By the Numbers
Bank demand supportive of low pay up, loan balance collateral
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Bank demand has helped drive a multi-year record for CMO issuance last month, with banks continuing to favor floating-rate exposure over fixed. The Street is structuring most floaters off generic current coupon pass-throughs and certain loan-balance specified pool stories. Spreads and pay-ups should remain well supported for these cohorts if bank demand remains strong.
Total assets across US depositories grew by nearly $90 billion from December 25 to January 24, according to the Fed’s H.8 report, and currently sits at nearly $24 trillion. Residential mortgage exposure comprised more than half of that growth with banks adding $26 billion in residential mortgage loans and $24 billion in MBS, likely adding duration in the loan book and mainly floating-rate exposure the securities book as unrealized losses still weigh on capital for some larger banks. Bank purchases helped drive elevated CMO volumes, with net demand averaging over $500 million a day in January (Exhibit 1).
Exhibit 1: CMO demand averaged $500 million a day in January
Source: Santander US Capital Markets, FINRA ICE Data Services (TRACE)
Depository demand for floaters was likely driven by a combination of attractive relative value compared to competing floating-rate structured products and a less dovish outlook for future rate cuts from the Fed. January saw issuance tilt towards conventional MBS, which comprised 58% of last month’s issuance. Greater conventional issuance is likely attributable to a few factors including the rally in Ginnie Mae/Fannie Mae current coupon swaps, floater demand from non-depositories and potential surplus risk weighted capital at depositories, given the outlook for a less stringent regulatory regime.
Despite the conventional current coupon mortgage basis trading in a very tight range last month, dealers were able to create CMO floaters at wider spreads as the steepening of the yield curve helped drive inverse IO OAS tighter. Spread widening translated to floaters comprising 60% of total issuance last month with conventional floater supply outstripping Ginnie Mae by roughly $5 billion (Exhibit 2).
Exhibit 2: CMO issuance skews towards conventional floaters in January
Source: Santander US Capital Markets, Fannie Mae, Freddie Mac, Ginnie Mae
Floater buyers migrated down in cap last month with 57% of production localized to 6.0% and 6.5% cap structures. The move down in cap sits in contrast to December issuance where 60% of floaters carried caps of 7.0% or higher (Exhibit 3).
Exhibit 3: Floater buyers moved down in cap last month
Source: Santander US Capital Markets, Fannie Mae, Freddie Mac, Ginnie Mae
Increased lower cap issuance is somewhat surprising given substantially higher forward SOFR rates than in October and November of last year, the last time we saw the majority of production in 6.5% caps and below (Exhibit 4). The migration down in cap may be attributable to a couple of factors. Total return managers may be reaching for more OAS in lower cap floaters as 6.5% cap floaters backed by conventional loan balance collateral offer 10 bp to 12 bp wider OAS than 8.0% cap bonds created off the same collateral. Money managers may also be looking to lower caps as they should, all else equal, tighten more and deliver higher returns than higher cap bonds as the Fed cuts rates. Additionally, depositories may be better positioned to add some duration through lower cap floaters as many have reduced portfolio durations substantially over the past two years.
Exhibit 4: Investors reach for lower caps despite higher forward SOFR rates
Source: Santander US Capital Markets, Bloomberg LP
Generic, loan balance collateral back most CMOs
Conventional CMOs have, for most of the past six months, been backed predominantly by generic collateral. Fannie Mae and Freddie Mac deals backed by the cohort represented 82% and 87% of issuance respectively (Exhibit 5). Demand for generic current coupon collateral has pushed OAS substantially lower. Conventional TBA 6.0% OAS stood at 50 bp at the beginning of November and has subsequently tightened by roughly 15 bp over the course of the past few months as demand for generic collateral increased. Certain conventional specified pool cohorts should continue to benefit from CMO demand as well. Pay-ups on certain higher loan balance cuts, particularly $275,000 and $300,000 maximum loan balance 6.0% and 6.5%s across both conventional and Ginnie Mae may continue to rally as well given substantial floater creation off these cohorts as well.
Exhibit 5: Generic collateral dominates conventional issuance, more loan balance in Ginnie Mae
Source: Santander US Capital Markets, Fannie Mae, Freddie Mac, Ginnie Mae
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