Banks swap roles with money managers in US$8t mortgage bond market

TRADING of mortgage bonds fell back to earth last year, as banks cut back on buying and higher mortgage rates halted the stampede of households that rushed to refinance their mortgages in 2020 and 2021.

Traded volumes of agency mortgage backed securities (MBS) fell about 14 per cent, according to Trace data compiled by the Securities Industry and Financial Markets Association. That was the lowest since 2018.

The effects of the slowdown are still rippling through the US$8 trillion agency MBS market, but it’s already brought big changes to the usual cast of characters.

Banks, among the biggest buyers in the market, are staying on the sidelines. That may be because their balance sheets are saddled with MBS purchased during the refinancing wave – when millions of households refinanced into mortgages with lower rates that then got packaged into low-yielding MBS – and face huge unrealised losses on those securities.

To avoid having their capital hit by those unrealised losses, many banks are surrendering the right to sell much of those securities by designating them as long-term holdings known as “held to maturity” instruments. It spares them from needing to mark their positions, but also effectively reduces the amount of bonds they own that can be readily sold.

Meanwhile the Federal Reserve, which gobbled up US$3.1 trillion in MBS during its post-Covid buying spree, has ended its purchases and is likely to hold onto them for the foreseeable future.

Falling demand from commercial banks and the Fed has created an opening for hedge funds and other money managers. DoubleLine Capital, Vanguard Group and TCW Group are among the MBS investors drawn in by unusually high yields that rival those on investment-grade corporate bonds for the first time in years.

After a rotten year for MBS in 2022, they’re betting that an MBS market not dominated by a rash of refinancings and by the Fed’s bond-buying binge creates room to value MBS based on fundamentals.

“With the Fed out of the market it’s now safer for money managers to come into the market as prices, freed from central bank manipulation, will more accurately reflect reality and fundamentals,” said Christopher Maloney, mortgage strategist for BOK Financial Corp. “I expect money managers to lead the charge in terms of demand during the first half of this year.”

Banks will be probably be relatively small players until the summer in North America, he added. “It’s all about money managers now.” BLOOMBERG