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Expect elevated net supply for the remainder of the year

| May 21, 2021

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.

Net supply of agency MBS should be strong for the rest of the year, driven by a strong housing market. If home sales persist at their recent pace, then net supply could average more than $90 billion a month. This is $50 billion a month above the Fed’s current level of net MBS purchases although roughly equal to combined Fed and commercial bank monthly buying this year. Before the pandemic, private investors typically absorbed $20 billion to $25 billion of net supply each month. The excess supply could begin to push MBS spreads wider if the Fed and banks began to step back from MBS.

The pace of home sales has a big impact on net supply in the agency MBS market. For existing homes with a loan currently in agency MBS, a new agency loan is likely to be larger than the loan being prepaid, adding to net supply.  For existing homes without loans or with loans held on a bank balance sheet or in a private securitization, a new agency loan also lifts net supply. New home sales tend to increase net supply for a similar reason, since there is no offsetting prepayment of an existing agency loan. A smaller contributor is the level of cash-out refinancing activity.

Net agency MBS supply tracks new and existing home sales well (Exhibit 1). From 2013 through 2019, a simple model of net supply using existing and new home sales captures most of the changes in net supply during this in-sample period. It only misses the peaks around January 2017 and the second half of 2018. It performed consistently during periods of faster and slower prepayments, and overall explains about 50% of the month-to-month changes in net supply.

Exhibit 1. Modeling MBS net supply using new and existing home sales

A seasonal ARIMA model with new and existing home sales regressors was estimated.  Data from January 2013 through December 2019 was used. One-step ahead forecasts are in-sample, while dynamic forecasts are used out-of-sample. Both series are displayed using a 3-month moving average to reduce noise.
Source: Fannie Mae Mae, Freddie Mac, Ginnie Mae, eMBS, Amherst Pierpont Securities

The model is run out-of-sample starting in 2020. Home sales plummeted at the start of the Covid-19 pandemic, which pushed the model forecast lower. But MBS net supply increased surprisingly during that time, leading the model to underpredict. It is possible that some borrowers moved from private mortgage financing to agency financing at that point, or that banks securitized agency-eligible portfolio loans to build liquidity. However, by mid-2020 home sales had rebounded to levels last seen before the 2008 financial crisis, and the model quickly caught up to the corresponding surge in net supply.

A few scenarios for future home sales lead to three forecasts of net supply over the next 12 months (Exhibit 2). The first scenario uses Amherst Pierpont’s chief economist’s projections, the second assumes home sales for the next year are held constant at the Bloomberg consensus level for April 2021, and the third forecast assumes home sales fall back to the pace from 2019.

Exhibit 2. Net supply could remain elevated for the rest of the year

APS forecast assumes 6.5 million existing home sales and 950,000 new home sales. Consensus forecast as of 5/20/2021 assumes 6.08 million existing home sales and 955,000 new home sales. The “return to 2019” assumes home sales drop to the level in the same month in 2019 starting in May 2021. All series use a 3-month moving average to reduce noise.
Source: Fannie Mae Mae, Freddie Mac, Ginnie Mae, eMBS, Amherst Pierpont Securities

The Amherst Pierpont forecast is the most bullish, and results in the highest levels of net supply—an average of $100 billion a month for the rest of 2021. The Bloomberg scenario is slightly lower, averaging $93 billion a month for the rest of the year. But net supply will fall sharply if home sales were to fall to 2019 levels. Supply would average only $71 billion a month for the rest of the year and fall to roughly $30 billion a month by the end of the year.

The MBS market eventually may have trouble absorbing this level of supply. The Fed is currently adding $40 billion agency MBS each month to their balance sheet, and commercial banks so far this year have added an average of $52 billion a month. In the years preceding the pandemic, private investors typically absorbed between $20 billion and 25 billion of net supply each month. If the Fed begins to taper later this year and if bank appetite cools, too, then the TBA dollar roll may become less special and spreads would likely widen. Money managers would be the most likely investor group to step into the market in that scenario. They will have a lot of paper to absorb.

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