Outlook 2010: Secondary agency market could widen in early 2010 as Fed support declines

By Kenneth Lim

Boston, Dec. 31 - The secondary agency market could be headed for some widening entering 2010 as key components of the federal support that defined 2009 come to a close, market sources said.

On the demand side, the already rich market faces the end of the Federal Reserve's quantitative easing program after the first quarter of 2010 and faces uncertainty about the future of Fannie Mae and Freddie Mac.

But the widening is unlikely to return to the 2008 crisis levels, with supply expected to drop considerably as Fannie Mae and Freddie Mac reduce their portfolios.

Tightening 2009

Spreads in the agency market tightened over 2009 despite beginning the year much wider than recent levels.

With investors still smarting from mounting losses at Fannie Mae and Freddie Mac, which came under federal conservatorship in 2008, 10-year agency spreads began the year close to 100 basis points over swaps. At the end of 2009, spreads were back to around zero against swaps, which is much closer to historical levels.

"Agency spreads to swaps are now back at pre-crisis levels as a paucity of liquid rate products (AAA rated) drove many banks and liquidity portfolio managers into GSE paper again," wrote Cantor Fitzgerald chief rates strategist George Goncalves in a report.

A trader said two-year agency bullets were trading at a spread of 35 bps over Libor at the start of the year and ended at 25 bps below Libor. Fannie Mae's 2% Benchmark Notes due January 2012, which were issued at the start of 2009, were sold at 83 bps over Treasuries and have since tightened to about 29 bps over Treasuries.

Overall, market observers said 2009 proved to be a strong year for agencies, especially after the scare in 2008, although Barclays Capital head of U.S. agency trading Michael Graf thought that the market "definitely swung the pendulum from cheap to rich."

"Valuations have continued to improve, nominally and versus Treasuries, and they've gotten pretty snug, so at some point in time you run out the marginal buyer," he said. "The market needs to find a balance point."

Fed narrows spreads

The main driver of the narrowing spreads was the Federal Reserve, which has bought about $160 billion of agency notes through its outright coupon purchase program since September 2008.

The quantitative easing scheme started as the credit markets came to a standstill following the collapse of Lehman Brothers, and has generally been seen as successful in lifting the paralysis.

"It enabled a cleansing of the balance sheets of Wall Street," Barclays' Graf said. "Last year or last summer, leading up to the conservatorship, our balance sheets were pretty clogged. Given the rally in rates, and uncertainties in the financial system there weren't a lot of ready and willing buyers.

"The purchase program was buying securities across the curve, and across the coupon stack, and it freed up some pressure from the Street."

The buying program was originally slated to end after 2009, but in September the Fed extended the purchases by three months. In November, the size of the program was cut to $175 billion from $200 billion, which some in the market saw as an acknowledgement by the Fed that it may have been soaking up too much market liquidity. A number of market participants felt that the purchasing program was good medicine taken for too long.

"From my standpoint I think the Fed's overstayed its welcome," one agency trader said. "They ended up keeping spreads artificially tight."

But the program could become a source of widening in 2010 as the Fed makes its exit.

'I think it's going to be really interesting to see how the market absorbs the supply without any Fed support," said Mary Ann Hurley, vice president of fixed income trading at D.A. Davidson & Co. "It shouldn't be a big problem, but the Fed's been a big player, they've taken a lot of supply from the market, so absent that it will be interesting to see how the agency and the mortgage-backed sectors do."

Parking cash

Agencies also benefited from a surge in the cash holdings of commercial banks, which had slowed down lending and were sitting on huge amounts of deposits in 2009 from risk-averse customers.

"A paucity of liquid rate products (AAA rated) drove many banks and liquidity portfolio managers into GSE paper again," Cantor Fitzgerald's Goncalves wrote.

On the flip side, foreign central banks have been shifting out of agencies and into Treasuries because of the perceived safer credit quality of Treasuries.

"Foreign buying, however, has not returned in force (or to prior levels)," Goncalves added. "Although this is not highly televised (or reflected in the price action) foreign central banks continued to diversify away from agency product in 2009 and into Treasuries.

