By Ron D’Vari
It is well known that fixed income liquidity and trading volumes have declined since the credit crisis. However, it is particularly disconcerting that the stringent post-crisis regulatory regime has significantly affected even the most liquid markets, including Treasuries and agency mortgage-backed securities (MBS). The lower liquidity in some of the most liquid instruments will significantly restrict the overall financial markets’ resilience in times of crisis. For example, there would be a significant drop off in volumes and a spike in spreads across all products just when liquidity would be needed most by the investment community. Everyone is anticipating an interest rate move by the Federal Reserve (the Fed) sometime in 2015. We expect that an actual Fed move will test the markets overall resilience and reveal market structural issues created by the new regulatory stringency.
According to J.P.Morgan research (Matthew Jozoff, et. al., May 1, 2015), agency MBS trading volumes have fallen by half since the beginning of the credit crisis and now stand at $200 billion per day, down from a peak of $350 billion based on SIFMA data. The overall size of the mortgage market on a net basis has been fairly stable and not grown due to lower refinancing driven by negative home equity and tighter mortgage underwriting standards. However, market structural changes, the Fed’s quantitative easing and lower dealer participation have impacted mortgage market liquidity.
In addition to fixed income investors, other key players in the MBS market are the Fed, government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, mortgage servicers as well as primary broker-dealers. The role of the dealers is to intermediate flows among market participants. The Fed has steadily increased its MBS position to $1.7 trillion, and GSEs’ retained MBS portfolios have been fairly stable. Net-net, this has reduced the size of available MBS bonds significantly. In addition, the servicers' hedging activities also have been falling due to a more benign prepayment environment. In turn, the dealers have become more reluctant to take on the large positions required to keep the MBS market liquid. The significantly lower dealer participation is a direct consequence of the tighter regulatory grip (Basel III, Volker Rule) and Comprehensive Capital Analysis and Review and liquidity risk management. As a result, there are fewer active dealers carrying fewer inventories.
Fixed income managers are measured versus various fixed income aggregate benchmarks (e.g., Barclays Capital Aggregate Bond Index) that include all specific-pool agency MBS bonds outstanding. To add value, active managers have to take on tactical positions relative to their bond benchmarks that need to be traded in and out. Active fixed income managers often use MBS to-be-announced market (TBA) instead of trading specific pools to position and express views on the overall direction of agency MBS, relative coupon performance or MBS basis vs. U.S. Treasuries. The majority of the mortgage market volume drop has been in the daily TBA trading. The significantly lower available liquidity in TBAs has made it a lot more challenging for larger and more active fixed income managers to add value through relative value trading and positioning since it makes it costly to exit large positions once established. Given the anticipated Fed interest rate move in the fourth quarter of 2015, most managers have lowered their risks relative to their benchmark, further lowering volatility and volumes. The current market calm is artificial, is the direct result of regulatory trends, and so could change at any time.