More Advice for the Fed

While the residential mortgage markets worry about what happens when Fed concludes its mortgage-backed securities (MBS) buy program at the end of next month, everyone else appears to be miles ahead, worrying about what the Fed Reserve is going to do with its heap-o MBS. That debate got a big boost from Fed officials in the last couple of weeks – from Chairman Ben Bernanke’s House testimony last week and, this week, the revelation of some spirited internal debate at last month’s Federal Open Market Committee (FOMC) meeting and a speech by Philly Fed President Charles Plosser in a speech (and covered here) Since I’ve been cogitating quite a bit about the Fed’s departure for HousingWire, my gut says talk of selling is premature. In fact, talk of selling makes me cringe. It could prove to be destructive because it reinforces the caution traditional MBS investors must already feel anticipating a Fed-less market. They already harbor opinions about how much spreads could widen without the Fed. (That is mortgage rates and MBS yields increase relative to other interest rates.) Investors also know how much pain they can take on existing positions, as well as how much wider spreads must get before they are willing to add new MBS holdings. The idea that supply would be coming out of the Fed any time soon only multiplies investors’ uncertainty. It gives them incentives to sell now in order to get out of the way of that widening. It induces them to raise the spread target they’ll require to come back into the market. In other words, jawboning Fed MBS sales only increases the likelihood and amount of spread widening that will occur with the Fed stops buying. However, even I, die-hard MBS booster that I am, know that there’s more at issue with the Fed’s stuffed balance sheet, matters on which I do not claim to be expert (money and banking, theory and practice). So I was delighted to see Chris Whalen, of Institutional Risk Analystics (IRA) take a swing at the subject of quantitative easing (QE) and what the Fed should do with its MBS holdings in this week’s Institutional Risk Analyst newsletter. Whalen is a banking and industry analyst and former investment banker with primo industry data at his fingertips. His opinions have clout – with bankers, bank investors and in D.C. (So if you are interested in our current collective plight and aren’t reading him, you should be.) Whalen calls on the Fed to end its purchases as scheduled and then “begin to aggressively make a two-way market in all of the securities it holds.” The Fed should “redefine the private market for MBS by example.” Then “as other dealers begin to follow the lead and trade this paper with greater confidence, the Fed can stand back from the markets gradually.” Since he’s not a mortgage market participant or observer per se, he probably doesn’t know how uneasy traditional investors of every sort are about the Fed’s departure or possible selling. He wouldn’t know that market participants are already calling on the Fed will to market liquidity, particularly by rolling its holdings (a “dollar roll” is similar to a repo or security lending transaction), as it owns most of the tradable float in 30-year GSE 4s, 4.5s, 5s and 5.5s (see my column “Who Takes the Slack From the Fed?” in the March 2010 HousingWire Magazine). I would argue that the confidence dealers need to position this paper (so that they may trade it to investors and mortgage servicers who employ it as a hedge for their servicing incomes) is a function of demand expressed by real investors. Watching the Fed and broker/dealers pass MBS back and forth won’t make investors any more eager to own them. When did a willing investor need to be convinced that broker/dealers stood ready to offer them bonds? The comfort real investors want in the current environment is a dependable buyer on the margin to provide a “floor” on spread widening. A buyer of last resort. That is what the GSE portfolios were, and that is what the Fed has been as foreign investors, hedge and other private equity funds, money managers (pension, trust, mutual funds, etc.) have faded the MBS sector. Broker/dealers are not going to be that buyer of last resort, regardless of how willing the Fed is to make two-way markets. At some point the horse trading has to stop, someone has to get on the horse and ride it. The Bank-Centric Point of View Bear in mind, Whalen is coming at the problem of QE from a different perspective, that of its impact on banks, not on MBS investors. His concern is that Fed policies – hewing to a zero interest rate policy, driving down Treasury and mortgage yields with its purchases, inducing banks to leave their cash at the Fed by paying interest on reserves – are driving global deflation. He defines deflation in a characteristically bank-centric way: “Loan loss rates among US banks continue to rise for the twelfth straight quarter in a row. Cash flows from bank loan and securities portfolios alike are still shrinking, forcing further contraction in balance sheets, loan portfolios, cash balances and new loan allocations for bank managers. This is what you call deflation.” The Fed’s QE does not alter “the deflationary effect of the mounting backlog of defaulted mortgage loans.” The only beneficiaries Fed purchases are foreign governments and the largest dealer banks who have been spared losses on securities. By dealer banks I think he means (or should mean) the huge MBS investment holdings of the gigantic commercial banks, not the smaller exposures of their broker/dealer subsidiaries. But I don’t disagree. As I discuss in my upcoming HousingWire column, banks have shifted the mix in their government-agency holdings from MBS toward Treasuries. As a percent of assets, it’s not a radical shift, but as a year-over-year change it’s significant. In 2009, the universe of large U.S. commercial banks tracked by the Federal Reserves H.8 statistical release grew their agency MBS investments by just 5%, they grew non-MBS Treasury and agency securities by 123%. I just don’t think banks were simply realizing fair value gains in