Blurred vision: The Fed readies the beginning of the end

With QE tapering off, what's next for mortgage markets?

Well, the time finally arrived. Mortgage industry analysts and housing finance experts are now talking about withdrawal — especially the Federal Reserve’s December decision to begin a $10 billion monthly taper, and eventually, from all things government. It’s the beginning of the end. And the taper came just in time for 2014, too.

Global liquidity, and the U.S. mortgage market along with it, nearly immediately became addicted to Federal Reserve monetary policy action soon after the breadth and depth of the credit crisis became apparent in the first half of 2008. For the Federal Reserve, the Great Recession proved to be its greatest live-fire trading battleground. The extent of the U.S.’s involvement, and what it meant to global stability — say nothing of stability here at home — may never be fully appreciated.

But now, after nearly seven years of ever-evolving monetary policy, the Federal Reserve looks set on further reducing its involvement in so many corners of the economic world. It started slowing pulling back from the market it helped create.

Where this change will be felt most acutely is arguably where the problems all started in the first place: the residential mortgage market.

The dilemma here is two-fold. The first is when the Federal Reserve pulls back on the purchase of mortgage-backed securities. Critics argue this could reduce demand and flood the bond markets with supply. (The slow withdrawal from the market is commonly referred to as tapering.) The second, and much further down the road after tapering ends, is to slowly rise up and away from the zero-interest-rate policy (commonly called ZIRP), which has kept the cost of lending artificially low.

The planning for this extraordinary level of government stimulus was years in the making, as outgoing Fed chairman Ben Bernanke was among the academics who had studied so-called “quantitative easing” prior to the crisis — and then put the largely untested theories of QE into practice during the worst depths of a financial crisis, with uncertain outcomes.


While the outcome of the end of quantitative easing may be a qualified unknown at this point, the Fed has had plenty of experience addressing crises in years past. On March 19, 1997, then chair of the Federal Reserve, Alan Greenspan, testified in front of the committee on Banking and Financial Services in the U.S. House of Representatives.

At the time Greenspan spoke, the country had just emerged from the savings and loan crisis but was facing the growing specter of (ultimately unfounded) Y2K fears.

“In a crisis, the Federal Reserve, to be sure, could always flood the market with liquidity through open market operations and discount window loans; at times it has stood ready to do so, and it does not need supervisory and regulatory responsibilities to exercise that power,” he said at the time.

“But while sometimes necessary in times of crises, such an approach may be costly and distortive to economic incentives and long-term growth, as well as an insufficient remedy,” he warned. Greenspan knew then the Federal Reserve could do so much more, summon greater powers — even though it had not yet done so — to prevent economic trouble from worsening when recessions came calling. But he also warned of the unknowable outcome inherent in pulling that switch.

The time would come for the Fed to exercise its muscle and might in more ways than maybe Greenspan anticipated.

Jan 14 cover feat 1Jan 2014 coverIndeed, the current monetary policy for keeping the economy on as stable a footing as possible contained some dramatic and far-reaching events that went well beyond U.S. borders.

In the second quarter of 2007, foreign entities borrowed $47 billion from the Fed to stay afl oat. In the fi rst quarter of 2008, the Fed lent almost $45 billion to what are primarily European banks. This lending was on par with similar credit arrangements the Fed made with banks here in the United States during the same time frame.

Today, this activity is only a fraction of what it was during the crisis, with the primary borrower being the Federal Home Loan Banks.

The point is, this unprecedented lending by the Federal Reserve unwound in a way that did not roil the markets. Soon thereaft er, on Feb. 18, 2009, Greenspan’s successor, Fed chairman Ben Bernanke, gave a speech at the National Press Club luncheon about how the Fed could possibly get out of its own mess.

“To reduce policy accommodation, the Fed will have to unwind some of its credit-easing programs and allow its balance sheet to shrink. To some extent, this unwinding will happen automatically, as improvements in credit markets should reduce the need to use Fed facilities,” he said. And improvements in credit markets did just that.

The Fed showed it could step slowly away from some aspects of its great global bailout — but make no mistake: the Fed will be forced to stage an even more protracted retreat from its support of the mortgage industry.

That’s because there are no functional, stand-alone credit markets to compete with the Federal Reserve when it comes to mortgage lending. And in this regard, the term addiction can be applied liberally — since the government helped create a mortgage market that could not survive without it, or be competed with, when it took Fannie Mae and Freddie Mac into conservatorship during September 2008.

In propping up a fractured market in its time of need, the Federal Reserve also sucked the rest of the air out of the room for anyone else.

