Shifting bank demand for MBS and mortgage exposure

Chris Helwig | July 19, 2024

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. This material does not constitute research.

MBS and broader mortgage exposures on depository balance sheets have swelled and ebbed in the wake of the Global Financial Crisis. The next cycle likely calls for smaller, more convex MBS portfolios with more floating-rate exposure. This risk paradigm will likely be reflected in banks’ residential loan portfolios as well. The changing shape of bank demand should, in all likelihood, have implications for both the agency and non-agency markets.

Some of the more important implications:

• The quality of the TBA float may worsen as banks add more positively convex MBS to their securities portfolios
• Declining quality of TBA will likely be constructive for specified pools, particularly ones with a low price premium to TBA
• Spreads in down-in-coupon MBS may widen if rates fall and mark-to-market losses on discount MBS holdings decrease, spurring an increase in portfolio restructurings
• Continued bank demand for floating-rate CMOs may drive derivative spreads wider given growing supply
• The private label market will likely be a more competitive outlet for non-conforming jumbo loans as the bank balance sheet bid for negatively convex assets weakens
• Bank demand for floating-rate home equity loans may increase, particularly across well capitalized institutions

A changing role for MBS on the balance sheet

The role of MBS portfolios on bank balance sheets has changed multiple times over the past two decades. Before the Global Financial Crisis, MBS portfolios served to provide ballast to bank balance sheets by allowing banks to manage balance sheet duration through sales in and out of MBS portfolios. In the wake of the GFC, bank portfolios were tasked with enhancing liquidity after the introduction of the Liquidity Coverage Ratio (LCR). Through multiple rounds of Quantitative Easing, banks have reached for MBS when deposit growth has outstripped loan demand as easing monetary policy pushed growing amounts of excess reserves into the system.

Fast forward to today and the size and substance of bank demand for MBS is changing yet again. MBS as a percentage of balance sheet assets has declined and banks are keenly focused on adding more convexity and less duration to their portfolios, including adding Treasuries at the expense of MBS. MBS as a percentage of total assets peaked at just over 13% in the second half of 2021 as Covid-related QE drove deposit growth, which substantially outstripped loan growth given the tightening of bank credit in response to pandemic-related recessionary concerns. The subsequent reduction in the size of bank portfolios has been driven by several bank failures attributable in part to the widening duration gap between assets and liabilities as negatively convex MBS and mortgage loans extended into the Fed’s tightening cycle while deposit durations contracted.

Shifting from MBS to Treasury debt

MBS as a percentage of total assets currently sits at just over $2.5 trillion, or 11% of total assets. That share seems poised to remain there as it appears banks have ‘right-sized’ their MBS exposure. Some of the reduction in MBS holdings has gone into more positively convex Treasuries, where holdings have increased by roughly 250 bp from 4.5% to just over 7.0% of total assets since 2020 (Exhibit 1). Given this, net demand for MBS from US depositories will likely be closely linked to overall balance sheet growth with every 1% in asset growth translating to an incremental $25 billion net MBS demand.

Exhibit 1: MBS exposures decline, Treasuries rise across bank balance sheets

Source: Santander US Capital Markets, Federal Reserve H.8 Report

Shifting between fixed and floating

In addition to the drawdown in absolute MBS holdings, the shape of bank demand has morphed as well. US depositories have materially shifted purchases away from longer duration, more negatively convex fixed-rate MBS for floating-rate CMOs. To some extent, floating-rate demand has been driven by greater nominal yield available in CMO floaters than shorter duration fixed-rate cash flows. As the Fed begins on a path to lower front-end benchmark rates, the expectation is that banks may begin to layer in some short duration, well structured fixed-rate exposure as yields on those cash flows exceed those of floaters. With that said, it appears likely that floaters will remain an integral part of depositories’ MBS portfolios going forward.

Implications for broader MBS

The changing shape of bank demand has implications for broader MBS valuations. Absent large scale net incremental demand from depositories, a scenario which seems remote, the MBS basis is likely to remain range-bound. Greater demand for convexity from bank portfolios, coupled with the potential for runoff from the Fed portfolio to ultimately be reinvested in Treasuries, may cause the quality of the TBA deliverable to worsen. Worsening of TBA should, all else equal, be constructive for specified pool valuations with the greatest benefit likely being realized in lower pay-up current coupon stories.

Other implications for MBS valuations include a potential widening in spreads in mortgage derivatives and down-in-coupon MBS. Perpetual demand for floating-rate CMOs from depository portfolios will likely result in floater spreads tightening, derivative spreads widening or some combination thereof. Anecdotally, increased demand for CMO floaters from depositories has driven greater amounts of derivatives being retained by dealers. Over the past two years, balances of non-pool government and GSE MBS on dealer balance sheets has swelled by roughly $10 billion, representing a 50% increase (Exhibit 2). Given this, dealers may have increasingly limited ability to position more derivative risk which may translate to wider spreads on derivatives going forward if bank demand for floaters holds.

Exhibit 2: Dealers’ CMO holdings on the rise

Source: Santander US Capital Markets, NY Fed Primary Dealer Statistics

Finally, a rally in the long end of the yield curve may drive increased supply of lower-coupon MBS as paring of mark-to-market losses on underwater MBS positions in banks’ Available for Sale (AFS) portfolios may spur an increase in bank selling.  Banks would then look to reinvest into shorter-duration, higher-yielding assets. Recent bank portfolio restructurings have been marked by elevated breakeven time frames, meaning the amount of time it takes for incremental net income to offset realize losses has been fairly protracted, in some cases upwards of five years. Given this, shortening of breakeven timelines should encourage greater bank selling.

Implications for the private-label and whole loan market

Reduced bank appetite for negatively convex assets may express itself in residential mortgage loan holdings as well, potentially paving the way for a bump in prime jumbo private-label MBS issuance. Reduced bank appetite for negative convexity in their whole loan portfolios can be seen, to some degree, in the basis between conforming and non-conforming jumbo mortgage rates. In the period leading up to the bank failures that occurred in the first quarter of 2023, non-conforming jumbo rates were inside those of conforming mortgage rates. This inverted basis has historically been driven by banks offering below-primary-market rates for larger balance loans to acquire higher net worth customers. Subsequent to those bank failures, the basis between jumbo and conforming rates has widened by over a point from the roughly 50 bp inversion observed in June 2022 (Exhibit 3).

Ultimately, the amount of non-conforming loans that flow to PLS channels will be governed by a number of factors. The cost of credit enhancement implied by the size and spreads on subordinate bonds will impact jumbo economics. The spread back of TBA at which pass throughs trade as well as potential structural arbitrage will impact securitization economics as well. With that said, widening risk premia or certainly the absence of negative SATO on jumbo loans should be constructive for jumbo securitization rates going forward.

Exhibit 3: Jumbo, conforming rates decouple as banks trim negative convexity

Source: Santander US Capital Markets, Optimal Blue, Freddie Mac, St Louis Fed

If banks do begin to reduce exposure to negatively convex, fixed-rate jumbo loans, they may increase exposure to shorter, floating-rate exposures, particularly home equity and HELOC loans. These loans have been on a steady decline in the wake of the GFC and currently represent just 1% of total bank assets. Given large stores of untapped borrower equity, relatively low leverage on newly originated second lien debt and shorter maturities than fixed-rate loans, banks may see these loans as attractive alternatives to jumbo mortgages. One potential headwind to banks adding meaningful exposure in floating-rate home equity loans is the higher risk-based capital that these loans require relative to first lien mortgage debt. Institutions that may be constrained with adding higher risk weighted asset exposures may have limited ability to express the change in mortgage risk appetite through these loans.