Sunday, December 2, 2012

Dealer MBS positions hit record levels; Volcker Rule creates market distortions

Primary dealer holdings of mortgage-backed securities was at an all-time high last week, as the dealers take advantage of the Fed's MBS purchases. Because of the public's push for increased transparency from the Fed, it is generally not that difficult to determine which securities the Fed will be buying (see discussion). And that means easy pickings for the dealers who "front run" the central bank.

USD mil (Source: NY Fed)

So how is it that securities dealers can load up on MBS, given the impending Volcker Rule? The new regulations have a small exception to the prop trading activities restriction. US treasury and agency securities will be permitted. And MBS securities in the chart above are mostly those issued by Fannie and Freddie. It's another example of regulatory driven market distortion. Moreover, these distortions are only going to get worse, as nations such as Canada and Japan are looking to obtain Volcker Rule exceptions for their government debt. A shift into mortgage and sovereign paper and out of corporate paper is the (not so) unintended consequence of the new regulations. This ultimately hurts middle market companies, as US legislators seem to prefer to see the dealers front run the Fed on MBS rather than holding middle market corporate bonds.

Of course private equity firms are loving this. With banks getting out of corporate bonds, private equity firms expand their lending business (a form of "shadow banking"), charging much higher rates. Some readers have questioned that this is actually taking place. Well, here is a direct quote from GSO/Blackstone:
Reuters: - "We really want to thank Mr. Volcker. That rule is a little bit like the Employment Act for GSO and what we do. And it kind of took our competitor prop desk and kind of put them off to the side, so that helps as well," Bennett Goodman, GSO's co-founder and a senior managing director at Blackstone told the Bank of America Merrill Lynch banking and financial services conference on Tuesday.
"The business model being adopted by the banks is they want to be syndicators of risk. They don't want to extend their balance sheet to provide capital to a mid-market single-B rated company, which is usually our target audience. And as a consequence, we want to own that risk."
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