Fed Competing Against Banks for Mortgage-Backed Securities

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Community banks are growing increasingly uncomfortable with the Federal Reserve Board's efforts to stimulate the economy.

Quantitative easing, particularly the Fed's ongoing effort to buy mortgage-backed securities, has frustrated a number of institutions that are also in the market for such assets. The initiative is driving up prices for MBS at a time when smaller banks have been stockpiling such securities. (The Fed on Wednesday committed to making more purchases through 2013.)

Bankers view securities as one of few viable ways to stash cash — and bring in some yield — as loan demand remains elusive. In recent years, banks have been regularly putting mortgage-backed securities on their books.

There are signs that small and midsize banks are struggling to keep the trend going. Excluding the 25-biggest U.S. banks, mortgage backed-securities fell 1% between Oct. 1 and Nov. 28, based on Fed data compiled by Sterne Agee. MBS at those banks made up 10.8% of total assets at Nov. 28, compared to 11% in early October.

Bankers such as Eric Nadeau, the chief financial officer at $1.1 billion-asset Home Federal Bancorp (HOME), wonder if the Fed is aware of the trouble that quantitative easing is causing his industry.

"It's definitely creating inflation in the fixed-income markets," Nadeau says. "Community banks that don't have the ability to do hedging, or have other sources of income to make up for tightening margins, are disproportionately impacted."

The Fed's purchases of mortgage-backed securities are "taking away a significant opportunity from the banks they are trying to help," says Joshua Siegel, managing principal at StoneCastle Partners. "They are penalizing the industry."

Barbara Hagenbaugh, a Fed spokeswoman, declined to comment.

Economic factors had already forced banks like Home Federal to redirect far more of their assets out of loans and into securities than they would prefer. When regulators visited Home Federal's headquarters this week, Nadeau joked that the examiner assigned to the securities portfolio had a tougher job compared to the staffer going through the loan book.

Securities made up 41% of the Nampa, Idaho, company's total assets at Sept. 30, compared to 30% at the end of 2010. Loans comprised 40% of total assets at the end of the third quarter.

Bankers would undoubtedly prefer making loans over MBS investments. Margins on 15-year mortgage-backed securities, often viewed as the typical MBS investment for small banks, are "lousy" right now, says Kevin Cavin, a mortgage strategist at Sterne Agee. "Spread levels in the MBS market are very, very low, historically speaking," he says.

It's not just mortgage-backed securities that have become more expensive. Other securities have risen in price after the Fed launched its latest round of stimulus.

"It's a pool of assets out there," Nadeau says. "If folks aren't buying mortgage-backed securities because they are overpriced, they'll buy other securities, driving those prices higher as well."

Banks are desperate to find securities with higher yields to bolster thinning net interest margins, which are a by-product of artificially low interest rates. Issues will arise if banks buy longer-term securities at a time when the durations of funding sources, such as deposits, shorten, Siegel says.

Bankers "want to stretch for yield, but don't do it," Siegel says. "For an extra 20 to 30 basis points, do not take that risk. It's absolutely not worth it."

Still, the Fed's decision to buy mortgage-backed securities could help banks in the long run, says Edward Shugrue, chief executive at Talmage, a firm that invests in MBS and commercial real estate debt. It gives banks a captive buyer of the securities if they want to unload them. The program also helps banks that held a significant amount of MBS before the latest round of stimulus.

"The Fed is propping up the prices of bonds and banks are benefiting, because the value of their assets is improving," Shugrue says.

The government's continued support of Fannie Mae and Freddie Mac also creates challenges for smaller banks, Siegel says. Again, the issue involves matching the durations of loans with those of deposits.

"Community banks can't compete with Freddie and Fannie" on rates for 30-year mortgages, Siegel says. "If a bank [underwrites] a 30-year mortgage, the longest deposit they can [pair it with] is a five-year CD."

The big problem looming for many community banks is the prospect that they could end up selling their mortgage-backed securities at a loss once the economy turns around. The losses could be more pronounced because the Fed's programs are forcing many banks to buy the securities at inflated prices, says Bob Davis, the executive vice president for mortgage finance at the American Bankers Association.

"If you're putting assets on your books at very low interest rates, prices on the securities will fall and the rates will go up even faster when the artificial demand goes away," Davis says. "So you'll take a hit because you've put the securities on your balance sheet at very high prices."

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