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Wall Street pulls back from mortgage market that Fed made boring

The US Federal Reserve is squeezing a good deal of the profit out of mortgage bond trading, and Wall Street banks are increasingly heading for the exits.

[NEW YORK] The US Federal Reserve is squeezing a good deal of the profit out of mortgage bond trading, and Wall Street banks are increasingly heading for the exits.

Barclays Plc cut 20 jobs in its US government-backed mortgage bond business in January as part of a broader bank reorganisation that is cutting 1,200 jobs, according to a person with knowledge of the matter. Deutsche Bank AG and Societe Generale SA have also scaled back in the market in recent weeks, people with knowledge of those moves said.

As the Federal Reserve has vacuumed up nearly a third of the government mortgage bonds in the market as part of its quantitative easing programme since early 2009, average daily trading volume has plunged by more than 40 percent. Unlike other investors, the central bank rarely trades its mortgage bonds.  "What incentive do banks have to stay in the business in a largely price-controlled market?" said Danielle DiMartino Booth, a former policy adviser at the Dallas Fed. Eric Kollig, a Federal Reserve spokesman, declined to comment.

Some banks are slimming down rather than pulling out of the business entirely. Barclays, for example, is still committed to the most actively traded parts of the US mortgage bond market but is scaling back from less liquid products, said the person who asked not to be named because the matter isn't public. The British lender and Deutsche Bank were once top-ranked dealers in the market, while the others were more marginal players.

Mortgage securities still trade actively, but if more players slim down their businesses, buying and selling large volumes could become harder, and home loan rates for consumers could also edge higher.

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The Fed isn't the only factor weighing on mortgage bond trading volume and profits. New capital requirements known as "Basel III" and new regulations including the Volcker Rule have boosted funding costs and reduced risk taking in bond trading. Also, a refinancing wave brought about by low mortgage rates began waning in 2013, which means fewer new bonds are being created.

The Fed now owns more than US$1.7 trillion of mortgage backed securities as a result of its US$3.5 trillion quantitative easing program, an effort to boost the money supply after it cut rates to zero and had few other tools for stimulating the economy. The central bank continues to reinvest principal it receives from maturing debt, or from the monthly payments it receives on its mortgage bonds. That means its holdings may no longer be growing, but they are not shrinking either.

At some point, the Fed will stop reinvesting principal it receives from its bonds, and its role in MBS markets will decline. But even then, it's unclear whether banks will find mortgage-bond trading as attractive as they did before given new regulations, said Ken Shinoda, a money manager at DoubleLine Capital.

"Banks pulling in and out of the mortgage market is nothing new, but this time is different," Mr Shinoda said. Banks are trying to figure out what businesses can be shed, he said.

Banks' shrinking mortgage bond desks are the latest sign of how new regulations and the Fed's stimulus efforts have forced Wall Street firms to rethink much of their fixed-income trading businesses, long a cash cow. Mortgage-backed securities are a key part of any full-service bond trading business.

"Dealers are far more selective in choosing which assets to own, how much to own, and how long to hold them," said Laurie Goodman, director of the Housing Finance Policy Center at the Urban Institute in Washington, DC.

On Thursday, Tidjane Thiam, chief executive officer of Credit Suisse Group AG, said mortgage- and asset-backed trading is one of two businesses that are "ugly ducklings that no one likes."

Deutsche Bank intends to totally exit the market for the safest mortgage bonds, those issued by government-owned agencies like Fannie Mae and Freddie Mac. It reduced nearly half of its remaining trading desk, or about 10 professionals last month. The bank suffered its first full-year loss in 2015 since the 2008 financial crisis, results that co-chief executive John Cryan called "sobering."

Sandeep Bordia, the top Barclays strategist for securitized products, was among the group that left the bank, others said. The bank cut 20 employees that worked with residential mortgage bonds backed by the US government, and another 30 that traded in other parts of the structured finance business, such as commercial mortgage bonds. Societe Generale has pulled back from agency mortgages, instructing traders to stop buying new securities, people familiar with that bank previously said.

Mr Bordia didn't reply to messages seeking comment. Barclays spokesman Marc Hazelton declined to comment.

SocGen spokesman Jim Galvin said the bank remains "fully committed to the continued development of its asset-backed products business, which includes origination, sales, trading and financing of asset-backed products including ABS, CMBS, and CLOs."

Other banks, including Royal Bank of Scotland Plc, are winding down their US-based mortgage-bond trading businesses.

"Between the Fed and Basel III, the broker-dealer community is disincentivised to be in the bond business," said David Castillo, managing director in Los Angles at institutional brokerage Odeon Capital Group.


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