The global credit squeeze has extended beyond bonds backed by risky securities to one of the safest asset classes in the world: Fannie Mae and Freddie Mac collateralised mortgage obligations.
Issuance of the bonds guaranteed by Fannie Mae and Freddie Mac, called "agency" CMOs, has plummeted over the past two months as the global credit market crisis dampened demand and siphoned liquidity from the sector, one of the largest segments of the US mortgage-backed securities market.
September's agency CMO tally was its lowest in over seven years and monthly volume has been running at less than half the average monthly pace in 2006. If the trend continues, MBS prices will suffer and Wall Street firms are seen slashing more jobs.
"The plummeting of issuance is a reflection of the marketplace, which is filled with jitters and the desire of people to be more liquid," said Andrew Harding, director of taxable fixed income at Allegiant Asset Management in Cleveland.
"The liquidity of the CMOs is less than pass-throughs, so they are pricing them to sell in a less liquid environment," he said. "The CMOs are cheap relative to pass-throughs and the arbitrage is just not there, so in many instances that is why you cannot do new issues."
US mortgage-backed securities can be sold to investors either through pass-throughs or in structured form, known as CMOs, to meet specific prepayment, maturity, and volatility tranching requirements of investors. Pass-throughs are parcelled out into CMOs. When demand drops for CMOs it can have a direct impact on pass-throughs.
While the dismantling of Wall Street CMO desks has not emerged in full force yet, some firms have been initiating job cuts and more may be looming, according to a Wall Street analyst who asked not to be named.
HSBC Securities USA, for instance, has cut staffing on its agency CMO desk by about half, he said. A spokeswoman for the firm declined comment. "Clearly everybody on Wall Street is worried about losing their job and there are probably more layoffs to come," he said.
The US mortgage-backed securities market has grown exponentially over the past 20-plus years, largely due to the popularity of CMOs. CMOs significantly broadened the investor base for MBS by offering near-US Treasury credit quality among other advantages. Out of the roughly $7 trillion market, which includes the subprime sector, there are about $730 billion in agency CMOs outstanding. But agency CMO issuance has steadily plummeted from $27.9 billion in July - prior to the unravelling of global credit markets- to a mere $9 billion in August and just $4.8 billion in September, according to Matthew Jozoff, head of mortgage strategy at J.P. Morgan in New York.
"Activity in the agency CMO market is still depressed but issuance has picked up from the lows in September," his team said in recent research. September's issuance was the lowest since May of 2000. In 2006, issuance averaged about $25 billion a month. "Almost across the board everything is cheap relative to TBA, so the ability to use collateral to create a CMO is almost completely gone right now," said Brett Rose, director of agency MBS strategy at Citigroup in New York.
Most agency pass-through securities trade on a to-be-announced, or TBA, basis. In a TBA trade, the seller and buyer agree to key terms at the time of the trade, but they do not specify the actual pools to be traded until shortly before settlement, an arrangement that improves market liquidity.
"It will take a while for the market to normalise, which will hopefully be in early 2008," said Rose. Analysts said the CMO market could get a boost if the Federal Open Market Committee, the Fed's policy-making arm, announces a rate cut at the conclusion of its meeting on Wednesday. A rate cut could cause the Treasury yield curve to steepen, which is when the spread between short- and long-term rates widens.