Mortgage Bond Market Dwindles to Aid Fed Punch: Credit Markets

Mortgage Bond Market Dwindles to Aid Fed Punch
New borrowing is being curtailed by lower home values, fewer new households and buyers using more cash, while outstanding debt is being erased by defaults and homeowners paying down their loans. Photographer: David Paul Morris/Bloomberg

The market for mortgage securities backed by the U.S. government is the smallest in three years, bolstering the value of the debt and potentially expanding the effects of any new buying by the Federal Reserve.

The outstanding amount of Fannie Mae, Freddie Mac and Ginnie Mae mortgage-backed securities shrank to $5.24 trillion in July, about the lowest since July 2009, following a $34 billion decline from March, according to Bank of America Corp. data. The market has receded by $150 billion from its 2010 peak.

The contraction, a legacy of the worst U.S. property boom-and-bust in 80 years, is deepening even as housing improves after a six-year slump and the corporate bond market expands. New borrowing is being curtailed by lower home values, fewer new households and buyers using more cash, while outstanding debt is being erased by defaults and homeowners paying down their loans.

“All that translates into this scramble to buy” even as the securities reached record prices, said David Land, a money manager at St. Paul, Minnesota-based Advantus Capital Management Inc., which oversees about $23 billion. “It’ll be even more acute if the Fed comes in and they start buying.”

The shrinkage contributed to a narrowing last week to a six-month low in the gap between a Bloomberg index of yields on benchmark Fannie Mae 30-year home-loan bonds and those on 10-year Treasuries. The spread, which reached 0.71 percentage point from 1 percentage point on Jan. 1, rose to 0.79 as of 10:45 a.m. in New York.

‘Remains Depressed’

Demand is coming partly from U.S. banks and real estate investment trusts, whose combined holdings soared more than $100 billion in the first quarter and is poised to jump again, according to analysts at Morgan Stanley and JPMorgan Chase & Co., which says the market may contract $70 billion this year.

The Fed, which said this month that housing “remains depressed,” failed to announce further action to boost the economy after an Aug. 1 meeting. While a JPMorgan survey the prior week had found almost 80 percent of mortgage investors forecasted a new round of buying, 6 percent of respondents expected the decision at the meeting.

The contraction is among the reasons Fed purchases of $300 billion could pack “just as much punch” as the $1.25 trillion bought during the first round of its so-called quantitative easing through March 2010, Bank of America analysts including Chris Flanagan and Satish Mansukhani said in a July 27 report.

Blackstone, Shell

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. was little changed, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, at a mid-price of 102.9 basis points as of 12:06 p.m. in New York, according to prices compiled by Bloomberg.

The measure, which has climbed from a three-month low of 102.4 on Aug. 10, typically rises as investor confidence deteriorates and falls as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, increased 0.99 basis point to 20.74 basis points as of 12:04 p.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

Shell Bonds

Bonds of Royal Dutch Shell Plc are the most actively traded dollar-denominated corporate securities by dealers today, with 77 trades of $1 million or more as of 12:07 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Shell, Europe’s largest oil producer, raised $2.5 billion yesterday in a three-part offering through its international finance unit. Its $500 million of 3.625 percent, 30-year bonds fell 1.2 cents from the issue price to 98.76 cents on the dollar to yield 3.69 percent as of 11:48 a.m. in New York, Trace data show.

U.S. home-mortgage debt fell to $9.75 trillion as of March 31 from a record $10.6 trillion four years earlier, according to the latest data from the Fed. The amount had doubled from 2001 to 2008, leaving borrowers overburdened as home prices tumbled. After values fell 35 percent through February from a 2006 peak, they gained 3.6 percent as of May, according to an S&P/Case Shiller index.

The so-called agency mortgage-bond market, composed of securities guaranteed by government-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae, initially grew at the start of the credit crisis as the private market froze amid record foreclosures.

All-Cash Deals

The outstanding amount expanded almost $1.5 trillion over three years until a peak in February 2010 as first-time home buyers relied on Federal Housing Administration loans packaged into Ginnie Mae securities and as borrowers with other debt refinanced in the market. Also at that time, Fannie Mae and Freddie Mac began to remove soured loans from their bonds after shorter periods of delinquency.

The market for U.S. home-loan securities without government backing has also contracted, falling to $1 trillion from a $2.3 trillion peak in 2007, Bloomberg and Fed data show. About $3 billion of bonds tied to new loans have been issued since 2008.

In contrast, the $4.5 trillion market for investment-grade U.S. company bonds has been growing. Outstanding debt without guarantees from governments has expanded by more than $270 billion this year, after increasing about $580 billion during the previous two years, according to JPMorgan data.

REITs Buying

The government-backed mortgage market, which helps finance about 90 percent of new mortgages, has also shrunk as more home buyers use cash for property investments. All-cash deals accounted for 29 percent of existing-home sales last quarter, according to the National Association of Realtors.

The weak economy is also depressing household creation. New households formed at an annualized rate of about 800,000 last quarter, Census Bureau data show. A normal rate is 1.2 million, Stephen East, an analyst with International Strategy & Investment Group LLC, wrote in a July 27 report.

Among mortgage borrowers who refinanced last quarter, 23 percent reduced balances, a tactic sometimes needed to qualify, according to Freddie Mac. Home equity tapped through “cash-out” transactions that boost loan amounts fell to $5 billion, from a record $84 billion in the second quarter of 2006.

The Fed owns $854 billion of agency mortgage bonds, buying $273 billion since October under a program to reinvest repayments into those notes to restrain yields.

Fed ‘Constrained’

“Across the world, there aren’t enough good, solid sovereign-like assets,” Dave Cannon, co-head of mortgage-bond trading at RBS Securities Inc., said in a telephone interview.

REITs that invest in U.S. mortgage debt have raised more than $3 billion in equity this quarter. That means their purchases of agency home-loan securities may be closer to the first quarter’s “impressive” $52 billion than last quarter’s $14 billion, JPMorgan analysts led by Matt Jozoff said in a report.

The companies, which ended June with about $300 billion of such holdings, about triple the 2009 level, are benefiting as the Fed says it plans to hold short-term borrowing costs near zero through at least late 2014.

That boon for the industry will continue for “several years,” AG Mortgage Investment Trust Inc. Chief Investment Officer Jonathan Lieberman said on an Aug. 7 conference call, three days before the New York-based firm raised $135 million in a share sale following a $45 million preferred stock offering in July. The Fed is “constrained” because increases would depress U.S. growth, he said.

58% Odds

U.S. banks may be poised to expand their buying as well, after a period in which their “deposit growth has far outstripped loan growth,” leading to “cash piling up,” the JPMorgan analysts wrote in their Aug. 10 report. Commercial banks increased their holdings from about $1.25 trillion at year-end to about $1.31 trillion at the end of March and then $1.34 trillion as of the week ended Aug. 1, the latest Fed data show.

A “pick-up in demand” was seen last week as a result of an increase in benchmark rates that drove yields higher, Morgan Stanley analysts Vipul Jain and Janaki Rao said in an Aug. 10 report. Fed policy makers may fuel more buying by pledging to keep short-term rates that guide banks’ borrowing costs low for a longer period at their next meeting in September, they added.

Agency mortgage-bond investors are speculating more buying by the U.S. central bank is also coming, with Credit Suisse Group AG saying trading patterns yesterday signaled perceived odds of about 58 percent. Average prices reached a record of 108.7 cents on the dollar on Aug. 2, before falling to 108.3 yesterday, Bank of America index data show.

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