By the Numbers
Weighing in on bank demand for MBS
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.
While steadily declining interest rate volatility has helped tighten MBS spreads recently, many market participants would argue that the next meaningful leg tighter needs more MBS demand from banks. The most likely scenario for that would be a tightening of credit availability, lower rates and a steepening of the yield curve against the backdrop of a weakening economy. Absent that, demand looks likely to be tethered to overall asset growth, as MBS holdings appear to be right-sized in the context of institutions’ balance sheets.
MBS investors have been forced to deal with a new normal over the past two or more years. For years before then, elevated demand for MBS from both the Fed and banks would routinely push spreads tighter, taking total return managers and hedge funds along for the ride. And in dislocated markets, that demand would provide a backstop, limiting how much MBS spreads could widen. Fast forward to the new normal and the Fed is slowly reducing their mortgage holdings by reinvesting pay downs in Treasuries, and depositories have been faced with the stark realization that outsized, negatively convex MBS exposures can be one factor that could force a bank into receivership.
Sizing bank demand historically
One way to evaluate the current size of banks’ MBS holdings is to look at the support that depository balance sheets have provided to the MBS market historically. At the end of the first quarter of this year, banks held just over 27% of outstanding agency MBS and debt. That reading is consistent with banks’ market share prior to Covid, before surging to a whopping 35% of the outstanding universe in the third quarter of 2021 and remaining there for three quarters (Exhibit 1).
Exhibit 1: Bank support of the MBS universe reverts to pre-Covid levels
Source: Santander US Capital Markets, Federal Reserve Z1 Report
The above suggests that the peak in depository holdings of MBS were an artifact of extremely elevated levels of monetary stimulus coupled with generationally tight levels of credit availability through 2020 and into 2021. Much of the roughly $7.7 trillion in monetary stimulus enacted by the Federal Reserve through the pandemic found its way to bank balance sheets in the form of deposits, as that excess liquidity remained uninvested against the backdrop of heightened economic uncertainty.
That same uncertainty precluded banks from making loans, leaving them in the unenviable position of facing a deluge of deposit inflows with scant few new assets to pair against them to maintain their net Interest margin. In response, banks’ investment portfolios ballooned under the weight of those deposit inflows, suggesting that these elevated levels of bank holdings were episodic and idiosyncratic in nature, and unlikely to be realized again in the near future.
Drivers of growth
If history suggests that current bank MBS holdings are to some degree ‘right-sized,’ then growth in bank portfolios is likely to come from either net growth of the MBS market, growth in depository balance sheets or some combination thereof. As evident during 2020, balance sheet growth was driven more so by the liability side of the balance sheet. And the longest standing and most consistent predictor of deposit growth has been the negative correlation between the level of rates and the velocity of deposit growth. Said another way, bank deposits tend to grow faster as interest rates are falling and slower when they are rising (Exhibit 2).
Exhibit 2: Bank deposits grow as interest rates fall
Source: Santander US Capital Markets, Federal Reserve H.8
Bank deposits grow as rates fall for a couple of reasons. Most obviously, if benchmark rates are low, the opportunity cost of being uninvested is as well. And both individuals and institutions are more likely to leave funds on deposit at a bank rather than in a money market or mutual fund. Furthermore, low rates are generally consistent with a slowing economy and correlated underperformance in risk assets, another reason deposits both grow and remain sticky in lower rate environments. Given this, the most likely scenario that would drive substantially greater demand from banks for MBS would be a significant economic slowdown that would trigger an aggressive Fed cutting cycle.
Other considerations
There are certainly other factors that could skew bank demand. Lighter touch bank regulations could spur more investment in securities. While changes to leverage ratios and how certain banks account for unrealized losses may be a modest tailwind for bank demand, loosening of the current regulatory framework likely will not trigger a reversion to how banks invested prior to the failures of Silicon Valley Bank and other depositories in the spring of 2023. Those bank failures shed light on how negative convexity on both sides of the balance sheet can leave banks’ duration gaps woefully offsides as assets extend and deposit durations shorten. Those lessons appear to be instilled in banks’ risk culture and shorter duration, more convex exposures appear likely to continue to make up the majority of depository dollars invested in securities. In that vein, recent growth in securitizations of Ginnie Mae ARMs may help spur increased bank demand as ARMs have always been a good fit on bank balance sheets from an asset liability management perspective.
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