Recently we commented on the potential for various investor market segments to increase their holdings of MBS as the Federal Reserve winds down its portfolio. An interesting category is foreign investors. At the end of 2018, when the Fed initiated its QE program, foreign investors held about 17% of outstanding MBS, and this has fallen to a little less than 12% at present. Most of the decline occurred in the wake of the global financial crisis when mortgage-related securities were revealed to be riskier than generally believed.
As noted in that post, there are many considerations facing foreign investors in US securities that do not weigh as heavily on domestic money managers. These include foreign exchange risk, local market conditions, and geopolitical risk. To gain a better understanding of the underlying behavior behind the trends in overseas asset holdings, we turn to another data set, the Treasury International Capital (TIC) data. This data provides balances and transactions of overseas holdings and transactions by country and asset class, including MBS. This note looks at recent developments in this regard for three key Asian economies: China, Japan and Taiwan.
The following chart provides a picture of the value of MBS holdings for each of these three countries back to 2012:
The fourth quarter of 2021 marked the 13th anniversary of the introduction of the Federal Reserve’s Quantitative Easing (QE) policy, whereby the central bank worked to push longer-term rates lower once short-term rates hit the zero lower bound. This activity largely took place via purchases of longer-dated Treasury securities and mortgage-backed securities. There were many nuances as the central bank bought securities in different proportions over time and occasionally let their balance sheet shrink as the securities they held paid off or matured.
The purpose of this note is to take a big-picture view of the MBS market impact of a likely decline in Federal Reserve holdings in the Agency space as the central bank has recently indicated its intention to begin letting these securities run off its balance sheet. In particular, the FOMC statement of March 16 stated, “In addition, the Committee expects to begin reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities at a coming meeting.” Which we guess will be in May. What does this mean to valuations in the MBS market?
Our analysis is based on the data collected on Agency MBS ownership broken down by major investor class by the Federal Reserve in the Financial Accounts of the United States. This data is produced quarterly and is a broad measure of Agency securities, including not just single family Agency MBS but also Multifamily MBS and Agency Debt. Below find a chart of the progress of the Agency MBS market from Q4:2008, when the Fed launched QE, through Q4:2021. The chart nicely shows the ebb and flow of activity in this market on the part of the major players. The holdings controlled by the central bank is one example, starting at near-zero in Q4:2008 and cycling up and down, reaching a record high of almost 25% at the end of 2021.
Our monitoring of the US housing and mortgage markets tends to focus on details obtained from a micro view of the market. This post takes a quite different perspective of treating the US as a single point across an international perspective. This is part of a long tradition in economics, including at the Federal Reserve, but is used infrequently as the market focus is generally directed more narrowly. But interesting patterns do emerge by stepping back and taking a big picture view.
For example, here is a scatter diagram of cumulative real house prices vs GDP from 2010-2019 for 45 countries using data from the OECD.
New research by Yihai Yu at MSCI shows that historically high mortgage paydowns and price premia related to the Covid-19 crisis creates a situation where MBS securities could exhibit negative durations.
This unusual situation arises because the extremely fast prepayment speeds can exceed the price impact of lower yields. This nuanced observation relies on careful calculations of the dollar amount of paydowns derived from Recursion data.
The Federal Reserve recently released its quarterly Z.1 report: The Financial Accounts of the US (formerly known as the Flow of Funds) for Q2 2020. This voluminous dataset contains very detailed information describing financial flows and stocks across all major segments of the economy. For our purposes the key chart is the distribution of holdings of Total Long-Term Agency Debt (Agency MBS + Agency notes and bonds):
The clear takeaway for Q2 is the central bank gained share as it took unprecedented actions to stabilize the financial system in the wake of the Covid-19 crisis. The Fed’s share of the stock of Long-Term Agency Debt jumped by about 4.9% from Q1 to Q2, a record high increase. The biggest losing category was “Others” which fell by 3.6%. This loss came largely from the household subsector within this category. The “Commercial Banks” share rose by 0.9%, but this does not necessarily imply greater appetite for mortgage risk as depositories are increasing their securitization rate by swapping whole loans for securities. Finally, the “Foreign Investor” category lost 0.5% to a 7-quarter low.
In a previous blog, we pointed out the importance of overseas investors to the mortgage market. We looked at the share of holdings from this sector, as well as on the country breakdown within the sector. These shares tend to move somewhat smoothly over time as they represent very large portfolios of assets. There is, however, a second data set released in the TIC system every month, namely net capital flows. These data are purchases (or sales) and can be quite volatile in the short term. But they may provide a picture of emerging trends that will not show up in the holdings data for some time.
The same important caveat that applies to the holdings data applies as well to the flow data: the data on purchases and sales of assets reported for a country may be on behalf of agents domiciled in a different location, even the US.
We also noted in that post the many motivations behind foreign holdings of stocks of long-term agency assets and these apply to the flow data as well. There is another caveat for the flow data, however. A key characteristic of MBS is prepayment. That is, homeowners have the right at any time to prepay their mortgage if rates fall. Also, if a homeowner sells the home the mortgage is typically prepaid and a new mortgage obtained if a new home is purchased. So if an investor faces prepayments, but wants to hold their stock of MBS steady, they may purchase new securities. Such purchases are not based on any assessment of near-term returns in various asset classes, but is rather an automatic flow based on longer-term considerations.
This phenomenon is particularly notable in an environment of falling interest rates, as prepayments would be expected to rise.
An interesting group of countries to look at in this regard is Asia ex-Japan. The bulk of these holdings are maintained by official entities looking to maintain portfolio liquidity and generate favorable long-term returns. The issue of country of the beneficial owner is less important here. Yet, they are not immune to conditions in the current investment environment. The charts below show net purchases in total and for three Asian entities: China, Hong Kong and Taiwan.
As we have been in a declining rate environment since the start of 2019, it is not surprising that purchases of long-term agency securities have been generally strong from the point of view of asset replacement over that time. But Q2 2020 marked a break in the pattern with the onset of the Covid-19 crisis. Flows were smaller than in Q1, notably so for China, but markedly so for Hong Kong which engaged in outright sales of assets. Interestingly, Taiwan bucked the trend and added substantially to its holdings in Q2 compared to the prior quarter.
In the background, the economic and financial environment remains highly uncertain. Added to that is the increasing factor of rising geopolitical uncertainty as we head into the US election. Following these flows may provide useful insights into how different agents assess these considerations.
The MBS market is the second-most liquid market in the US after the Treasury market. The collateral for these securities is completely domestic but a significant share of the ownership is held by offshore entities. As such, investors need to be cognizant of the attitudes of overseas investors towards this market, particularly in the current highly charged geopolitical climate.
The following chart shows total holdings of Agency and GSE-backed securities over time broken down by a broad category of investors. The most recent figure is as of Q1 2020; Q2 data will be released later in September.