US mortgage-backed securities issued by Fannie Mae and Freddie Mac should underperform US Treasuries again in 2008 as a supply overhang and listless demand threaten the sector's performance.
A confluence of negative conditions as the housing market crumpled severely impacted valuations of "agency" MBS in 2007, with the $4.3 trillion sector set to end the year with the worst performance since 1998.
The global credit market crisis dried up liquidity and caused interest rate volatility to rise, hurting prices on agency MBS in 2007. These negative factors are not seen improving any time soon, while other conditions are expected to worsen in 2008.
"It is definitely very possible we may see a repeat performance next year for mortgages as there seems to be a supply and demand imbalance in fixed-rate collateral," said Nicholas Strand, a manager with the mortgage strategy group at Barclays Capital in New York.
"What is going to weigh on the market is who is going to be the marginal buyer of agency mortgage-backed securities and is the market going to be able to cope with the increased supply next year," he said.
The agency MBS market captured the lion's share of issuance in 2007 as non-agency mortgage origination dropped sharply as buyers fled the sector on growing concerns about mortgage foreclosures.
J. P Morgan is projecting agency fixed net issuance at $530 billion in 2008, which is about 18 percent higher than the $450 billion expected this year.
Commercial banks, government-sponsored enterprises - Fannie Mae and Freddie Mac - money managers and overseas accounts are the biggest buyers of MBS.
Overseas demand out of Asia, in particular, played a pivotal role in the performance of MBS in 2006, but that trend weakened in 2007. A depreciating US dollar diminished demand out of Asia for US fixed-income securities in 2007.
"I think if the dollar stabilises, or strengthens, and our mortgage crisis subsides, you may see more interest from Asia," said Bill Chepolis, senior portfolio manager for Deutsche Asset Management in New York.
Chepolis, who oversees $8.5 billion of bonds, said Asia and banks may get more involved if the market for collateralised mortgage obligations becomes active again.
Collateralised mortgage obligations, or CMOs, are structured with mortgage-backed securities, and are tailored to meet the specific requirements of investors. CMOs can be structured to meet specific prepayment, maturity, and volatility tranching requirements of investors.
Making matters worse, Fannie Mae and Freddie Mac have taken significant losses in the third quarter of 2007 due to provisions for credit losses and has been forced to seek $13 billion of new capital through the sale of preferred stock.
"It is clear the GSEs are not in the position to grow their mortgage portfolios," Barclays Capital's Strand said.
The GSEs will opt to hoard their capital and be cautious adding to their portfolios as they might have to make additional provisions for credit losses, Barclays Capital said in its 2008 Mortgage Outlook.
Commercial banks are also key investors in the roughly $7 trillion US MBS market, including the subprime sector. They played a large role in 2006, but demand this year has been mediocre as many took multibillion dollar mortgage-related write-downs.
The banks, at best, should be a neutral for MBS in 2008, the same as in 2007. At worst, they could end up selling much more MBS if their capital continues to shrink and balance sheets remain involuntarily bloated, Barclays Capital said. "It was a horrible year for mortgage bonds," said Arthur Frank, director and head of MBS research at Deutsche Bank Securities in New York.
The yield spread on the Fannie Mae 30-year current coupon, the most actively traded issue, has widened by about 0.75 percentage point to the average of the five-year Treasury yield and the 10-year Treasury yield, leaving it poised to finish the year with the worst performance since 1998. It is also in stark contrast to 2006 when it tightened by about 0.295 percentage point, Frank said. "It happened rather suddenly in late July and in August when the subprime crisis hit and basically everything greatly underperformed Treasuries," he said.
Deutsche's Chepolis said while MBS have done poorly, they have outperformed many sectors of Lehman Brother's widely followed US Aggregate Index on a duration adjusted methodology to Treasuries.
As of December 21, agency MBS have returned negative 203 basis points, while commercial mortgage-backed securities have returned negative 469 basis points. Asset-backed securities, credit, and agencies returned negative 570 basis points, 472 basis points and 91 basis points, respectively, he said.