Outlook 2011: Primary agency market to shrink as agencies trim portfolios, redemptions slow down

By Kenneth Lim

Boston, Dec. 31 - Agency supply should continue to decline in the year ahead as Fannie Mae and Freddie Mac trim their portfolios and higher interest rates lead to a slowdown in calls.

"Supply technicals look good for the coming year, as a slower pace of mortgage issuance will reduce issuance from Fannie and Freddie and a shrinking balance sheet at the [Federal Home Loan Banks] will do the same for that agency," wrote Janney Montgomery Scott chief fixed income strategist Guy LeBas in a research note.

The past year saw supply generally slow down from 2009, when the Federal Deposit Insurance Corp.'s Temporary Liquidity Guarantee Program fueled a surge in issuance. Although TLGP paper was issued by corporates, the FDIC backing led the asset class to be considered similar to agency debt by most traders.

Total gross agency supply in 2010 was about $1.2 trillion in 2010 at Dec. 20, LeBas estimated in his report.

"While behind 2009's TLGP-driven record issuance, [that] is still much stronger than any prior experience," LeBas wrote.

The size of the overall agency market decreased because issuers did not issue enough debt to fully replace matured or redeemed paper.

Net issuance by Fannie Mae, Freddie Mac and FHLB, the three biggest issuers among the government-sponsored enterprises, was negative $160 billion in 2010, according to data compiled by Barclays Capital analysts Rajiv Setia and James Ma.

FHLB issued $84 billion less of benchmark bullets than the amount that left the market, overshadowing positive net issuance of $27 billion by Fannie Mae and $4 billion by Freddie Mac in bullets.

The amount of outstanding short-term paper issued by the three agencies shrank by $13 billion in 2010 due to Freddie Mac's $30 billion shortfall, the analysts said. Fannie Mae's net short-term issuance was $9 billion, while FHLB added $8 billion.

In 2011, the Barclays analysts expect total net issuance to be negative $130 billion as Fannie Mae's outstanding debt falls by $80 billion and FHLB reduces its debt obligations by $50 billion. The analysts expect Freddie Mac to keep its outstanding debt issuance the same in the year ahead.

LeBas foresees new supply in 2011 will drop by 11% to 14%, or about $130 billion to $165 billion, "which should provide some support for the markets and limit the impact of reduced real money demand," he wrote in his note.

Callable surge

Issuance of callable and callable step-up notes remained strong in 2010 on the back of high redemption rates and investors' desire for defensive assets that can protect against higher rates.

"As forecasts of rising rates became increasingly prominent in the early days of 2010, demand for step-ups emerged in force, leading Fannie, Freddie, and particularly the FHLB to issue a greater portion of their funding as steps," LeBas wrote.

Only Fannie Mae had positive net issuance, of $13 billion, in 2010, according to the Barclays team. Freddie Mac did not replace $50 billion of callables that left the market, while FHLB let $56 billion of callable debt leave unanswered.

A key driving force behind the callable issuance volume was also the high rate of redemptions by the issuers, who wanted to take advantage of historically low interest rates in the middle of 2010. A lot of the money from called issues ended up being reinvested in new callables.

One agency trader said the callable trend turned out to be a bit of a mixed bag for investors, most of which were insurance companies and pension funds, which were not necessarily looking for current income. Those real money investors were more interested in locking in higher back-end rates.

"At least early on it offered a sense of protection," the trader said. "They're designed to provide insurance against forward rates and people purchase these as insurance, but when the market turned down they were left with underperforming assets."

LeBas, in his note, said a straight five-year non-callable one-year note would "easily outperform" a five-year multistep note in a base-case scenario of an "orderly rise in rates" as well as an aggressive 200 bps gain in rates over the year. One-time step, one-time call structures, however, could potentially outperform straight callables at aggressive rate hike scenarios, LeBas said.

"Despite the conceptual appeal of step-ups (and especially multi-steps) as hedges to rising rate scenario, the reality is a great deal more nuanced," he wrote.

LeBas reckoned that the redemption-fueled issuance could persist into the early part of 2011.

"Calls on outstanding agency deals will continue through 1Q, so issuance will be weighted toward the beginning of the year," he wrote.

Shrinking portfolios, needs

The chief reason for an expected decline in primary market volume in 2011 is that the portfolio limit for Fannie Mae and Freddie Mac decreases by 10% to $729 billion each in 2011.

Fannie Mae has to trim its balance sheet by $70 billion in 2011, while Freddie Mac is already under the cap by $26 billion, the Barclays analysts said.

Meanwhile, FHLB has also been shrinking its balance sheet by about $131 billion in line with a $130 billion decrease in advance lending. The need for advance lending should continue to drop in 2011 as the Federal Reserve's "quantitative easing 2" policy of monetary stimulus and high deposit rates keeps banks flush with cash, the Barclays analysts wrote.

LeBas added that the agencies are also likely to have lower funding requirements because of falling mortgage underwriting.

"We're looking for a big decrease in mortgage underwriting volumes," he told Prospect News. "In 2010 70% to 80% of new mortgage supply has been refinancing for lower rates. But we can't depend on those rates to sustain in 2011, so net supply is likely to shrink."

Preference for term funding

The agencies did the bulk of their funding at the front end of the curve in 2010. In 2011, they could seek to issue more term debt at longer maturities.

The three agencies have around 60% of their outstanding debt maturing in one year, with FHLB particularly exposed to this "short funding," so they could seek to term out some of their debt, the Barclays team wrote.

"This becomes apparent when considering all callables outstanding at their first call dates, as the vast majority of recent issuance has been in structures with six or fewer months to their first call date," the analysts wrote.

A large volume of bellwether benchmarks is also maturing in 2011, which might lead to a bias toward issuing term debt.

"Many of these were front-end issues placed shortly after the conservatorship through the early stages of QE1, when investor appetite could bear $10 billion or greater issue sizes," the analysts wrote. "The need to maintain a deep and liquid curve in the bellwether bullet market could keep net issuance from becoming too negative in this market segment."

The possibility of higher rates in 2011 could also lower the rate of callable redemptions, allowing extension of term callables. Finally, funding costs at intermediate maturities could go up in 2011, giving the agencies an incentive to reach further out on the yield curve.

Need for flexibility

The Barclays team added that the agencies' uncertainty over their exposure to non-performing mortgages could also keep them on a deliberate path of diversifying their funding sources.

"We believe that this...quandary should encourage the GSEs to retain maximum flexibility in their funding mix in 2011, not drawing down too much on any particular class of debt outstanding - discount or term, bullet or callable," the analysts wrote.

The agency trader said that 2011 may eventually not look drastically different from 2010 from a primary market standpoint.

"We saw a glimpse of the future with more passing on deals and reopening, a symptom of having been forced to trim their portfolios and the mortgage market having quieted own, so there are not that many needs," the trader said. "We've already gotten the calendar, so that's a sign that they're going to maintain business as usual. Beyond that, they do try and maintain the ability to be opportunistic."

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