What's Down the Road When the Fed Exits MBS?
The United States government’s support of the agency mortgage-backed securitization (MBS) industry, like the training wheels on a child’s bicycle, cannot keep the vehicle stable forever. The Federal Reserve for months has been winding down its weekly purchases of agency mortgage-backed securities from Freddie Mac, Fannie Mae and Ginnie Mae in preparation of a purchase program termination at the end of the first quarter of 2010. The aim has been to wean the agency MBS market off government support and prepare private investors to step back into a leading demand role. How MBS spreads to Treasuries behave once the Fed’s purchases end remains to be seen, and so far the available private investment capital is obscure. … Members of the Federal Reserve, in notes from its mid-December meeting, considered extending and expanding government-led initiatives to buy assets from mortgage agencies Fannie Mae, Freddie Mac and Ginnie Mae. The Federal Open Market Committee (FOMC) also confirmed plans to buy $1.25 trillion of agency mortgage-backed securities (MBS) and $175 billion of agency debt by the end of the first quarter of 2010 (Q110), according to minutes released in January. The size of these purchases were reduced gradually over months, with the aim of preparing private investors to return to the market. Questions abound, however, as to the effect of a potential exit by the government from the mortgage securities market. A few committee members considered the possibility of at some future point providing more policy stimulus through an expanded scale and time line of large-scale asset purchases extending beyond Q110. This scenario, according to the Fed minutes, would be especially applicable in situations where economic growth were to weaken or mortgage market functioning were to deteriorate further. Such a scenario — the “double dip” — is expected by many in the financial markets, including PIMCO bond chief Bill Gross, who in an interview with Time magazine said he expects economic growth in the U.S. to weaken in Q3 and Q4 of 2010, “which would basically call for some additional help.” According to Gross, the Fed will exit mortgage markets, only to have to consider a re-entry later this year. “[B]ased on our forecasts for the second half of the year, they may have to reinitiate it, and that will be difficult to do once they stop because it then becomes a political hot potato,” he told Time. ... Barclays Capital, in a piece of securitization research dated Dec. 29, said spreads could widen 30 basis points from current levels when the Fed purchases stop. But analysts anticipate adequate demand to return from the private sector, with participation from money managers providing enough backstop to keep spreads stable. “We think that banks, money managers and foreign investors should all be buyers of MBS in 2010, albeit at wider spreads,” BarCap researchers said. “A host of factors — muted loan demand, low appetite for credit risk, a steep yield curve, large cash holdings, and shortage of other spread products — point to increased MBS demand from banks. International demand could also rise as risk aversion abates and reserve growth picks up.” Nevertheless, the Fed’s role was “overwhelming” in 2009, as Fed purchases totaled $1.086 trillion of agency MBS, BarCap said, but net issuance of agency MBS was lower than in 2007-2008 (pictured below). BarCap researchers expect new issuance of agency MBS to remain “muted” around $350 billion to $400 billion in 2010. Despite the supply, BarCap said the Fed is unlikely to increase the size of the purchase program beyond $1.25 trillion or extend the timeline for purchases. TO READ THE FULL STORY, SUBSCRIBE NOW.