Economist Milton Friedman is credited with saying “nothing is ever so permanent as a temporary government program,” and that aphorism may as well apply to the situation currently faced by U.S. mortgage markets.


The result of the Fed’s eventual exit in the mortgage fi nance market will likely be a negative net scenario for issuers, where their liabilities outweigh their assets. At least in the short term.

It’s a concern because while this does not immediately signal a mortgage market doomed to failure, such a scenario typically impacts the ability of fi nancial institutions (read: those that would otherwise fund new mortgages) to qualify for new credit from counterparties that ultimately grease the wheels of fi nancing for such things like mortgages backed by private capital.

Analysts at Bank of America Merrill Lynch (BofAML) summed up the 2014 private bond markets — those not linked to Fannie and Freddie, or Ginnie Mae — as becoming overly sensitive to macroeconomic data in the wake of an announced taper. Fortunately, overly sensitive or not, it appears that there is money to be made in the private mortgage bond market. At least, what there is of it.

Jan 14 cover feat 2“We think non-agencies will produce positive total and excess returns in 2014, but both will be lower than what was delivered in the prior two years,” noted head BofAML mortgage analyst Chris Flanagan in an email to clients.

“We expect that non-agency gross issuance to reach $37 billion in 2014 which we project would be a 36% year-over-year increase. We expect a modest decline in Jumbo 2.0 issuance will be off set by an increase in agency risk sharing, nonperforming and reperforming loans, and REOto- Rental securitizations,” he added.

In other words, those looking for private markets for mortgage bonds and associated liquidity are increasingly going to have to look at existing mortgage retreads and towards the emerging REO-to-Rental asset class. The embedded implication here is that the more traditional private-label RMBS market will remain largely in the deep freeze.

In their 2014 outlook, Flanagan and his team discussed the taper at some length. They feel communication from the Federal Reserve is such that investors will be best positioned to withstand the eff ects of any tapering by spring 2014. As the chair position transitions from Bernanke to his likely replacement and fellow Fed colleague Janet Yellen, there is some expected volatility and the sense that fi nancial markets will need some time to universally digest the change in leadership.

The big question relative to any tapering by the Fed is this: who, exactly, will be standing to purchase the mortgage bonds currently being sopped up by the government — and therefore keep a lid on mortgage rates?

“With banks, GSEs, foreign portfolios and REITs all struggling with issues that make them unlikely to step into the Fed’s place, total return portfolios stand out as the only other candidate with pockets deep enough to make a diff erence,” said Steven Abrahams, head of mortgage bond analysis at Deutsche Bank.

The limitations on the GSEs themselves may, somewhat quixotically, be among the most damning aspect of any planned taper. That’s because the GSEs, while in conservatorship, are restricted from one of their traditional roles: holding MBS in their own portfolios, which served to put a fl oor on mortgage pricing prior to the crisis.

The GSEs purchase mortgages from lenders, package the mortgages into MBS, and either keep the MBS “in portfolio” or sell them to institutional investors. To finance the MBS that they keep, the GSEs sell bonds to investors. When the GSEs were taken into conservatorship, their contact with the Treasury required the GSEs to eventually shrink their portfolio holdings to $250 billion for each entity — a goal that recent FHFA targets have the GSEs committed to achieving by 2018.

This means the GSE bond market as a whole is shrinking as its portfolios shrink, although Fannie Mae and Freddie Mac (along with the Federal Housing Administration) remain the only real funding mechanism the market has for many mortgages.

As Deutsche’s Abrahams points out, these are truly delicate times for mortgages, taper or no taper: data compiled by Bloomberg indicates that 2013 will be the fi rst year of bond losses from Fannie Mae, Freddie Mac and Ginnie Mae in total, the fi rst seen since 1994. BofAML has recommended investors keep portfolios underweight for both private and government- linked (agency) mortgage bond holdings, as a result.

“The GSEs only have $6.2 billion left to sell at the end of Q3 to meet their 5% portfolio reduction target,” said 2014 outlook research from JP Morgan, looking at GSE bond issuance. “We expect them to sell another $32 billion in 2014 if they target another 5% of portfolio reduction.”


For their part, JPM’s team of analysts said they expect the taper to come in the same month this magazine is printed (January 2014). But they are voicing a larger concern with the impact of Mel Watt, the newly confi rmed director of the Federal Housing Finance Agency, which oversees the GSEs; a change in leadership may serve to complicate the GSE picture at the very same time the government backstop is being dismantled.

