'Treasuries on steroids': U.S. banks' mortgage bond trading bonanza

By Kate Duguid and Lawrence White
NEW YORK / LONDON (Reuters) - Wall Street banks are on their way to a record year in revenue from US government-backed mortgage debt trading, industry insider Reuters told Reuters amid the surge in demand - the Federal Reserve battling it out the pandemic and from investors chasing returns.
Home loan trading revenues at the largest global banks - including JPMorgan, Citi and Goldman Sachs - are projected to exceed $ 3 billion in 2020. A source with direct knowledge of banks' trading volumes peaked last year at $ 2.5 billion.
The source has not been identified as the data is not publicly available.
"Buying a mortgage in March was one of the best mortgage trading opportunities since the last financial crisis," said Daniel Hyman, director of MBS Portfolio Management at Pacific Investment Management Company (PIMCO).
The rise in demand and activity has also allowed new names to enter the space. The Bank of Montreal, which acquired mortgage security broker KGS-Alpha Capital Markets in 2018, is now actively trading in mortgage-backed residential real estate securities, or RMBS, according to the source.
The Bank of Montreal and JPMorgan did not respond to a request for comment. Goldman Sachs and Citi declined to comment.
The trade boom is likely to offer US banks a silver lining in an otherwise difficult time given record low interest rates and rising bad debts. You will start reporting on the third quarter results next week. JPMorgan and Citi launch on October 13th.
The Fed's coronavirus stimulus measures are responsible for the mortgage bond rally guaranteed by government agencies Ginnie Mae, Fannie Mae and Freddie Mac, according to investors.
The premiums investors asked for holding these bonds over risk-free government bonds, as measured by the Ginnie, Fannie and Freddie MBS ICE BofA indices, were the largest since the 2007-2009 financial crisis in mid-March. That was just before the Fed announced that it would increase its holdings in the securities known as the RMBS agency.
Since then, the Fed has bought more than $ 600 billion in agency RMBS and spreads have narrowed by more than 50 basis points.

Graphic: The US mortgage trade in March was a golden opportunity - https://fingfx.thomsonreuters.com/gfx/mkt/qzjpqnboyvx/Pasted%20image%201602066583313.png

But the Fed isn't the only one buying. Demand for safe havens rose when the pandemic first hit financial markets and has continued ever since. Investors have joined the RMBS agency, which is government sponsored and at the same time offers a higher yield than government bonds.
Government bond yields have fallen to all-time lows since the Fed cut interest rates near zero.
"Agency MBS are Treasuries on steroids," said Greg Parsons, CEO of Semper Capital Management, a hedge fund specializing in mortgage-backed securities.
Some investors who bought heavily in March are seeing returns more than one percentage point above the benchmark, according to investors. This is a huge return in this interest rate environment. The PIMCO Ginnie Mae fund returned 4.59% for the year to August versus a benchmark of 3.32%.

THE PREPAYMENT RISK
The average daily trading volume in the RMBS agency peaked in March of this year, according to the Securities Industry and Financial Markets Association. New issuance in 2020 hit a record $ 2.6 trillion at the end of September.
Agency RMBS differ from the non-agency variant, which became known for its central role in the 2008 crisis. When a homeowner defaults on a mortgage that is wrapped in an RMBS agency, the agency - Fannie Mae or Freddie Mac or Ginnie Mae - makes up that lost principal amount. However, non-agency RMBS investors absorb the loss.
While defaults are less of a problem, agency-backed RMBS carries a significant risk of borrowers paying the mortgage upfront, shortening the life of the security and reducing the number of installments paid to investors.
Prepayments increase dramatically when borrowers can refinance loans due to low interest rates.
It is precisely for this reason that Semper Capital does not invest in the traditional RMBS agency.
"If there's one specific problem that is limiting the return potential on the agency side, it's that prepayment speeds remain elevated, which is a strong positive for credit quality and performance on the non-agency side, but really price on the agency side hold back, "said Parsons.
But the banks will likely keep buying. Although they may be overtaken by the Fed this year, commercial banks are still the largest owners of the MBS agency for now. During the coronavirus crisis flooded with deposits, big banks used this money for the agency MBS and increased their holdings to 2.3 trillion US dollars, according to the Fed.
"If you talk to a Wall Street company, they're making a lot of money right now selling to banks," said Ken Shinoda, portfolio manager at DoubleLine, who manages strategies that invest in both agency MBS and non-agency MBS .
"There's just an insatiable demand for agency mortgages from all custodians. And deposits have increased. Saving rates have increased. Everyone is hoarding cash."

(Adaptation by Carmel Crimmins)
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