Viewpoint: Like Us, Whitney Sees Risks in FedÕ MBS Exit

HousingWire readers have already been reminded on a number of occasions that the Federal Reserve dominates the agency/GSE MBS market (and has since the purchase plan was announced almost a year ago) and that banks and would-be mortgage borrowers are first in line to be whacked when the Fed exits the MBS market. So I was thrilled yesterday when celebrated bank analyst Meredith Whitney put out an industry note that zeroes in on the Fed’s MBS purchase program; She calls the “Great Exit” the biggest market and bank risk over the next four months. I’d qualify that – I’d say let’s hope it emerges into the public view over the next four months, because it could be – if the Fed exits as planned at the end of first quarter 2010 – the biggest kick in the stomach housing and financial markets have gotten since surviving the near total shut down of credit last fall. Here’s what I wrote in July 2009: “When mortgage spreads were in virtual free fall last autumn, the Fed stepped in,” pulling spreads to historic tights. When the Fed leaves, “U.S. banks – as the single largest private institutional investor sector after the GSEs – have the most to lose. Or should we say, if the Fed leaves, the banks have the most tangible capital to lose (their MBS are largely carried as available for sale, with changes in fair value reflected in shareholder equity).” I picked up the discussion again last month, featuring the comments of professional MBS analysts on the likely impact of the Fed’s departure. Many hesitate to put a number on the potential widening, but a couple brave analysts have published that option-adjusted spreads (these are spreads to Treasury rates or LIBOR that deduct an expected cost, to maturity, of the prepayment options held by borrowers) could widen 20 to 25 basis points after the Fed. I’ve long thought it might be worse than that. When I wrote about this topic in September in my HousingWire Magazine column, “After the Fed the Abyss,” I wondered if mortgage rates might not just give back the 125 basis points of tightening versus comparable Treasury yields Fed demand achieved. Which means that, in addition to any change in Treasury yields (say under the pressure of relentless supply, increasingly shifted to longer maturities), mortgage rates could increase by 1.25% without the Fed. That’s possibly too gloomy. MBS investors – whose demand translates into mortgage rates – are likely to be more cheerful about buying than they were a year ago. The MBS pros believe that at some point, hard to gauge in advance, other traditional MBS investors, crowded out by the Fed, will find MBS yields attractive and step up their demand. But that is not going to make mortgage loans as attractive as would be borrowers or pols and policy makers would like. Whitney’s gloomier than that. It’s not clear to her that there is another buyer to replace the Fed on the margin. (At this point, I always like to point out that the GSEs used to perform this role, putting a floor on mortgage prices during periods of sharp rate movements or exploding supply.) Which means that “prices will go down meaningfully and rates will go up meaningfully.” The consequence: “banks could stand to take write downs and it will be far more expensive for consumers to secure mortgages.” Here here. If only more cable-ready analysts would follow Whitney into this discussion. The Fed is in a pickle – it can’t continue to support the mortgage market indefinitely (certainly the size of its balance sheet has already rattled nerves in some sectors). And the risks to investors (including, via mutual funds, individuals), home buyers, home owners in need of affordable refinancing, if it does stop supporting the market are significant. Maybe if more high profile analysts start to wave the flag, the pols and policy makers will get down to business and face up to the looming question: the fate of the $5 trillion Ginnie Mae and GSE MBS market. It’s time for hard thinking about the government’s proper role in housing, given the hard facts of $5 trillion securities outstanding and the only viable source of housing finance still, after two years and counting, is government sponsored securitization. Replacing GSEs with smaller, tamer entities or none at all and counting on private lenders and private securitization (try to build that market with minimum retention standards!) as the “ideological” foes of government-sponsored entities would have it, will orphan a vast amount of widely held securities and choke off the flow of capital market funding to U.S. housing.