"A main issue among foreign buyers is that to this day the GSEs still do not have an explicit guarantee (but instead deep credit lines to the Treasury)."

But commercial banks should remain attracted to agencies for a while, another trader said.

"Based on everything that occurred, agencies have been a hot commodity and will continue to be that way," the trader said. "Banks really aren't lending a lot. They want to stay short and they want to stay liquid."

Fannie, Freddie in the air

The year ahead has a number of question marks hanging over the market, beginning with anticipation of a government announcement in February to lay out plans for the future of Fannie Mae and Freddie Mac.

The market currently appears to expect only minor changes in the short term.

"We believe that at this point there is a low probability of major change in the GSE business model," Goncalves wrote. "The GSEs are playing a crucial role in the nascent recovery of the housing market. Instead of sweeping changes we see minor tweaks developing in 2010 with some starting before the end of [2009]."

Goncalves said the government could take some measures in the short term to continue supporting Fannie Mae and Freddie Mac. That includes lowering the 10% dividend rate that the agencies have to pay on Treasury-bought preferreds - to 5%, in line with banks that received aid during the financial crisis - and lower the risk weighting on GSE debt to zero.

Graf said even the end of the conservatorship could be a few years away.

"They could set a sunset date for the conservatorship, but that date could be five years out," he said. "There's no magic recipe there. There are simpler things the administration could propose, but truly redefining the system will take a long time. I could see things go sideways next year. You're not going to change it overnight."

One agency trader said how Fannie Mae and Freddie Mac deal with limits on their portfolio sizes and debt will also be a key theme in 2010. The limit on the portfolios and debt of the agencies will reduce by 10% a year beginning in 2010, according to guidelines by the Treasury.

"The thing that's kind of keeping people on the sidelines is how will the portfolios of Fannie and Freddie evolve?" the trader said.

The Treasury has already taken some early steps to reaffirm its support of the agencies. On Dec. 24, the government removed the limit on a $200 billion credit line that was made available for each agency. The lifeline's amount will now be adjusted depending on the loss faced by each agency in order to keep the GSEs financially liquid.

The Christmas Eve move could provide very strong support for front-end yields in the short term, said Chandler Asset Management investment strategist Brian Perry.

"That makes the paper inside of three-years essentially Treasury quality," Perry said.

Short-term weakness

The ending Fed purchase program, questions about the future of Fannie Mae and Freddie Mac and the relative richness of the market suggest that the first part of 2010 could lead to some widening in agency spreads, a number of sources said.

Agencies, as with other credit markets, will also be affected if the Fed raises interest rates.

"Now we're very steep, and if the Fed starts to move...what that historically causes is spreads to widen somewhat," a trader said.

Margaret Kerins, head of agency strategy at RBS Securities, said there is limited upside in agency bullets in the near term with most of the confidence in the market already priced in. Longer maturities are an exception, having underperformed in 2009.

"Aside from the near-term political risk, we expect 10-year agencies to tighten slightly into wider swap spreads," Kerins wrote in a note. "In the intermediate term, the 10-year should benefit from a flatter agency spread curve versus swaps driven by reinforced government support and the lack of supply."

An improvement in the economy could take away commercial bank demand as deposits fall and lending increases. Cheaper non-U.S. government guaranteed, supranational and sovereign debt in 2010 could also put pressure on spreads, while in the longer term there could be concern about the Fed potentially selling its agency holdings.

Still, Kerins does not expect a replay of 2008's crisis-period spreads because investors who wanted out of agencies have already done so by selling to the Fed, dealers' exposure has decreased and international selling pressure has eased.

"We do not expect agency spreads to revisit the crisis levels of late 2008, which was driven by reduced liquidity due to severe dealer balance sheet constraints, international selling of agencies and the expectations for massive amounts of competing supply from government guaranteed programs," she wrote.

Chandler's Perry said he is neutral on agencies for 2010 and expects spreads to be rangebound.

"Right now we're probably market neutral on agencies with a slight bias for spreads to widen, and if they do widen we might want to pick up a little," he said.

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