage bond market, holding about $1.16 trillion in securities at the end of 2005, according to Inside Mortgage Finance. The total size of the American market, by comparison, is about $5.8 trillion.
With the Federal Reserve having raised short-term rates — and by extension, banks’ borrowing costs — from mid-2004 until last month, concern about bank sales of mortgage bonds, and the resulting widening pressure on mortgage bond risk premiums, has been in the background for more than a year. The reason: Banks fund their purchases of mortgage bonds through borrowing, so any increase in borrowing costs can diminish the returns from these investments.
But so far in 2006, banks have not had an incentive to sell, and have continued to be far better buyers than sellers overall. That’s because Treasury yields rose for much of 2006, dragging mortgage yields with them (and pushing mortgage bond prices lower, as yields and prices move inversely). Banks have not been motivated to sell mortgage bonds since it would have meant taking losses on bonds that had fallen in price.
But since late August, Treasury yields have reversed course — the 10-year Treasury was yielding 4.77% in early afternoon Friday, compared with 5.25% at the end of June — and mortgage bond prices have risen steadily. In late August, for example, Fannie Mae 30-year 6% mortgage coupons rose in price above par (100) for the first time since March, the director of mortgage-backed securities research for Nomura Securities International, Art Frank, said.
In this environment, it makes more sense for banks to sell mortgage bonds, Mr. Frank said, as they may be able to register modest gains when they do so.
Potential bank selling is a “story that’s really catching on” and investors are taking note, the manager of mortgage products and strategy for FTN Financial Capital Markets in Chicago, Walt Schmidt, said.
It’s not just “potential” bank sales that have investors concerned, either. Some banks have already taken advantage of higher prices and sold mortgage bonds, the head of global liquid product research for Bear Stearns, Steven Abrahams, said in a recent report. “The rally of recent months has allowed profit-taking on some positions,” Mr. Abrahams said.
The bank sales — potential, actual, and rumored — may partly explain why investors haven’t been buying mortgage-backed securities with much enthusiasm this week, allowing risk premiums to drift wider. Fixed-rate 30-year agency mortgage-backed securities spreads were about 0.5 basis point wider for current coupons (a blend of 5.5% and 6% coupons) in early afternoon Friday, after widening 1 to 2 basis points in the two previous trading sessions.
Banks may also sell even if it means taking a small loss Mr. Schmidt noted, especially if the sale allows the banks either to pay down debt or to reinvest money in new securities at a higher yield.
Case in point: PNC Financial Services Group (PNC) said on September 8 it was selling about $6 billion in mortgage-backed securities at a pretax loss of $200 million. PNC said it would use roughly half the proceeds from the sale to buy new securities and the other half would be used to pay down debt. The sale represented about 27% of PNC’s roughly $22 billion portfolio.
But even with scattered reports of bank selling from Wall Street desks and PNC’s announced sale, few mortgage-backed securities analysts expect it to significantly damage mortgagebacked securities performance.
For one thing, banks are likely to reinvest in higher mortgage coupons when they do sell, and that will continue to support the mortgage market.
Also, bank holdings of mortgagebacked securities are largely concentrated in a handful of bank portfolios, noted Frank of Nomura Securities International.
A recent report from Barclays Capital put Bank of America’s mortgage-backed securities holdings as of the second quarter 2006 at $207 billion, followed by Wachovia Bank at $92 billion, Wells Fargo at $59 billion and JP Morgan Chase at $57 billion.
“You’re really talking about a handful of banks that matter,” Mr. Frank said. Because the holdings are “highly concentrated…it makes it harder to generalize” about what effect bank selling could have on mortgage bond spreads, he said. “If 50 banks lighten up by about $20 million, that’s only $1 billion in selling,” a level that would go almost unnoticed, he said.
On the other hand, if a large bank were to sell $20 billion “that’s a much bigger event,” Mr. Frank said. While such an event seems unlikely, “you never know what’s in the mindset of a single institution…The Street gets surprised sometimes,” he said.