You all remember the Fed’s plans to buy over a trillion dollars worth of MBS and Agency bonds. I heard my MBS trader this morning quote that the Fed now owns around 34% of the all outstanding Fannie and Freddie pass through securities. I’ll give you a minute to let that one soak in…34% of all pass through MBS are now owned by the Fed.
A whirlwind review of how MBS spreads blew out so wide goes as follows: Hedge Funds begin to falter as sub-prime CDO’s start to fail, big creditors issue margin calls, funds sell good MBS to satisfy margin calls, prices on MBS drop as sustained selling occurs to fund an ever increasing amount of margin calls, fear enters the market and now people begin to balk at buying even high quality MBS as they know there is more forced selling coming down the pike and they don’t want to buy ahead of it. Why buy a bond today that you know will be cheaper tomorrow? Now there are fewer buyers and an increasing volume of sellers; the law of supply and demand tells us how this story will end. Huge volumes of MBS product are dumped on the market as big funds and big firms begin to fail, there are not enough buyers and prices plummet causing spreads on MBS to rise like a rocket. Current coupon 15 year MBS trade at a long term average of roughly 116 basis points over treasuries. This spread blew out to 311 basis points at the height of the crisis.
Through the entire episode we spoke of mean reversion and counseled buyers to take as much MBS product at these spreads as your position would allow. This strategy has paid off very, very well. Bonds that were purchased with spreads of 200 to 300 basis points of spread have delivered both high yields and large price gains as spreads have tightened in over time.
What was the Fed thinking?
I think it makes sense to occasionally go back and look at WHY the Fed started down this road. There is so much going on that sometimes the genesis of this program can get lost in the fray. The Feds plan was to keep borrowing rates for households and small businesses affordable and accessible. These two factors are very important parts of the lessons that Bernanke learned from the Great Depression (see the market update from Jan 8, 2009 to review Bernanke’s thoughts on the Great Depression…if you don’t have it just let me know and I can resend it). They’ve achieved their goal of keeping rates low. Every time a Fed governor gets in front of a microphone they tell us that they plan to keep rates low for a long time. OK so rates are low…but how accessible is credit?
Credit is not as accessible as Uncle Ben would like it to be. While he can control the short end of the curve very well he can’t control who banks lend to (I feel the need to add the qualifier “YET” to the end of this statement…scary times). The Feds view of how much credit should be accessible and a banks view of the same can be quite different.
In an era where individuals are highly leveraged AND they are losing their jobs it is obviously a good time for caution to be involved in the underwriting process. While the Fed sees the solution a little differently than banks do, deep down the Fed must understand that banks will begin making large volumes of loans when they get large volumes of qualified credits coming in the front door. This will take time…plain and simple. Consumers need time to clean up their personal balance sheets. It takes a while to pay off the credit cards and the car loans and to build up some cash savings in the bank. It will also take a while to get past the fear of losing one’s job or a spouse losing theirs. All of these factors act as constraints on consumer spending. Fear is a powerful thing.
Where are we today?
After all of the buying by the Fed where are we today? The Feds plan has certainly had its intended effect on the level of rates. Spreads on MBS product have been absolutely crushed. This morning the spread on current coupon 15 yr MBS sits at 125 basis points. OK…now what?
Now our attention must turn to how the Fed will exit this role as the provider of liquidity to the mortgage market. There is tremendous concern that if they just turn off the magic liquidity faucet at the deadline date then spreads will blow out in a big way. Nobody expects a reversal to the high water mark of 311 bps because the fundamentals aren’t in place to cause a run like that…the fear that drove those levels is gone. We are no longer seeing large firms and hedge funds going bust after waves of margin calls and forced liquidations. However it is widely expected that we will have some material amount of widening as the Fed tries to exit this role. The official stop date for the Feds MBS purchase program is in October. There has been a fair amount of talk that they may have to extend this deadline to early 2010 to avoid killing the housing recovery. This is a tricky piece of business. How long do you kick this can down the road? How much more will you have to spend? Is anyone comfortable with the Fed owning 50% of the mortgage market? 60%? Is supporting the recovery in housing a large enough issue to justify owning a larger chunk of the mortgage market? We all cautioned that it could prove to be a very difficult thing to disentangle yourself from so we are watching intently to see if it goes as smoothly as the Fed thought it would.
The flip side of this coin is that a lot of buyers are sitting on cash and when the fed backs out it will cause yields will pop up, which will in turn lure buyers back to this sector, who will in effect replace the Fed as the major liquidity provider, which by definition moves us toward a more normal market. That’s the best case scenario…the Fed steps out and the normal market participants step back in. We might have to start calling this “The Bernanke Two Step”.
The ultimate question here is “when will the buyers step in?” We all know when the Fed is going to quit buying at some point. We’re all going to be watching spreads too. As spreads rise there is a tendency to not get in the way…after all prices are falling and with the 800 pound gorilla no longer in the room they might fall a good ways before they stop. Who wants to try to catch a falling knife? The fact is that if people expect the market to go one way then they tend to wait until it gets there before doing anything.
In closing
Who knows which scenario we’ll get but the facts as we know them currently are that we are approaching the end-date for the MBS purchase program, the Fed owns 34% of the pass through market, and we appear to be a long way from seeing a recovery.
If you are considering selling MBS then this is a very good time to do so. Treasury yields are very low and spreads are very tight...this combination is your friend if you are selling bonds.
If you have any questions on this material just let me know.
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