“We can expect more policy changes and a more active FHFA going forward,” they wrote in an email to clients during late 2013. “While the future of FHFA policy is unclear, it could entail a renewed focus on principal forgiveness, a broader credit box, aff ordable lending, and a preservation of much of the existing GSE infrastructure.”

Ashley Gam, an analyst with the Royal Bank of Scotland, agrees the big outlier is whether President Barack Obama’s FHFA head pick, Rep. Mel Watt, D-N.C., gets into place. Watt, a long-time housing advocate, will likely not look to interpret the conservatorship as narrowly as current acting director Ed DeMarco has done; DeMarco, for example, never wished to see the value of Fannie and Freddie debt written off .

“The major risks will come in if he introduces borrower-friendly modifi cations,” said Gam about a Watt-led FHFA. “One being expansion of the HARP program. That would mean expanding the HARP cut-off date, which would make more borrowers eligible,” Gam said. If that were to take place, RMBS deals with 4½ to 5 handles on them would suff er the most, she suggested.

For her part, Gam doesn’t expect a potential Fed tapering of mortgage- backed securities purchases to hurt too much since it’s likely to come in small waves, possibly beginning in March, she said. But not knowing where the FHFA or other regulators could head in 2014 remains far more challenging.

“You have nowhere to hide. It’s sort of across the whole stack,” she advised. Previously, she said investors could move to higher coupons if one part of the market is affected, but now there is the added risk of rising interest rates.


Individual investors interviewed by HousingWire shared a wide array of thoughts on the year ahead and the expected ledger shift of mortgage holdings out of the government’s hands, although that shift is expected to be anything but smooth. Some intend to look for short opportunities in 2014, acknowledging the risk associated with higher levels of expected market volatility.

Those who are involved more broadly in the space — international wealth managers for example — intend to employ great flexibility in their investment strategies and appear to have a plan for when the Fed makes the call to taper. They are happy enough with the volatility, and actually trade on it. They will flood the markets as appropriate and then pull out in a heartbeat.

In fact, they’re playing the taper.

“We have substantially changed our U.S. economic call, due to a significant delay in the tightening process while keeping strong GDP numbers, and accordingly have raised the risk profile of our allocation,” said Paris-based Alain Bokobza, the global head of asset allocation at Societe Generale. He explains his plan to move from “rather risk-averse (42% equities, 20% cash) to somewhat more risk-taking (55% equities, 5% cash).”

“So we are not fighting Janet Yellen’s Fed for now,” he added. “We expect that there will be a more appropriate time to do so later on.”

And it is the ability to play that risk that is common across the entire investor landscape, irrespective of which side of the mortgage market is involved.

One of the most interesting potential developments in the investor field may be the emergence of real estate investors into the mortgage bond market. As one investor said, these investors already battle the credit risk landscape of REO-to-rentals and nonperforming loans and, therefore, setting aside some allocations for MBS — where risk is more primarily limited to interest rates, versus credit and collateral — may not be unfounded.

It will be important to watch activity from Real Estate Investment Trusts, too, and more broadly the entire private equity space. According to Preqin, the alternative asset manager and private equity data provider, U.S.-focused real estate property funds saw a large increase in fundraising recently. Closed funds in 2012 raised $4.3 billion while similar funds surged to raise $9.2 billion in 2013 at the time this story was printed.

According to Andrew Moylan, head of real estate assets products at Preqin, real estate investors are continuing to become more and more sector-specific, with the demand for niche asset managers in each individual area growing.

“This increased appetite for specialist managers has resulted in sector- specific offerings accounting for an increasing share of fundraising for the U.S. private real estate market,” Moylan said, “with specialist firms more likely to meet or exceed their fundraising goals than those raising funds which target a range of sectors.”

What this means in so many words is that an investor in residential real estate is increasingly likely to stay in the sector and diversify across corporate bonds, GSE issuances, private issuances, whole loan purchases, and more—versus spreading risk into associated sectors, such as commercial mortgage-backed securities.

Investors stateside are doing the same as the global investor, getting tighter instead of going broader. In practice, this means that appetite increases across a sector-wide basis and demand increases for products within that sector, a move that in the aggregate is a positive development for mortgage liquidity.

The Barclays outlook for 2014 reflects this understanding and feels constructive on the non-agency market as a result.

“We expect demand-supply dynamics for non-agencies to go from being lopsided in the past few years to being more evenly matched,” said the Barclays outlook. “That said, most of the positive factors from 2013, including yields higher than on comparable assets, strong HPA/credit performance and an accommodative Fed, should remain, which bodes well for non-agencies.”


