The Big Idea

The rising role and risk of dealers in MBS

Steven Abrahams | October 25, 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.

Through the latest episode of Fed QT, primary dealer exposure to MBS through outright gross positions and financing has grown much faster than the outstanding MBS market. While the reason for the surge is hard to pin down, it has put more paper in leveraged positions subject to value-at-risk limits. If positions continue to grow and especially if falling rates accelerate run-off of MBS from the Fed portfolio, it could be a recipe for higher MBS spread volatility.

Federal Reserve numbers show primary dealers’ gross positions in MBS have jumped from $571 billion in May 2022 to $1.06 trillion at the end of March this year, a 91% gain (Exhibit 1). That absolute exposure as well as the growth in that exposure is almost certainly greater than primary dealers’ net position since most dealers hedge MBS pools with TBA contracts. Nevertheless, Fed numbers on net exposure shows a 17% increase through March this year and a 54% increase into October. Meanwhile, primary dealer financing of MBS has run from $165 billion to $281 billion, a 70% gain. To put this increasing exposure in context, agency MBS outstanding, net of securities in the Fed portfolio, has moved up only 8%. Dealers have clearly picked up a significantly larger share of gross outstanding MBS outside the Fed portfolio.

Exhibit 1: Dealers’ gross positions and financing of MBS has jumped with QT

Source: Cochran, P., and L. Petrasek, Z. Saravay, M. Tian and E. Wu (2024), Assessment of Dealer Capacity to Intermediate in Treasury and Agency MBS Markets, FEDS Notes, Washington: Board of Governors of the Federal Reserve System, October 22, 2024.

The current accumulation of gross MBS positions stands out against both average dealer behavior since 2012 and behavior during earlier periods of Fed QT. Recent work by the Fed staff shows that for every $1 increase in agency MBS held by the public from March 2012 to March 2024, primary dealer gross positions grew an average of 10.5 cents. During the QT running from 2017 to 2019, a $1 increase in publicly held MBS lifted dealer gross exposure on average by 1.8 cents. During the current QT, a $1 increase in publicly held MBS has bumped dealer gross positions up by an average of 37.4 cents. The current episode is showing unusual dealer response to rising public MBS supply.

Dealer financing of MBS also shows that something has changed with the current round of QT. Dealer financing of MBS from March 2012 to March 2024 actually declined on average by 7.7 cents for every added $1 of publicly held MBS. During QT from 2017 to 2019, financing increased on average by 4.7 cents for every added $1, and in the latest round financing has increased on average by 11.7 cents for every added $1.

The increase in MBS exposure also stands out against a relatively muted dealer response to increasing supply of Treasury debt outside the Fed portfolio during current QT, something mainly happening because of rising federal deficits. From May 2022 through July 2024, primary dealers’ gross positions in Treasury debt rose from $738 billion to $819 billion, an 11% increase. Exposure to Treasury financing rose from $2.47 trillion to $2.66 trillion, an 8% increase. Meanwhile, marketable Treasury debt beyond the Fed portfolio rose 20%. Dealers have lost share in the Treasury market.

Exhibit 2: Dealer gross positions and financing has lagged Treasury supply

It would probably be a mistake to attribute all of the sharp rise in dealer exposure to MBS to QT. Other factors likely play a roll, too. In particular:

A sharp decline in MBS holdings at US bank investment portfolios from 2022 through 2023, adding to public supply of MBS, and
A drop in special financing in the TBA market since the end of QE, allowing dealers to hold pools, hedge with TBA contracts and generally collect more carry, an incentive to holder larger positions
A steady improvement in recent years in the supplementary leverage ratio at the biggest banks, which happen to be the parents of the biggest primary dealers and which could allow those dealers to hold larger positions in any securities

Nevertheless, the surge in dealer exposure to MBS puts a rising share of the market in hands that hedge the interest rate risk and are subject to value-at-risk limits on leveraged positions. Dealer hedging is unlikely to have much impact on broader rate volatility, but VaR on a rising balance of leveraged MBS positions could have a bigger impact.

One place where the impact of VaR limits would likely show up is in MBS spreads, where the need to get back inside VaR limits could add to spread volatility. In fact, spread volatility in MBS has been relatively elevated for most of the period of QT (Exhibit 3). The monthly standard deviation of 30-year par coupon OAS ran around 2 bp a day before QT but then jumped to two or three times that during QT. Only lately has it returned to pre-QT levels, likely as bank demand has started to absorb some of the public supply.

Exhibit 3: OAS volatility picked up after QT started in mid-2022

Note: data shows the rolling 20-session standard deviation of daily changes in OAS on the 30-year conventional par coupon MBS.
Source: Bloomberg, Santander US Capital Markets.

Dealer’s gross holdings of MBS are likely to rise as QT continues, and that could set up the market for a return of material MBS spread volatility if either rates begin to move sharply or if refinancing speeds up the run-off of MBS from the Fed portfolio, adding to public supply. The movement of MBS from the Fed to dealers has added some contingent risk to the market.

* * *

The view in rates

The rise in rates through October is starting to make things more interesting. The market seems to believe that elevated risk of federal deficits and an inflationary impact from tariffs justify the yields. But because the federal government has influence through the annual appropriations process on less than 30% of the federal budget, the marginal impact of the election is likely to be small. The impact of tariffs could nudge up inflation, but the Fed would likely respond to that and bring long-term inflation back to target. The flattening of the curve makes sense, but the level of rates—especially at longer maturities—does not, at least in the long run.

Other key market levels:

Fed RRP balances closed Friday at $227 billion, down $33 billion in the last week. Since the Fed dropped policy rates by 50 bp on September 18 and set the RRP rate at 4.80%, balances initially jumped as T-bill yields dropped well below RRP yields. But in the last few weeks repo rates for general Treasury and MBS collateral have far exceed RRP, drawing balances away from the Fed facility.
Setting on 3-month term SOFR closed Friday at 460 bp, down 3 bp on the week.
Further out the curve, the 2-year note closed Friday at 4.10%, up 16 bp in the last week. The 10-year note closed at 4.24%, up 17 bp in the last week.
The Treasury yield curve closed Friday afternoon with 2s10s at 13 bp, unchanged in the last week. The 5s30s closed Friday at 43 bp, flatter by 8 bp over the same period
Breakeven 10-year inflation traded Friday at 229 bp, down 2 bp in the last week. The 10-year real rate finished the week at 195 bp, up 18 bp over the last week.

The view in spreads

Implied rate volatility continues to rise. Investors are primarily questioning the pace of Fed easing, although election concerns get airtime, too. That is a marginal negative for spreads in risk assets. The Bloomberg US investment grade corporate bond index OAS nevertheless closed Friday at 82 bp, wider by only 3 bp on the week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 154 bp, wider by 11 bp for the week. Par 30-year MBS TOAS closed Friday at 53 bp, wider by 11 bp over the last week.

The view in credit

Fundamentals for consumer and corporate credit still look relatively good. The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding so falling rates have limited immediate effect. Unemployment is showing signs of plateauing for now, and high levels of home equity and investment appreciation should buffer any stress on consumers. Leveraged and middle market balance sheets are vulnerable, although leveraged loan defaults and distressed exchanges have plateaued in recent months. Commercial office real estate looks weak along with its mortgage debt.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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