Picking up the slack when the Fed pulls back

Brian Landy, CFA | June 25, 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.

Money managers and other MBS investors will clearly need to pick up the slack when the Fed begins to taper its MBS purchases. The Fed and banks today own 65% of outstanding MBS, up from 51% at the start of the pandemic. Historically tight spreads driven by Fed and bank buying led many investors to reduce MBS holdings. Underweight investors at the very least will need to slow their outflows as the Fed stops buying but may not need to increase their MBS holdings if banks continue to absorb net supply. If banks also back away from MBS, then spreads would likely widen sharply until money managers and other relative value investors step back in.

The Fed’s and banks’ MBS portfolios have grown significantly since the start of 2020 (Exhibit 1). The Fed started its current quantitative easing program in the middle of March 2020. It purchased a record amount of MBS in the second quarter of 2020 before settling into the current pace of adding $40 billion monthly. The Fed had allowed its MBS portfolio to run off during 2018 and 2019, falling to $1,409 billion at the end of 2019 from $1,765 billion at the end of 2017. But QE pushed the Fed portfolio to $2,174 billion at the end of the first quarter this year. Banks added almost as much MBS as the Fed after growing modestly in 2018 and 2019.

Exhibit 1. The Fed and banks grew their agency MBS holdings in 2020 ($ billion)

Amount of agency MBS owned in $ billions. Balances at end of year or quarter.
Source: Inside Mortgage Finance, Amherst Pierpont Securities

Most other investors backed away from MBS during the pandemic. Money managers sold the most, with aggregate holdings falling from $965 in March 2020 to $685 billion in March 2021. This reversed the growth in 2018 and 2019. REITS, insurers, and pensions also backed away from MBS. Foreign holdings also fell, but to a lesser amount. Total MBS outstanding away from the Fed is $75 billion lower than at the end of March 2020. Excluding the banks and Fed, the supply of MBS has dropped $733 billion.

Banks have absorbed most of the net supply of agency MBS during the pandemic (Exhibit 2). This exhibit shows the period-to-period change in holdings for various investors, and the bottom row shows the net supply of agency MBS. For example, banks added $134 billion of MBS in the second quarter of 2020, and the overall net supply was $138 billion. Banks came up a little short in the third and fourth quarters but added more than net supply in the first quarter of 2021.

Exhibit 2. Bank demand absorbed most net supply since the start of the pandemic

Change in MBS holdings in $ billions during the stated year or quarter.
Source: Inside Mortgage Finance, Amherst Pierpont Securities

Since the Fed was also growing rapidly during this period, it was, in effect, buying MBS from other investors. For example, in the second quarter of 2020, the Fed added $507 billion in MBS. Money managers, foreign investors, insurers, pensions, and the GSEs reduced their MBS investments by a combined $528 billion during that quarter.

When the Fed starts tapering, these investors will not need to increase their MBS holdings, if banks continue to absorb net supply. They will merely need to slow, or stop, shrinking their MBS investments. This may reduce the pressure to widen spreads, since all these investors have less money allocated to MBS than before the pandemic. However, net supply is expected to remain very high due to a hot housing market. If bank demand falters, then spreads could widen rapidly. And banks were not buying this much MBS before the pandemic. They have added more MBS in each of the last five quarters than they did in all of 2017 or 2018.

Money managers own a smaller fraction of outstanding MBS than at any point since the end of 2017 (Exhibit 3). This exhibit shows the percentage of MBS owned by each investor over time. Banks and the Fed together own 65% of all agency MBS, up from 51% at the start of the pandemic. Money managers only own 9% of agency MBS, down from 14% at the start of the pandemic and below their 11% share at the end of 2017.

Exhibit 3.

Source: Inside Mortgage Finance, Amherst Pierpont Securities

Money managers are likely underweight MBS—they own a smaller share of the MBS market, but the MBS component of the index grew. MBS spreads have widened recently but other sectors have tightened. When the Fed starts tapering MBS spreads should widen further, and money managers may see opportunity in MBS that has been absent for over a year. This ready demand, coupled with a smaller stock of MBS available to investors, may limit how much widening occurs. But this hinges on the banks’ ability to keep absorbing the significant net supply of MBS expected due to a hot housing market. Should bank demand falter as the Fed tapers then spreads should widen significantly.