A funny thing happened in July: Freddie Mac decided to offer a new bond product, the first of its kind.

The securities, entitled “Structured Agency Credit Risk” notes, were the first in a series of such risk-sharing offerings, heralded as a key step in the process of attracting private capital back into the mortgage finance system.

The enterprise has offered $500 million of derivatives linked to mortgages it holds, as well as guarantees under the new program thus far, a success by the CEO’s standards.

“This debt issuance is an important step forward in reducing our exposure to residential credit risk by transferring a portion of it to private sector investors,” said Freddie Mac CEO Donald Layton. “Our intent is to create a product that will be well-received by investors and can become repeatable and scalable over time.”

He added, “Due to investor demand, the size of the offering was increased from $400 million to $500 million, and about 50 broadly diversified investors participated in the offering, including mutual funds, hedge funds, REITs, pension funds, banks, insurance companies and credit unions.”

The securities are bonds issued by Freddie Mac to protect against credit risk with the value depending on the performance of a pool of $22.5 billion of residential mortgage-backed securities — so at $500 million, really a small portion of the overall deal. But the precedent set was pregnant with more profound implications for mortgage bond investors.

“The recent success of the risk-sharing deal shows investors may be willing to bear more mortgage credit risk,” said Laurie Goodman, head of the new Housing Finance Policy Center at the Urban Institute, and a mortgage analytics legend. HousingWire caught up with Goodman at her new role, asking what could meaningfully improve the investor outlook.

“If Fannie and Freddie were to do 100% risk-sharing, I believe the investor capacity is there,” Goodman said — but without the confidence that such an event will one day occur. But imagine that: a reform of the GSEs that places credit risk squarely back into the hands of private investors.

“That could potentially reform housing finance administratively, without legislative action,” she said.

But the risk-sharing will never go that far in practice, she added. In order to really get investors active in the Fannie and Freddie space, “the reality is there needs to be a catastrophic government guarantee in order to preserve the fungibility of the TBA market,” according to Goodman.


The credit ratings agencies, those firms that ostensibly measure the risks associated with investing in mortgage bonds, are generally stable in their outlook for 2014 — at least at the start of the conversation. Words such as “poised for a stable outlook” quickly deteriorate to “political issues also continue to fester,” in the case of one email from analysts at Fitch Ratings.

Fitch expects the vast majority of new issue RMBS in 2014 will be compliant with upcoming qualified mortgage (QM) regulations promulgated under the Dodd-Frank law. The QM standard, coming into force in January, will adjust both lending guidelines and operational controls.

As a reaction, Fitch said it expects pools of non-QM loans to come to market as part of private RMBS issuances in 2014, as lenders search for liquidity — although the agency says any issuance in the non-QM space will likely be limited to established lenders/issuers that can demonstrate a low risk of challenge and liability exposure to the RMBS trust.

“Equally important, this summer, a revised proposal on the qualified residential mortgage definition was released, which effectively equated the QRM definition with the QM definition,” said Fitch analysts.

The qualified residential mortgage, or QRM, standard defines mortgages exempt from risk retention requirements applicable to RMBS issuers, and is part of the massive Dodd-Frank legislation passed by Congress on the heels of the financial crisis. A final definition for QRM is still being worked on at the time of this story’s publication.

“Key changes under the [current] proposal include the elimination of the premium-capture, cash-reserve account, and borrower credit history and LTV requirements. A secondary proposal labeled ‘QM-plus’ defines QRM as loans that meet QM guidelines, in addition to borrower credit history and LTV requirements. Finalizing the QRM definition and related risk retention rules will be an important milestone for the market in 2014,” Fitch said.

Moody’s Investors Service offers a different take, arguing that in 2014 the extent of the risks for RMBS will vary depending on mortgage originators’ practices and documentation, the strength of the transactions’ representations and warranties, and whether any new-issuance transactions include indemnifications that shield investors from borrower lawsuits.

“The degree to which RMBS will need additional credit enhancement to account for the increased risk of losses from non-QM and rebuttable presumption QM loans will depend on the strength of originators’ compliance practices and the trust mechanisms protecting against lawsuits,” said Moody’s Senior Vice President Kruti Muni.

All of which should serve to bring into clearer focus the role of private capital in mortgage markets in 2014: more needed than ever before — but how, when and even where remains a mystery to be played out.

Such is the nature of withdrawal from any addiction, after all. A return to more normal life is always the end goal, but the road to that eventual recovery is rarely well-marked.

— Paul Jackson also contributed to this report.

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