Market Eats Up Rate Increase Despite Illiquidity
August 30, 1999
Most Wall Street participants agreed that the mortgage market had responded very well last week to the Federal Reserve's decision to increase both the federal funds interest rate and the discount interest rate, and many agreed that the past several weeks have signaled a critical turning point for mortgages - one which may ultimately lead to a slightly better outlook in the long-run.
"The reason for the favorable response to the FOMC is that it gives participants assurance that the Fed is proactively mitigating the prospects of higher inflation," said Michael Youngblood, managing director of real estate at Banc of America Securities. "And the confidence that the market has in chairman Greenspan and the FOMC will lead to the expectations over time of lower and more stable interest rates."
The week before last had been a critical turning point for the mortgage market: Spreads had reached the widest levels since 1989, and market players report that these extreme spreads were viewed as a buying opportunity, thereby causing improved participation in the market and tighter spreads overall.
"The tone of the mortgage market is pretty good - we had some really good days this week," said Art Frank, director of mortgage research for Nomura Securities. "The market liked what the Fed did, and then they announced that they were neutral, so that was certainly a positive."
Moreover, insiders see stepped-up agency issuance for the rest of the year, and some even think that, between Fannie Mae and Freddie Mac, the agencies could very easily absorb all net new issuance of agency pass-throughs.
"Furthermore, we've seen good real estate mortgage investment conduit issuance in August, avid demands for planned amortization class bonds, and other well-structured REMIC classes," added Youngblood.
Market Still Ill-liquid'
Unfortunately, there is no end in sight for the illiquid market, participants say. Mortgage markets will remain illiquid because the Street is not willing to allocate more capital to a sector that is now viewed as fully mature, Youngblood explains.
"I do not think that existing dealers will retreat, but think of what has happened," he added. "In recent years, we lost Kidder [Peabody], we lost Daiwa, we lost Nomura, we have seen Salomon and Smith Barney and Citicorp consolidated, removing two more voices from the mortgage market. And against that, we've seen Chase minimize its presence in the market.
"So you can simply look at the numbers and compare the amount of capital at work today relative to any time historically, and we are at or near historically low levels of dealer capital in mortgages."
Moreover, with emerging markets and high yield being so much more lucrative for dealers, it is unreasonable to expect more commitment of capital to these business lines.
Similarly, on the buy-side, agencies are participating across more product lines, continually buying their own pass-throughs and REMICs. According to players, agencies have become major buyers of whole loan REMICs, home equity and manufactured housing securities.
Add to this the fact that the arbitrageurs who were once major holders of mortgages are no longer collectively major holders - including the recent directive to the Federal Home Loan Banks to shed their mortgage-backed securities holdings - and it is hard to be optimistic about prospects for liquidity going forward.
"You have declining liquidity on the buy-side and the sell-side," Youngblood added. "These are mature markets with mature spread relationships, and mature players whom it is exceptionally hard to displace.
"I just don't think the return prospects here will induce major new money or be a magnet for hot money to come into."