Although agency mortgage-backed securities liquidity has declined recently, it remains mostly where it was prior to the housing bubble; the current levels of agency MBS liquidity are likely to be in place for a while, since the factors driving the decline are unlikely to slow down in the foreseeable future, according to an analysis from the Urban Institute released Monday.
In a white paper titled “Declining Agency MBS Liquidity Is Not All about Financial Regulation,” Karan Kaul and Laurie Goodman of the Urban Institute contend that tighter financial regulation and higher capital requirements are not the only reasons behind the recent decline in agency MBS liquidity.
With approximately $5.7 trillion in securities outstanding as of the end of Q2 2015, according to data from Securities Industry and Financial Markets Association, making it one of the most liquid fixed-income markets in the world (behind only the U.S. Treasury market), according to the Urban Institute. The majority of these agency mortgage-backed securities are issued by Fannie Mae, Freddie Mac, Ginnie Mae, or another government agency. The market has “historically been very liquid because participants have been able to trade large volumes of securities relatively easily and quickly,” according to the authors.
The average daily trading volume of agency RMBS is down substantially from the bubble period of 2008, when it was $350 million; even though it has fallen since the crisis, the average daily trading volume has still been about $190 million since the beginning of 2014. That number is close to the 2003-2004 pre-bubble average, according to the authors.
Whether or not the trading volume is simply reverting to more sustainable levels or is a sign of a more serious problem has yet to be determined, according to the authors. Existing research and many reports in the press have asserted that more stringent regulation put in place post-crisis is responsible for the declining fixed-income liquidity.
“The new regulatory safeguards have had their intended effect of reducing the amount of risk taken by financial firms. But to expect a reduction in risk without causing some impact on liquidity is trying to have it both ways.”
Karan Kaul and Laurie Goodman
“Specifically, higher capital requirements, conservative leverage ratios and curbs on proprietary trading under the Dodd-Frank Act have made it more expensive for large financial services institutions to take risks,” the authors wrote. “While that is certainly true, our view is there is more to declining agency MBS liquidity than just regulation.”
Two high-level trends are in play as far as reasons for declining agency MBS liquidity beyond regulation: investor heterogeneity has been reduced by a major shift in MBS ownership from active traders to “buy and hold” investors, and with it, the “ability of markets to self-correct temporary price dislocations, resulting in more pronounced episodes of volatility”; and mortgage refinance volume has dropped steeply without an increase in purchase originations, which has resulted in a drop in agency MBS issuances, which has in turn led to a decline in trading volume, according to the authors.
After-effects of the crisis are driving these trends, which leads the authors to the conclusion that the levels of agency RMBS liquidity are here to stay. First, the Fed’s ownership of outstanding agency RMBS is not likely to change until the Fed changes course, and no one knows when that will be (the Fed and commercial banks now own more than half of outstanding agency RMBS); second, it is “virtually certain that the GSEs won’t be allowed to run investment portfolios in any meaningful way, form, or scale moving forward”; and third, there is no concrete reason to believe that stringent regulations put in place after the crisis will ease up.
“If excessive risk-taking led to an increase in liquidity previously, then it should be no surprise that a reduction in risk will cause liquidity to decline,” the authors wrote. “Part of this reduction in risk and liquidity is no doubt driven by tighter regulation, but it is also driven by an extraordinary shift in MBS ownership pattern as well as weak mortgage originations and issuance activity. The new regulatory safeguards have had their intended effect of reducing the amount of risk taken by financial firms. But to expect a reduction in risk without causing some impact on liquidity is trying to have it both ways.”