By the Numbers
Sizing up bank demand
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 spreads have snapped tighter since the beginning of the month, spurred in part by lower volatility and anecdotally by bank demand. Prospects for higher rates, a steeper yield curve and less regulation should encourage net demand for MBS. And if more of the MBS float were to migrate from actively managed portfolios to depository balance sheets, it could reduce volatility, all else equal. Heightened demand paired with lower volatility would continue to drive MBS spreads tighter, particularly against potentially elevated mortgage rates and lower net supply.
A steeper curve brings banks, REITs
While a parallel shift lower in rates would likely be a headwind to bank demand for MBS, higher rates and a further steeping of the yield curve driven by an anticipated increase in Treasury supply under the Trump administration could signal increased bank demand. Both near- and longer-term observations suggest that a steepening of the curve would spur a continuation of recently elevated levels of activity.
Exhibit 1: Bank demand rises as the yield curve steepens.
Source: Santander US Capital Markets, Federal Reserve H.8, Bloomberg LP
Over a 5-year horizon, MBS holdings across US depositories surged when the curve steepened and waned as the curve flattened, generally with some lagged effect. Admittedly, other factors have weighed on bank demand over this observation period, particularly the influx of excess liquidity during Covid and the de-risking of investment portfolios after the failure of Silicon Valley Bank and other depositories in the first quarter of 2023. However, looking at recent buying patterns suggest that banks will continue to add MBS when both rates rise and longer rates de-couple from short-term ones (Exhibit 2).
Exhibit 2: Sizing up recent CMO demand
Source: Santander US Capital Markets, FINRA ICE Data Services (TRACE)
Since the start of this quarter, daily net demand for CMOs has surged above the $1 billon mark on two occasions. The first was in the wake of the September non-farm payroll release, which surprised to the upside and pushed both short and longer dated rates higher. The second incident was after last week’s election results which not only pushed rates up but steepened the curve as well. These spurts of bank demand should, at least for now, be viewed as episodic and opportunistic. However, if higher rates and a steeper curve persist, opportunistic demand could become more programmatic.
And while a steep curve should spur greater bank demand, it should especially help net demand from mortgage REITs. A further steepening of the yield curve will not only make the proposition of levering MBS more attractive for REITs, it will, in all likelihood, serve to lift book valuations at these companies, freeing them up to raise additional capital to be levered and deployed.
Gauging the shape of bank demand
Fueled in no small part by less hawkish expectations for the path of Fed rate cuts on the heels of September’s non-farm payrolls reading, banks piled into floating rate CMOs last month. Demand for floaters was roughly double that of any other month over the past six observations with demand split fairly evenly across Ginnie Mae and conventional execution (Exhibit 3). Floaters made up nearly three quarters of total CMO production last month. More than 80% of floaters issued in October had caps of 6.5% or less. However, bank buyers may go up in cap on future purchases given a steeper forward curve.
Exhibit 3: Demand for floaters surges in October
Source: Santander US Capital Markets, Fannie Mae, Freddie Mac, Ginnie Mae
Looking forward, bank demand for floaters may continue to remain elevated, likely complimented by some longer duration fixed-rate exposure. A steep forward curve suggests floaters both have upside to higher yields if the curve is realized and more duration given a greater probability of hitting the cap at some point in the future. Given this, banks may be looking to go up in cap against the backdrop of a steeper curve. Going up in cap will come at the cost of lower margins, especially in Ginnie Mae floaters given the recent performance of Ginnie/Fannie swaps. Given this, it seems plausible that banks will lean more heavily in conventional floaters to recoup some of the margin given up by going up in cap.
The effects of deregulation
While somewhat difficult to quantify, deregulation could be an additional tailwind to bank demand for MBS in the form of surplus capital that otherwise would have been allocated to an enhanced regulatory framework. In comments made in September, Federal Reserve Vice Chairman for Supervision Michael Barr provided guidance that under a revised Basel III Endgame proposal, Tier 1 capital requirements for global systemically important banks (G-SIBs) would still rise by roughly 9%. Smaller banks, broadly defined as between $100 billion and $700 billion in total assets could expect capital requirements to rise by an additional 3% to 4% over the intermediate term. The majority of additional capital for these banks would be earmarked to support unrealized losses on the investment portfolio that these institutions would have to realize in their equity bases, similar to the current treatment for larger depositories.
An attempt to translate potential surplus capital into a net MBS demand figure is tricky for a number of reasons. Given the fact that Ginnie Mae MBS is a 0% risk weighted asset, a bump in risk-based capital likely wouldn’t be the primary catalyst to drive greater net demand absent the potential capital that would need to be held against unrealized future losses should the market value of those bonds drop below their book value. Instead, other factors such contribution to overall balance sheet leverage under the Supplementary Leverage Ratio (SLR) or ROA may be the binding constraint when decisioning whether to add Ginnie Mae MBS. Conversely, surplus capital may create incentives for banks to shift purchases away from Treasuries and Ginnie Mae MBS towards a greater allocation to conventional exposures.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
Important disclaimers for clients in the EU and UK
This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.
This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.
This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.
This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.
