More housing-related write-downs at U.S. banks could push them to sell more of their massive holdings of bonds issued by Fannie Mae and Freddie Mac, hitting the most stable part of the mortgage market.
U.S. banks, the largest holders of mortgage-backed securities (MBS) issued by the two companies, have already written down or taken outright losses of more than $50 billion, rushing their balance sheets and leaving little room for new investments.
Even worse, the losses and write-downs could quickly turn the once-consistent demand from banks into big outright sales, pushing up yields in the $4.3 trillion market, investors say.
The Federal Reserve's slashing of its key federal funds target rate twice in little more than a week has improved the profit outlook of banks. But the cuts will do little to offset problems already in place, analysts say.
"The Fed action improved funding issues at banks, but they are still recovering from poor investment decisions and dealing with more write-downs," said Pankaj Jha, head of mortgage strategy at RBS Greenwich Capital in Greenwich, Connecticut.
"Heavy bank selling is one of the major concerns to the agency MBS market right now," he added.
The rate cuts have widened the spread between short-term and long-term interest rates, a process known as steepening the yield curve. That tends to improve funding levels of banks because they use short-term borrowings to make longer-term investments that pay higher rates.
Indeed, a steeper yield curve and cheaper valuations make mortgages bonds more attractive for banks, but they first must get over their current balance-sheet constraints, according to Morgan Stanley.
"However, we believe it will take the larger part of 2008 before one can reasonably expect bank balance sheets to become unencumbered enough to resume purchases of MBS," the investment bank said in its 2008 Mortgage Outlook.
The agency MBS market captured the lion's share of issuance in 2007, and loan origination in non-agency mortgages dropped sharply as mortgage credit troubles spread.
Agency MBS are widely considered to be the most liquid sectors in the fixed-income markets. With large amounts on balance sheets, agency securities are prime candidates for selling to alleviate capital pressure at banks.
Fannie Mae and Freddie Mac are shareholder-owned companies charged by Congress with supporting housing by keeping money flowing in the mortgage market.
To do this, they sell debt and use the proceeds to buy mortgages from lenders, which gives lenders money to make more loans. They then repackage the loans into securities for sale to investors. They also hold loans and securities in their portfolios.
The biggest roadblock to new investments by banks right now is a bailout of their Structured Investment Vehicles, or SIVs, which ran into trouble because of fears about the extent of their exposure to subprime mortgages. Citigroup alone said in December it would bring $46 billion of SIV assets on to its balance sheet, a move that will likely cut its appetite for agency MBS.
"Banks have been grappling with all the exposure they have had to SIVs and subprime, and that is limiting the amount of money they have to invest in their securities portfolio," Jha said.
Banks dominate the MBS market, with a market share of 21 percent in 2007, followed by Fannie Mae, Freddie Mac and Ginnie Mae, which have a total 17 percent share, Jha said.
Even though there are over 8,000 domestic banks and thrifts, a handful own the majority of mortgage bonds.
Bank of America had the largest MBS portfolio, with about $152 billion at the end of the third quarter, followed by Wachovia with around $82 billion.
Bloated Balance Sheets
"In the past, banks put a lot of agency MBS on their books when they did not have any other place to invest funds, so they just thought of it as a temporary parking place," said Christopher Sebald, chief investment officer at Advantus Capital Management Inc, in St. Paul, Minnesota.
Bank demand for agency MBS was voracious in previous years.
They had an excess of cash available to invest as business loan demand dropped. But their appetite waned in 2007.
Large and small U.S. banks decreased their holdings of MBS by about $40 billion in 2007, to $907 billion, according to Federal Reserve data. That is in stark contrast to 2006, when positions increased by around $69 billion.
In 2007, commercial and industrial loans climbed by about $254 billion and whole loan holdings, or loans that are not securitized, rose by about $223 billion. Bank deposits increased by about $536 billion in 2007.
Banks have also shifted away from mortgages to focus on more lucrative businesses such as commercial and industrial loans. Banks typically prefer making loans over buying agency MBS because it does more to bolster their profitability.
Sebald, who oversees a $13 billion in fixed-income investments, said banks may not return to the agency MBS market on a large scale even when things get better for them. He expects them to prefer other options such as straight loans.
Potential MBS sales by banks is one of the reasons why he is "neutral to negative" on the sector.
"The first half of the year banks will be gone from the market and I would be surprised in a pleasant way if they come back sooner, but realistically it is going to be tough for them," RBS Greenwich Capital's Jha said.