Question: Why are mortgage-backed security spreads remaining so wide?
Todd Abraham: Well, spreads are always a dynamic of supply and demand, and in mortgages, it's no exception to that. So let's take a look at supply and demand dynamics in mortgage-backed securities. On the demand side, it comes from domestic and international sources. On the domestic front, it can take the form of insurance companies, ETFs, mutual funds, the central bank, even US domestic banks. Internationally, there are large investors in MBS in Japan, China and Taiwan. So the biggest holders of MBS are the Federal Reserve and U.S. domestic banks collectively. So how did we get here? From the demand side, the Fed has purchased a lot of MBS through their QE program. We're all aware of the Fed adjusting the federal funds rate up or down to influence economic growth, but they used QE, or quantitative easing, as a compliment to that program to decrease longer term rates. It's a policy goal.
Abraham: If we go back to their first program, which came as a result of the great financial crisis, the idea was to compliment the cut in federal funds by reducing longer term rates to reduce financing costs for homeowners, for example. So the latest iteration of QE occurred as a result of the pandemic. In 2022, their buying increased their portfolio holdings up to 2.7 trillion dollars of MBS, an increase of roughly 1.3 trillion dollars from the pre-pandemic level. For banks, they were buyers as they could borrow very cheaply and invest and get the net interest margin spread, and they would invest in MBS. So, these two buyers, domestic banks as well as the Federal Reserve, own approximately two thirds of all MBS, but they evolved from being buyers to sellers over the course of 2022 to 2023.
Abraham: The Federal Reserve became a seller as they moved from quantitative easing to quantitative tightening, where it was concluded that they no longer needed to buy to help induce growth in the economy, but they wanted to exit that program. So they not only stopped buying, but they began to let the portfolio run off in quantitative tightening. So they went from being a buyer to a seller. Now we're also aware of the problems in the financial sector where we saw some bank failures. In those cases earlier this year, the FDIC took over those failed institutions and proceeded to liquidate their investment portfolios, which held large amounts of MBS. So again, a large buyer evolved from significant buying to selling. As we said earlier, spreads always respond to supply and demand so we went from the two biggest buyers moving from strong demand to being sellers and spreads adjusted accordingly.