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MBS leads bank asset growth

| May 3, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Since US banks hold more than $3.6 trillion in securities and $9.7 trillion in loans and throw that weight around in a wide range of markets, their investment appetite matters. The most appealing items on the early 2019 menu seem to be MBS, both agency and private, which are growing on bank balance sheets at a pace far outstripping other securities or loans and as excess reserves plunge.

With total assets up 0.9% so far this year, banks have grown their holdings in private MBS by 5.5% and agency MBS by 4.5% (Exhibit 1). Private MBS still amounts to a small $77 billion as April 17 with agency MBS at $1,958 billion. Nevertheless, the interest in MBS is notable especially with holdings in residential mortgage loans up by a smaller 1.0%. Banks are either converting mortgage loans into securities for credit and liquidity or reaching into the market for liquidity and spread.

Exhibit 1: Growth YTD in MBS is outstripping other bank assets

Note: Growth from 12/31/18 to 4/7/19. Source: Federal Reserve, Amherst Pierpont Securities

One possible spur to the MBS interest is the nearly 13% drop in cash, which is mainly excess reserves. The continuing drop in the Fed’s portfolio of Treasury and agency debt and MBS by design takes cash out of the banking system, so the drop is no big surprise. But excess reserves also help meet regulatory liquidity requirements. At least with agency MBS, banks may be adding securities to make up for drawdowns in cash.

The Fed late last year proposed a new set of liquidity regulations that would ease demand for excess reserves and other liquid securities for a broad set of banks. The Fed also this month started slowing the reduction in its Treasury holdings

and plans to end reduction in total securities balances by late September. That should dampen if not end the drawdown in cash assets, dampening the likely correlated demand for MBS at the same time.

The MBS market seems to have the wind of bank liquidity demand at its back for now, but that looks likely to fade by the fall.

* * *

The view in rates

Concerns about low inflation have started to weigh on Treasury yields. The yield on 2-year notes remains at 2.33% The market still sees the probability of a cut or a hike at 50/50, and the Fed seems to be reinforcing that message. The market is also comfortable pricing 10-year yields right around the Fed’s target rate. Eventually, growth should push 10-year rates a little higher, with fair value above 2.75%. However, if the debate on rates is now tightly focused on whether the Fed will cut or hike by 25 bp for the balance of the year, then rate volatility seems far away.

The view in spreads

A relatively flat yield curve, low volatility and heavy net supply of Treasury debt should steadily tighten spread markets. The longer the Fed remains patient, the longer the spread advantage in assets other than Treasury debt compound to the advantage of portfolio return. Leverage and loosening of underwriting remain a concern in investment grade corporate debt and leveraged loans, but concerns about recession, which would trigger those vulnerabilities, has diminished. Agency MBS could see a softening of bank demand, but it should still outperform credit.

The view in credit

Companies have started to divert cash flow toward paying down debt, have started to sell non-core assets and have curtailed stock buybacks. Management has heard the concerns of debt investors. Households continue to look strong with low unemployment, rising home prices, and generally good performance in investment portfolios.

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