Despite anticipated higher rates and wider spreads, investment opportunities will likely remain after the government exits the agency mortgage-backed securities (MBS) market this month, according to research-driven institutional global asset management firm Smith Breeden Associates. The Federal Reserve is on track to wind down purchases of $1.25trn of MBS by the end of the month. MBS bond yield spreads to Treasurys tightened to historic levels during the program, and investor uncertainty lingers over whether spreads will blow out again in the the post-Fed agency MBS market. Credit-rating agency Fitch Ratings sees signs both mortgage rates and loan loss severities will likely rise following the Fed's exit from the agency MBS market. Going a step further, economists warn the Fed's withdrawal will trigger a rapid decline in the monetary base and, ultimately, a resurrection of the asset-purchasing program. “Since the peak of government purchases in the spring of 2009, the Fed has been tapering their purchases with the intent of having an orderly exit from the market," said Smith Breeden principal and senior portfolio manager Dan Adler, in commentary e-mailed to HousingWire. "While this slow exit should lessen the Fed’s overall impact, it’s difficult to envision their exit having no impact, as they’ve been the majority buyer of MBS for much of the last 13 months." Adler anticipates spreads will widen somewhat and mortgage rates will increase in the wake of the Fed's exit. But instead of the 70-100bps increase commonly expected, Adler said spreads will likely widen around 25-30bps. A drop in net issuance of MBS and a reduction in the supply of new mortgages will keep supply low, which will ease the widening pressure on spreads, he said. But the Fed's exit will likely add some volatility to the market. "[W]hile it’s safe to assume we’ll see some short-term widening resulting from the Fed’s exit from the MBS market, we believe there will only be a limited amount of cheapening, which suggests investment opportunities will remain and investors need not abandon the agency mortgage market entirely," Adler said. Although investor uncertainty casts doubt on the return of the buy-to-hold investor, researchers from global financial services firm Credit Suisse are looking ahead to an expected strength of bank and foreign investor demand for agency MBS in 2010. The Fed's exit from agency MBS, however, combined with the wind-down of the first-time homebuyer tax credit and government-led loan modifications -- which so far have shown underwhelming results -- will also have the knock-on effect of raising loss severities on distressed US residential mortgages this year, according to Fitch Ratings market commentary. The expiration in the coming months of both the homebuyer tax credit and the Fed's MBS purchase program will increase negative pressure on home prices and loss severities, Fitch said. An increase in the liquidation of loans with unsuccessful loan modifications is expected to add to the supply of distressed inventory in the housing market. Write to Diana Golobay.