Supply of quality collateral is short, GSE’s are key


There is no doubt that a perceived and/or actual lack of quality collateral exists in the markets today.  Let’s take a look at some of the evidence I see and what it could mean for the markets.

In some cases, institutions appear to be hoarding their most pristine collateral as Izabella Kaminska points out here.  One of the biggest sources of quality government backed collateral, and the one I’ll focus the most on, is the Agency MBS market.  The total amount of Agency backed MBS (b/t Fannie, Freddie, and the FHA) is estimated to be ~$5.4trillion. We have heard pundits cry for the elimination of the GSE’s, but I believe that isn’t even close to being possible at this time.  A big reason is just how important to the system quality collateral is right now.  There are other reasons why I’d argue eliminating GSE’s is not a good idea, however I will save those for another day.

As I touched on a few months ago in a post titled “Could Basel III create a floor for Sovereign Debt Prices”, Agency MBS are included as a source of highly liquid assets as part of the soon to be imposed LCR ratio.  Numerous large European banks are already preparing for this implementation and are short highly liquid assets.  Many are proposing 3mo repo agreements paying 25-35bp with other institutions where they would send Muni, HY Corps, or Non-Agency MBS in return for Agency MBS.  Read that again.  These institutions are short high quality collateral, and are willing to pay up 25-35bps over three months or more to hold this high quality collateral.  While the details on this particular transaction are less important, the key is that they are short these type of bonds.

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There is a relentless demand for spread products right now, particularly ones of high quality.  The $5.4T Agency MBS market is a key cog in this equation (this is not even mentioning the Agency Debt market), and any talk of near/medium term transition away from the GSE’s is pure fantasy.  The supply of these Agency MBS (which are fungible and easily deliverable into the TBA market) would be a gigantic removal of liquid assets.  Furthermore, a certain faction of institutional investors are required to carry AAA/Govt securities including banks.  We know, according to Fed data, that banks continue to load up on Agency MBS.  The Fed’s purchase of Agency MBS makes this supply even shorter, and any additional purchase programs would only exacerbate the supply/demand dynamics.

All in all, there are a lot of signs that high quality collateral is scarce.  This applies very prominently to the securities lending/repo markets as Kaminska points out, and this blog summarizes.  For the purposes of this short post, I think its clear that the GSE’s play a major role in the supply of quality collateral and any talks of reform that may include a winding down of the GSE’s during this decade are unlikely at best.