Mortgage Bonds Vulnerable as Bank Demand Wanes

Fri Mar 11, 2005 11:39 AM ET

NEW YORK (Reuters) - A top executive at one of the nation's largest banks confirmed what many in the mortgage bond market have been fearing: There is waning demand for mortgages among commercial banks.

SunTrust Banks Inc. Treasurer Gary Peacock said Thursday that while he does not expect the bank to aggressively sell mortgage-backed securities (MBS) down the road, he does anticipate letting mortgage assets run off of the portfolio as they reach maturity.

"It is a possible risk that when loan demand grows they (banks) are going to be forced to sell MBS," he said at the Reuters Banking Summit.

SunTrust tends to keep shorter duration assets on its portfolio, such as hybrid adjustable-rate mortgages as opposed to 15- and 30-year fixed rate mortgages.

At the summit, held at Reuters offices in New York, Peacock said that as the U.S. economy picks up steam, it is inevitable that funds will be redeployed into business lending and away from mortgages.

The Atlanta-based bank has been a substantial buyer of MBS, ranking 11th in the nation at the end of the fourth quarter of 2004, with $18 billion of MBS on its books, according to JP Morgan.

SunTrust tends to keep shorter duration assets on its portfolio, such as hybrid adjustable-rate mortgages as opposed to 15- and 30-year fixed rate mortgages.

An improving U.S. economy is expected to boost demand for bank commercial and industrial (C&I) loans. To fund these loans, banks may opt to stop buying or shed their massive holdings of mortgage bonds.

That's unwelcome news to investors in the $4-trillion plus mortgage-backed securities (MBS) market since the loss of these key buyers could herald a longer-term drop in MBS prices.

"Many times we have seen banks exit the market, and sell, not just slow buying, when they feel rates are headed higher," said Bill Chepolis, senior MBS strategist, fixed income group, at Deutsche Asset Management in New York. "Right now the supply/demand factor in the (mortgage) market is more driven by the lack of supply...if demand from banks evaporated, then MBS would trade poorly."

The U.S. banking industry has benefited from massive growth in the mortgage sector that was fueled by record-low interest rates and the strongest housing boom in U.S. economic history.

This coincided with a substantial reduction in commercial and industrial (C&I) loan demand, leaving banks with plenty of excess cash to invest.

With interest rates at record lows, banks invested in the fixed income market through "carry" trades, transactions which involve borrowing at low, short-term rates and buying longer-dated investments, such as MBS and Treasury bonds.

But with the Federal Reserve on track to continue its policy of monetary tightening, that lucrative trade is quickly losing its luster.

That, coupled with recent increases in C&I loan demand, could be a harbinger of lower bank MBS holdings.

FANNIE, FREDDIE SUPPLY PRESSURES

MBS have been languishing in recent weeks on expectations of heavy supply and lower demand from two of the mortgage market's biggest players, Fannie Mae and Freddie Mac .

Fannie Mae said late-February that it plans to deleverage its mortgage portfolio to meet its 30 percent capital surplus requirement by its regulator, the Office of Federal Housing Enterprise Oversight, as it faces a massive restatement of earnings.

The mortgage giant will need to reduce its retained portfolio from $890.8 billion reported at the end of January to $825.8 billion by the end of September, according to Citigroup research.

That is on top of the $6.4 billion of mortgage securities Fannie Mae sold in January. Freddie Mac has also been an active seller, dumping $7 billion in the same month.

To Deutsche Asset Management's Chepolis, who oversees approximately $25 billion in MBS, this is not a positive development for MBS.