Why It's Tough to Find MBS Buyers to Replace the Fed

The Federal Reserve's role as a purchaser of mortgage bonds guaranteed by government-related entities is a hard act to follow.

There are candidates — including real estate investment trusts, foreign investors and banks — but numerous obstacles make them hesitant to jump in right away.

"A lot of it has to do with the new regulatory influence," Steven Abrahams, a managing director at Deutsche Bank, said at the Mortgage Bankers Association's secondary market conference last month.

The trading volume of Fannie Mae, Freddie Mac and Ginnie Mae securities is trending downward largely because of regulatory constraints. The Fed after all has been a significant player in the market since the crisis, government officials have pressured Fannie and Freddie to curtail their securities portfolios, and broader financial reforms have restricted securities trading.

The system has its quirks, too. For example, Freddie Mac's securities trade at a discount to larger rival to Fannie Mae's, a concern regulators are working to address gradually.

But concerns about that differential are overblown, said Laurie Goodman, director of the Housing Finance Policy Center at the Urban Institute. Regulators are trying to close the gap between Fannie and Freddie securities pricing, in order to improve liquidity. And that gap is smaller than the differences among the prices of bonds backed by loans from originators with varying degrees of prepayment risk, something that is more or less an accepted characteristic of the market.

Moreover, the securities have some major selling points, experts said. Government agency MBS liquidity is far stronger than that of many other types of bonds, such as corporates.

"Mortgage securities are still among the most liquid assets on the planet," Abrahams said.

And Goodman cautioned that it is too early for the issue to cause a panic. Though it is winding down purchases, the Fed is still restocking its agency-debt and MBS portfolios with newer MBS. It could taper these reinvestments starting in early 2016.

"This is a problem over time," Goodman said. "It's not an immediate problem."

So what will it take to draw in the reluctant buyers?

Money managers and REITS could increase purchases under certain conditions, she said.

REITs "have to get returns" for this to happen, said Stan Middleman, president and chief executive officer of Freedom Mortgage Corp., which has a REIT affiliate.

Investment in MBS by REITs was more than $274 billion in the first quarter, representing a $1 billion decline quarter over quarter, according to a Credit Suisse report.

"REITs have continued to take a cautious approach heading into a potential Fed-hiking cycle," researchers said in the report. The Fed could increase the Fed funds rate "toward the end of the year," Frank Nothaft, CoreLogic's chief economist, said in a recent interview.

The Federal Housing Finance Agency has proposed banning captive insurers from being members of the Federal Home Loan Bank System, which could affect REITs' MBS purchasing power. That is because some REIT-owned captives are members and rely on the system's financing.

Also, REITs are heavily dependent on repurchases of MBS as a source of financing, and repurchases are likely to get more expensive thanks to increased regulation.

Foreign investors also like MBS but have been allowing some of their investments to roll off, and banks have been "in and out of the market," said Michael Fratantoni, the MBA's chief economist and the author of a report on prospects for MBS ownership.

The extent of financial services giant Bank of America's interest will largely be determined by the "accounting classification" the securities get as well as the attractiveness of competing asset classes, said Avi Sengupta, senior vice president of mortgage analytics in the bank's chief investment office.

Banks are likely to be in the market for MBS but they are less interested in the collateral mortgage obligations they historically invested heavily in. CMO issuers offer investors a range of long- and short-term maturities, while typical MBS provide cash flows that can extend as long as 30 years.

It has been unclear under new liquidity-coverage-ratio requirements, which regulators instituted to ensure banks have some assets they can readily sell, whether CMOs can count toward their ratios. Ginnie Mae pass-throughs get better liquidity-coverage treatment than Fannie and Freddie securities.