Sense on Cents

Will the Federal Reserve surprise the markets and not fully purchase the $1 trillion+ worth of mortgage-backed securities via its quantitative easing program? Why would the Fed slow, if not stop, its mortgage purchases? What might this mean for mortgage rates?

Bloomberg highlights this potential development this morning in writing Lacker Says Fed May Not Need To Buy MBS Authorized:

The Federal Reserve may not need to buy the full $1.25 trillion in mortgage-backed securities the central bank has authorized by year-end as the economy improves, Federal Reserve Bank of Richmond President Jeffrey Lacker said.

“I will be evaluating carefully whether we need or want the additional stimulus that purchasing the full amount authorized under our agency mortgage-backed securities purchase program would provide,” Lacker said today in a speech in Danville, Virginia.

The Bloomberg story follows up on news released by the Fed that it had decreased and changed the money managers through which it has purchased mortgage securities. The New York Fed released a statement on August 17th highlighting this development, New York Fed Streamlines External Investment Managers for Agency MBS Purchase Program:

The Federal Reserve Bank of New York today announced that it has streamlined the set of external investment managers for the agency mortgage backed securities purchase program, reducing the number of investment managers from four to two. The New York Fed has retained Wellington Management Company, LLP for trading, settlement and as a secondary provider of risk and analytics support; and BlackRock Inc. as the primary provider of risk and analytics support.

Let’s address some basic questions about the Fed’s MBS purchase program, MBS in general, and implications for the economy.

1. Which money managers were removed by the Fed?

>> Goldman Sachs Asset Management and Pimco

2. Why might the Fed slow its purchasing of MBS?

>> While Fed governor Lacker would maintain that the Fed may slow its purchasing of MBS because the economy has improved and continues to improve, I would beg to differ. Home sales are rebounding, but delinquencies and foreclosures are running at record pace. Those statistics, in my opinion, continue to cast dark clouds on our housing landscape.

The Fed’s purchasing of MBS has skewed this market and implicitly crowded out private investors from buying these assets at higher rates.

3. How are MBS valued?

>> When the Fed or any other investor purchases a MBS, the return is determined not merely by the coupon on the bond but also by the rate of prepayment. That prepayment rate is an option the homeowner has and the purchaser of MBS effectively sells.

The value of this prepayment option needs to be weighed when evaluating MBS. How is this done? As with any option in the market, valuation factors include volatility and time to option expiration.

In the current market environment, mortgage valuations are EXTREMELY RICH. How so? The OAS (option adjusted spread) an investor can expect to receive in purchasing a 30yr MBS security is BELOW Libor, which is the effective borrowing rate for most banks.

4. What does this mean?

>> While the U.S. Treasury issues debt along the entire yield curve (1 month to 30 yrs), the Fed is purchasing MBS effectively at valuations which are negative to funding. That differential is the implicit subsidy Uncle Sam is providing to homeowners.

5. What happens if and when the Fed slows its MBS purchases?

>> Mortgage rates will move higher to a level at which private investors deem MBS to represent fair value. How much higher? I would guesstimate at least .25% and more likely .50%-.75%.

LD