Why Such Illiquidity?


By Laurie Goodman, director of mortgage research at PaineWebber Inc.

The mortgage market is molti illiquid. Actually, the market for all fixed income products is very illiquid. We believe that most of the reason for this is simple - risk aversion on the part of the dealer community, coupled with low volume on the buy side.

Dealer Positions

Let's start with the state of dealer inventories. They are down. Way down. Dealers are also taking less risk in hedging their inventories, and switch-hitting over to hedging spread product with other spread product.

Net dealer positions in mortgage-backed securities were very high last September and October, according to data compiled by the New York Federal Reserve. This information is compiled on a weekly basis. Within the tabulation, when a dealer holds a mortgage hedged with a mortgage, the net dealer position is zero. A mortgage security hedged with a Treasury security results in a net dealer position equal to the nominal holdings.

Dealers were holding sizeable inventories, and most hedging was with Treasurys. Dealers also ran match-funded positions using mortgage-backed securities as a hedge. (Simple example: A dealer enters a total-rate-of-return swap with a hedge fund, in which the dealer pays the total-rate-of-return on the mortgage-backed security and receives LIBOR. Essentially, the proceeds of the mortgage-backed security held as a hedge are simply passed through.)

Look at what has happened since. Dealers lost a lot of money last September and October. As a result, dealer risk profiles dropped. Dealers started holding less inventory, and began to hedge what they did hold with other spread product. Match-funded positions were reduced as hedge funds downsized and mortgage swaps were unwound.

The result? Net dealer positions have gone down dramatically.

Wide Swap Spreads

Meanwhile, swap spreads look very wide for a market in which there is no real flight to quality. As dealers increasingly used swaps to hedge fixed-rate dealer positions, fixed payers have increased, thus widening spreads.

We have heard market participants argue that swap spreads are not all that wide. They believe that swap spreads look wide because on-the-run Treasurys have gotten very special in the repo market. The richness of current Treasuries in the repo market means the securities will sell at a lower yield than surrounding issues, making nominal swap spreads appear wider. The reality, however, is that swap spreads are wide, even relative to off-the-run issues.

Light Buy Side Activity

Investor activity in the mortgage market has been light, which is compounding the dealer community's changing fundamental risk profile. In particular, banks and agencies, which command almost half of all mortgage holdings, have been less active. Depository institutions account for 30.3% of the outstandings, the Fannie Mae and Freddie Mac portfolios another 16.1%, and Federal Home Loan Banks another 2.5%. Thus banks and agencies represent 48.9% of total outstandings.

Banks are not buying because prepayments are way down and loan demand is up. Moreover, they seem content with accumulating small amounts of cash. They don't believe the market is going to run away.

The agencies have been less active because their costs of debenture issuance have risen as least as much as mortgage-backed securities have cheapened. Thus, while mortgages are cheaper to Treasury securities, they are not cheaper to the agencies' funding costs.

The FHLB also fear that a proposal expected later this month could constrain future purchases of mortgage-backed securities. Bottom line? In short, nearly 50% of the market is less active.

What Lures Liquidity Back?

It's not a pretty picture. Dealers are not carrying large positions. If they do not have an order on the other side and must position the security, the bid/ask spread will be much wider than six months ago. There are simply fewer buyers - hence positioning risk is larger. Wider bid/ask spreads then crimp turnover. Investors are less apt to do that marginal trade with a wider bid/ask spread. This, in turn, diminishes trading volume, making price discovery more difficult, and bid/ask spreads even wider.

What incentive do dealers have to carry larger inventories? Not much. They might if investor volume picked up, or if they thought mortgages would tighten dramatically. However, investor volume is showing signs of being light the rest of the year, particularly with Y2K threatening to dry up activity in the fourth quarter. Meanwhile, mortgages look fairly priced versus other spread product.

Obviously, the liquidity situation will change at some point, but we can't be sure how soon. If any one investor group starts buying, things could change quickly.

For example, if the market were to rally more, pushing bank investors back into the market, volume would pick up. This would cause spreads to tighten, and market makers would be more comfortable holding larger inventories.

What's An Investor To Do?

Liquidity will improve at some point. Sit tight, and go for "liquid" with any new purchases. You can always move into less liquid securities when there is a compelling opportunity.