available-for-sale securities. The Fed may have been happy to facilitate that outcome. The MBS purchase program also gave banks an opportunity to get out of the way of the inevitable widening when the Fed leaves. Also, it allowed banks to remove longer duration securities from their balance sheets before interest rate risk – a hot button now with regulators – is amplified by an increase in interest rates. (Note that the $300 billion Treasury purchase program Whalen refers to in passing was aimed at longer dated issues, was limited to 35% of any new auction and was concluded in October, many months ago.) I also believe banks may be prudently scaling back in MBS given the non-zero possibility that policy makers will replace Fannie and Freddie securitization programs with something else, a step that would suck the oxygen out of existing MBS markets. Here’s where Whalen’s argument really confuses me. The banking industry is “largely powerless to manage the massive duration risk created by the Fed’s QE program.” I thought the most massive duration created by the Fed’s QE program came in the form of 30-year 3.5s, 4s, 4.5s and 5s created largely from refinancings by the highest credit quality borrowers in the favorable rate environment fostered by Fed purchases. (Whalen’s right, the Fed purchases did not expand credit – underwriting happily has reverted to standards in force three decades ago.) The massive duration bomb created by the Fed’s buy program has gone into the Fed’s vault. So when Whalen says the Fed, in unwinding the QE, should follow the FDIC’s example of pushing assets of failed banks back into private hands ASAP, I’m confused – does he want the long duration assets back on bank balance sheets? Maybe he means at wider yields because QE, he asserts, has also bid MBS and Treasury yields “down to levels that nobody in the private sector finds remotely attractive.” Furthermore, Fed policy has squeezed net interest margins in the banking industry at the same time that assets are shrinking. “This is why the search for earning assets has become one of the most pressing priorities for the banking industry.” Let them make loans? No. Whalen reminds that “by purchasing $2 trillion worth of securities through QE, the Fed also has taken tens of billions of dollars per year of interest income from these assets out of private sector banks and transferred it to the Treasury.” Note – this is QE earning money for taxpayers – their cost of funds on the excess reserves created by buying MBS is 0.25%, but they take in coupons of 3.5% to 6.5% from the MBS. Nice spread. It’s far more common to hear QE criticized as inflationary. And it would be inflationary if the banks were to begin lending against those reserves before the Fed manages to reduce it’s balance sheet (that’s one reason why the Fed pays interest – to undermine this “printing money” effect). But Whalen takes a different tack – in effect, the Fed’s eating the banks’ lunch and creating a dead pool of cash to do it. Instead, Whalen wants the Fed to actively discourage “banks from placing reserves with the central bank and instead encourage them to repurchase private MBS and other liquid assets.” Whalen is pitching normal bank practice in economic downturns. Historically, when lending is risky and existing loans are rotting, banks increase security holdings and reduce allocations to consumer and commercial lending. Has the Fed “forced” them to do so less than in the past, or are interest margins on securities narrower in this than in past cycles? Where Whalen Scores As a mortgage analyst, I’m not unhappy with the result that the Fed has put upwards of $1.5 trillion longer duration securities out of the reach of the banking system before interest rates can rise. On the other hand, I’m not happy that they bought so many MBS. Once the Fed saw how small an impact lower mortgage rates had on home sales and prices, once they observed the end to the big wave of refinancings by those borrowers who could qualify, I’d have been happy to see the Fed step back. Keep their powder dry. For me (others will opine all day), it’s way too early to guess whether the Fed can drain those reserves in time to prevent a spike in inflation (and another round of witless lending). I can’t say now how effective a stance of providing liquidity to the market through rolls, repos, selling into real bids and allowing natural runoff will be in reducing that heap-o MBS, just that I think those are the only safe tools the Fed has. Whalen does press for a step I believe is essential to get move mortgage and housing markets onto firm ground. President Obama, Fed Chairman Bernanke, Treasury Secretary Geithner and FDIC Chairman Bair must “sit down at the same table and devise a plan to redefine the legal and financial template for bank securitizations. … A new model for bank securitization is a necessary condition for the recovery of the US economy.” Hear, hear! I would add they – or someone – needs to school the chairs and ranking members of the banking committees in Congress and the rest of the leadership on both sides of the aisle on the difference between, on the one hand, expedient, practical and practicable and, on the other, influence peddling, grandstanding and partisan gamesmanship. I would also add that ensuring a real basis for private securitization of residential mortgages should be the first order of business before undertaking to resolve any of the issues surrounding Fannie and Freddie. I have a question for Whalen (or any one else expert in the financial industries that invest in MBS). What happens to the market value and tradability of banks’ MBS if the government and the corporate interests it serves, in their collective “wisdom” pursue a plan for Fannie and Freddie that does not result in continued issuance of standard MBS that are fungible with their existing securitization programs? Those securities that currently account for more than 10% of US bank (gross) assets. NOTE: Linda Lowell writes a regular column, called Kitchen Sink, for HousingWire magazine. Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.