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Wall Street CMOs Crushed as Sales at 3-Year Low: Credit Markets

Wall Street CMOs Crushed as Sales at 3-Year Low
The Marriner S. Eccles Federal Reserve building stands in Washington, D.C., U.S. The slump shows how the Fed is depressing bank results even as it aids them. Photographer: Andrew Harrer/Bloomberg

The Federal Reserve’s effort to support the economy by acquiring $40 billion a month of mortgage bonds is crimping Wall Street’s business of packaging the government-backed securities into new notes.

After falling last month to a three-year low of $19 billion, issuance of so-called agency collateralized mortgage obligations, or CMOs, may decline 10 percent to 20 percent in October, according to Scott Buchta, head of fixed-income strategy at Brean Capital LLC. Sales last month were 25 percent below the 2012 average through August, according to data compiled by Bloomberg.

“When you have a buyer with a different goal than the rest of the market” it can crowd out other investors, said Bill Anast, who runs the agency CMO business in New York at Barclays Plc, the third-largest underwriter. “In the next couple of months CMO issuance could be slow,” he said.

The slump shows how the Fed is depressing bank results even as it aids them. While its third round of so-called quantitative easing, or QE3, helped JPMorgan Chase & Co. and Wells Fargo & Co. report record quarterly earnings last week by boosting homeowner refinancing and loan-sale profits, the lenders also said their investment margins are being squeezed by lower yields on securities and loans.

Double-Edged Sword

A rally in mortgage bonds being targeted by the Fed sent relative yields on unpackaged pass-through securities that guide home-loan rates to record lows last month of 0.56 percentage point. That’s left dealers led by Deutsche Bank AG and Goldman Sachs Group Inc. with less opportunity to attract investors to CMOs, which are used to create new notes with varying risks tied to changes in interest rates and refinancing.

Higher mortgage bond trading volumes spurred by the Fed also may fade as the central bank’s holdings in the $5.2 trillion market swell to more than 25 percent of outstanding debt within a year. The large swings in spreads can be a double-edged sword for dealers, said Howard Hill, a former Babson Capital Management LLC executive who helped start securitization-related departments at four banks.

“They hate volatile markets when the big boys show up,” seeking to sell or buy at the same time as others, said Hill, who is based in Litchfield County, Connecticut. “Otherwise, it can be a lot of fun to be a trader” when they are opportunities to bet on the direction of the market, he said.

Default Swaps

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. increased, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbing 0.6 basis point to a mid-price of 90.2 basis points as of 12:08 p.m. in New York, according to prices compiled by Bloomberg.

The measure 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, or 0.01 percentage 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, rose 0.8 basis point to 9.75 basis points as of 12:10 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.

UnitedHealth Bonds

Bonds of UnitedHealth Group Inc. are the most actively traded dollar-denominated corporate securities by dealers today, with 188 trades of $1 million or more as of 12:15 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The biggest U.S. health insurer raised $2.5 billion yesterday in a four-part, dollar-denominated sale to help finance its plan to buy 90 percent of Amil Participacoes SA. UnitedHealth’s $625 million of 0.85 percent, three-year notes increased 0.4 cent from the issue price to 100.4 cents on the dollar to yield 0.72 percent, Trace data show.

The Fed’s open-ended mortgage purchases announced Sept. 13 to support housing and boost employment target bonds guaranteed by government-supported Fannie Mae and Freddie Mac or federal agency Ginnie Mae, which serve as the collateral for agency CMOs.

Ranieri, Fink

Bankers transform the debt in a bid to make it more attractive to different sets of investors, such as by creating some bonds that get paid off before others or notes that receive only principal or interest. They can also turn fixed-rate debt into two types of floating-rate securities with payments that move in opposite directions as short-term benchmarks fluctuate.

The $1.3 trillion agency CMO market was pioneered in the early 1980s by Salomon Brothers’ Lewis Ranieri and First Boston Corp.’s Laurence D. Fink, who now runs BlackRock Inc., the world’s largest money manager.

