Yields at about two-year highs are failing to entice U.S. banks to add to their $1.35 trillion of government-backed mortgage securities holdings as lenders respond to changing regulations and price swings sparked by the Federal Reserve.
After soaring more than $300 billion over the previous two years, commercial banks’ investments in agency mortgage bonds have been “remarkably flat” over the past 12 months, according to JPMorgan Chase & Co. analysts. A Fed measure based mainly on market values shows a decline of $25 billion, or 1.8 percent, in the seven weeks ended July 24, exceeding a 1.3 percent drop in average prices.
Weaker bank demand, even with average yields up almost 1.4 percentage points from this year’s lows, is hampering the $5.5 trillion market, increasing borrowing costs for consumers seeking to buy homes or refinance. Rules that mean unrealized losses will erode capital at the largest banks will keep lenders from purchasing at their typical pace while rates are rising, according to Nomura Securities International.
“Depository institutions are proving reluctant to invest right now,” said Adam Yarnold, the head of U.S. securitized product trading in New York at Barclays Plc, the third-largest underwriter of collateralized mortgage obligations.
Home-loan securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae have lost 0.02 percent since the end of June, compared with gains of 0.52 percent for U.S. investment-grade corporate bonds, Bank of America Merrill Lynch index data show. Mortgage debt lost 1.9 percent last quarter, the worst period since 1994, while high-grade bonds declined 3.4 percent.
Holdings at Bank of America Corp. swung to a net paper loss of $2.3 billion as of June 30 from a $3.4 billion net unrealized gain at the end of March.
The attractiveness of the low-risk weightings of the debt under certain capital rules also may be reduced, according to Bank of America analysts led by Chris Flanagan and Satish Mansukhani. Proposed rules may cut purchases by the eight largest banks, which account for 45 percent of total holdings, by lowering the firms’ borrowing limits relative to equity under calculations without adjustments for asset type, they wrote.
Smaller banks that would be exempted from both rules also have grown more cautious, mindful that mortgage securities pay down slower as higher interest rates reduce refinancing, said Jeffrey Caughron, a partner at Baker Group LP in Oklahoma City who advises community banks on more than $42 billion of investments.
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. increased, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbing 1.1 basis points to a mid-price of 73.9 basis points as of 11:28 a.m. in New York, according to prices compiled by Bloomberg.
The measure typically rises as investor confidence deteriorates and falls as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of debt market stress, rose 0.32 basis point to 17.88 basis points as of 11:28 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.
Bonds of Citigroup Inc. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3 percent of the volume of dealer trades of $1 million or more as of 11:29 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
In the U.S. agency mortgage bond market, the lack of purchases by banks is helping to limit gains even as the Fed continues its own buying of the securities while signaling it may slow them and sales tied to planned issuance fall.
Average yields on agency mortgage bonds ended yesterday at 3.03 percent, up from this year’s low of 1.62 percent on Jan. 9 and after reaching 3.33 percent on July 5, the highest level since July 2011, Bank of America Merrill Lynch data show.
Monthly issuance of fixed-rate mortgage bonds will fall to about $90 billion with homeowner refinancing at current levels, down from about $150 billion in the first half of 2013, according to BNP Paribas SA. Fed buying, including $40 billion of new purchases and reinvestments of proceeds from past holdings, will likely fall to $55 billion, assuming no tapering, from $69 billion, the bank estimated in an Aug. 1 report.
Dealers are now seeing about $2 billion to $2.5 billion in daily forward sales by originators in preparation for future issuance, compared with Fed purchases of about $3 billion to $3.5 billion, according to Yarnold of Barclays.
“Every day, there’s just a little more being taken out of the market,” he said in a telephone interview.
At the same time, money is flowing out of mortgage-focused mutual funds, with $10 billion of redemptions last month, the second-most since the start of 2011, according an Aug. 2 report by JPMorgan analysts led by Matt Jozoff.
Mortgage real-estate investment trusts sold as much as $40 billion of the securities last quarter to reduce borrowing, and a slump in their shares is “effectively shutting new capital raising and curtailing near-term demand for agency MBS” from the firms, Barclays analysts led by Nicholas Strand wrote on Aug. 2.
The biggest U.S. banks’ capital standards would rise to 5 percent of assets for parent companies and 6 percent for their banking units under a July 9 proposal by regulators including the Fed and Office of the Comptroller of the Currency.
Under separate risk-based rules, Fannie Mae and Freddie Mac securities are counted at 20 percent of acquisition cost and Ginnie Mae debt at zero.
The regulators approved final rules last month requiring bank capital to adjust with losses now recognized only in an accounting line known as accumulated other comprehensive income. The change, which allows small banks to opt out, will start next year and be phased in through 2018, according to Nomura analysts led by Ohmsatya Ravi.
Bank of America held about $257.7 billion of agency mortgage bonds on June 30, up from about $254 billion on March 31, based on quarterly disclosures, which don’t detail about $50 billion in “held-to-maturity” investments except to say they’re “substantially all” the debt.
Wells Fargo & Co. (WFC:US) has been “disciplined during periods of lower rates and we were prepared to deploy liquidity as rates rose” last quarter, Chief Financial Officer Timothy Sloan said on a July 12 conference call (WFC:US).
The bank purchased $21 billion of “primarily” agency mortgage securities for its available-for-sale portfolio and $6 billion more early last month, he said. The company’s agency mortgage-bond holdings climbed $5 billion to $110.6 billion last quarter, potentially reflecting repayments on existing holdings, according to its disclosures.
Some planned regulations may boost demand at banks for agency mortgage securities. The debt may prove attractive to lenders that need to hold more easily traded assets, according to Barclays analysts. At the same time, the rules may fail to treat repackaged bonds known as CMOs as generously as pass-through notes.
Jerry Dubrowski, a spokesman for Charlotte, North Carolina-based Bank of America, Justin Perras of JPMorgan in New York and Ancel Martinez of Wells Fargo in San Francisco, declined to comment on the banks’ investment strategies.
While smaller institutions are seeing higher yields as a signal to buy certain mortgage bonds with the Fed committed to holding down short-term borrowing costs, the lenders don’t want to be stuck with notes as refinancing declines, Baker Group’s Caughron said.
The average duration of agency mortgage securities has extended to 5.2 years, from 3.2 years at the end of April, Bank of America data show.
“People who don’t care about the price volatility will still care about the cash flow characteristics,” Caughron said.
While BB&T Corp. is happy to be reinvesting proceeds from past purchases at about the same yields as it originally booked, the lender is maintaining the portfolio’s size and its mix of debt with a variety of durations, CFO Daryl Bible said.
BB&T, with $183 billion in assets, is sticking with its previous strategy because it doesn’t know where the economy and yields are headed, Bible said in a telephone interview. The Winston-Salem, North Carolina-based bank also needs to pay attention to new regulations even though they don’t yet apply to the lender, he said.
“We’re one of the largest banks just under the $250 billion-asset threshold,” Bible said. “So you don’t know when you’re going to cross that threshold, but you have to manage it like you’re going to cross it at some point down the road.”
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