As the government-sponsored enterprises continue to wind down their portfolios, market experts are noting that there aren’t any formal housing finance reform proposals that address the need for the government to provide a portfolio function that acts as a countercyclical stabilizer to the market.
The Federal Reserve, through its quantitative easing program, has stepped into that void, replacing the GSE portfolio function, according to Bank of America Merrill Lynch’s (BAC) latest report.
"In fact, given that no longer-term alternative to the GSEs is being proposed, the Fed may actually have signed up for a more permanent role as the buyer of last resort in the agency MBS market," explained mortgage-backed securities strategists Chris Flanagan and Justin Borst.
Since 2009, the GSE ownership share of the market has been dropping, while the Fed’s share continues to grow. Thus, the combined share now stands at 30%, comparable to the ownership share at the end of 2009 and 2010, but roughly 5% higher than the 2011 and 2012 ownership share.
Given the GSEs’ wind down requirements, the Fed has stepped in, first suggesting QE purchases could return and then formally announcing $40 billion net MBS purchases per month.
Consequently, this will inevitably impact the looming tapering decision, specifically, if the Fed does taper, will it taper both MBS and Treasury purchases or just one of the sectors.
Royal Bank of Scotland (RBS) marketing & international banking analyst Jeana Curro pointed out that given the recent backup, new supply is expected to shrink dramatically. Furthermore, any eventual Fed tapering could be offset by a decline in supply, therefore having minimal effect on the basis.
"If the supply was expected to grow, we believe this could partly reduce (or delay) an eventual tapering, but that does not seem to be the case," Curro said.
She added, "The RBS view on what will be tapered is a combination of MBS and Treasurys. This essentially comes from the fact that the Fed is somewhat divided, so we could foresee tapering both as a compromise."
Since taper-talk led to a rise in mortgage rates, the Fed’s share of gross MBS issuance is expected to rise from 50% to 70% by the fall as a result of the rate-driven drop in MBS production, BofAML explained.
"This is the 'flow' argument, which, admittedly, the Fed has been somewhat dismissive of when discussing QE," Flanagan and Borst stated.
They added, "In fact, generally the Fed has been more concerned with its stock of ownership."
If the GSEs still have $368 billion in portfolio reduction to achieve, and need to reduce it at a rate of 15% per year, this gives the central bank room to taper MBS fairly dramatically and quickly – if the Fed wants to maintain a combined 30% share of the market.
However, market experts only expect about $100 billion to $200 billion in net MBS issuance over the next year, the Fed only needs to purchase a maximum of $115 billion net over the next year to maintain the combined 30% share.
Alternatively, the Fed could drop purchases to $20 billion per month and meet its requirements in six months or to $10 billion per month for the next 12 months.
"In our view, from the stock perspective, September tapering of MBS purchases seems to be an eminently viable option for the Fed," BofAML strategists concluded.