Agency CMO deals, after peaking at $609 billion in 2003, fell to $145 billion five years later as non-agency securities sparked the worst financial crisis since the Great Depression. Sales averaged $404 billion in 2010 and 2011 even as offerings of home-loan debt without government backing remained limited.

Issuance, which occurs at the end of each month, reached $219 billion in the nine months ended in September, the least since $13.3 billion was sold in April 2009, Bloomberg data show.

Spokesmen for the two top underwriters, Renee Calabro at Frankfurt-based Deutsche Bank and Michael DuVally of Goldman Sachs in New York, declined to comment.

Potential CMO

Creation of agency CMOs is usually highest when the difference between shorter- and longer-term rates is steeper and after refinancing that pays down investor holdings. Underwriters’ earnings vary as they seek to create new debt worth more than the sum of its parts.

All the pieces of a potential CMO studied on Sept. 27 by Nomura Securities International Inc. analysts would have been worth about 0.7 cent on the dollar less than the collateral.

The gap between a Bloomberg index of yields on Fannie Mae mortgage bonds trading closest to face value and an average of rates on five- and 10-year Treasuries narrowed 49 basis points last month, the most on record, to 71 basis points. The spread then expanded to 95 as of 11:50 a.m. in New York.

While CMO activity has “finally picked back up” with wider spreads, it’s not “at the levels previously seen over the summer,” Christopher Helwig and Ian Carow, Deutsche Bank analysts, wrote yesterday in a report.

Refinancing Protection

Some of the widening on generic collateral has been offset by rising prices for securities with protection against refinancing. So-called pay-ups on Fannie Mae securities with 3.5 percent coupons filled with low-balance mortgages rose yesterday to a record of almost 2 cents on the dollar, after falling to a month-low of 1.5 cents following the Fed announcement, according to Credit Suisse Group AG data.

CMO underwriters also can earn money by holding securities they plan to package into the bonds and slices that aren’t immediately sold, though they also risk price changes. Dealers often expect to make 0.13 cent to 0.25 cent on the dollar, according to market participants who declined to be identified because the figures vary.

On a $1 billion deal, that would mean as much as a $2.5 million profit.

Trading Volumes

Daily trading volumes in the agency mortgage-bond market averaged $361 billion in the two weeks ended Oct. 3 among the 21 primary dealers that transact directly with the Fed, compared with $289 billion a month earlier and $325 billion in the same period of 2011, according to the central bank’s data.

The effect of the Fed’s buying has been the most dramatic on the lowest-coupon mortgage bonds such as Fannie Mae’s 3 percent securities, the focus of its purchases because they most influence loan rates, Barclays’s Anst said.

“That means there’s still a lot of collateral for CMO desks to work with,” he said.

The Fed is acquiring notes in the so-called To Be Announced market for pass-through securities, in which orders to buy can be filled with debt that may not yet be issued and matching a range of characteristics.

“As you get deeper into QE3 you might actually see CMO issuance come back, as tighter TBA levels push investors into other products,” such as CMOs or higher-coupon debt, Anst said.

So-called option-adjusted spreads on all of the slices of CMOs fell to 30 basis points on Oct. 16, from 63 basis points at year-end, according to Bank of America Merrill Lynch’s Agency CMO index.

Alternative Assets

Home-loan rates at record lows are fueling refinancing that returns cash to investors. U.S. banks held $469 billion of agency CMOs as of June 30, up from $340 billion two years earlier, according to Federal Deposit Insurance Corp. data.

Tight spreads and lower yields on government-backed mortgage securities mean those investors may look elsewhere, such as the market for commercial-mortgage-backed securities, Brean Capital’s Buchta said.

“While banks will need to reinvest principal paydowns, you may see a growing portion of this cash flow go into alternative asset classes such as CMBS, which will also impact volumes,” he said.

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