Quantitative Easing 3 Seen Boosting both Residential and Commercial Mortgage Backed Securities Markets
As the presidential campaigns began their home stretch following Labor Day weekend, it wasn't surprising that people in some camps dismissed the Federal Reserve's decision to initiate a third round of quantitative easing (QE3) as political hocus pocus.
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One month in, though, it appears the latest round of stimulus is sparking some expected and unexpected good.
Under the September plan, the Federal Reserve agreed to purchase additional agency mortgage-backed securities at a pace of $40 billion per month. And, if the outlook for the labor market does not improve substantially, the Fed said it would continue that level of purchasing, or perhaps even increase it, until "improvement is achieved in a context of price stability."
At the time, John O'Callahan, capital markets strategist for CoStar Group's PPR, noted that, coming on top of the Fed's existing purchases, QE3's incremental ongoing flow of $40 billion per month is pretty significant.
"It looks to be between 25%-30% of monthly new issuance, on average (and over 50% when combined with existing purchases), assuming refi volume continues to be strong in the future, which means the Fed will crowd out other investors such as some mortgage REITs," Callahan noted.
And that is what the market is seeing.
According to Marielle Jan de Beur, managing director CMBS and Real Estate Research at Wells Fargo Securities, the Fed's mortgage purchases are displacing private mortgage investors in the residential mortgage-backed securities market.
"Putting QE3 into perspective, the Fed's $60.65 billion of gross mortgage purchase commitments amounted to roughly 50% of the gross agency MBS new issuance for the month of September," Jan de Beur reported. "On the other hand, the Fed's demand accounted for nearly 20 times the net supply of $3.07 billion for the month."
Ze Theory of Displacement, Is Zis Familiar?
(As this is Halloween week, you Addams Family fans will understand that header.)
And where did all those displaced residential buyers go? Interestingly, they began showing up in the CMBS sector.
"The displacement of private investors in the mortgage market means that other markets, such as CMBS, are likely to continue experiencing spillover demand as long as QE3 remains in effect," Jan de Beur said.
"Since mid-July, the credit curve for 2012 vintage CMBS has flattened 165 basis points, as measured by the spread between Aaa rated A-S tranches and Baa2 tranches," she added. "The Fed's mortgage purchases are programmatic, and the effect is likely to be ongoing. For CMBS, we believe the implication is a further decline in the steepness of the credit curve."
And finally, "Because new issue Baa tranches face less uncertainty regarding upcoming bank capital and insurance company risk-scoring changes than legacy securities, yield buyers may focus on this segment and spreads may continue to tighten, in our view."
CoStar's O'Callahan said it appears that QE3 is impacting some areas a lot more than others.
"CMBS continues to benefit while the boost to equities is beginning to falter already. With the extreme tightening of Agency-backed RMBS spreads resulting from QE3, the scramble in the search for yield has become even more frenzied - hence the rapid CMBS spread tightening over the past month," O'Callahan said.
"It's not a surprise to us that investors have found value in CMBS," he added. "We pointed out the attractive relative value at our client conference prior to QE3. However, the speed at which spreads have tightened is surprising."
The supply-demand imbalance is probably a key factor in the rapid price appreciation, he said, as those investors holding quality CMBS bonds don't want to part with them for the lack of anything else to buy with the proceeds in this environment.
A Strong Air Compressor
"In light of the Fed's ongoing actions, CMBS still appears to be relatively attractive and investors will likely continue to push spreads even tighter, especially down in credit," O'Callahan said. "We expect supply to continue to remain constrained, although at some point it will make economic sense for some holders to sell and take gains."
As with any investment though, high prices doesn't mean risk is lower. In fact, risk may be higher now, O'Callahan said. With record price levels and low yields across many asset classes today, it's appropriate to question if the risk-reward proposition is out of whack, maybe even reflecting the formation of a bubble.
"We had a discussion about "bubbles" at our client conference and only a few in the audience of roughly 100 senior investment and risk managers raised their hands when asked if there may be bubbles forming as a result of the Fed's actions. It was surprising that only a few hands went up," he said. "The combination of cheap funding, leverage, a herd-like mentality, and excessive government manipulation makes for a strong air compressor from which to blow bubbles."
And an abrupt shift in sentiment can be enough to pop a bubble, if one exists.
"What will happen if investors' expectations regarding the Fed's future actions change abruptly, say under a Republican administration, for example?" O'Callahan asks. "Investors should be assessing the possible impacts of various scenarios playing out."
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