Waiting for the Fed to Withdraw

The pass-through market (location of virtually all of the action in capital market funding of residential loans; loans for pass-through execution are the predominant form of residential lending) generally accepted the FOMC’s statement last week as the final word on its MBS purchase program. The Fed will end the program by March 31 at $1.25trn. There is still chatter, however, about what circumstances would prompt the Fed to resume MBS purchases after March 31. It boils down to two things: a substantial re-weakening in home sales and prices or an excessive spike in mortgage rates. However, at this point, I haven’t read anything that attempts to define where the Fed’s “pain threshold” would be on housing depreciation or mortgage rates. We do know what was too painful in late November 2008, when the Fed announced the MBS and GSE debt purchase programs. Monthly postings of the Case-Shiller 20 city composite were showing 16-17% year-over-year declines (compared to a decline of 3.41% percent November ’09 versus November ’08, the most recent data). Similarly, mortgage spreads (Fannie current coupon versus interpolated 7.5 Treasury yield) were around 285 basis points (compared to 135 basis points currently, as tracked by UBS). My own gut tells me that it would take similarly negative conditions to prompt the Fed to resume MBS purchases in an effort to support housing. The Fed’s efforts pulled mortgage rates to historic lows and allowed a substantial portion of existing loans to refinance. But it appears that the Administration’s home buyer tax credit had a stronger impact on home buying than did record low rates. Add the fact that the program will have packed $1.25trn of assets ($1.425trn including agency debt purchase) onto its balance sheet. The offsetting liability is bank reserves in the same amount. Fed critics cry it’s printing money – but the dough is ephemeral until the banks decide economic conditions are ripe to rebuild their loan books. Still, further ballooning the balance sheet, in no matter how good a cause, has a political cost the central bank might weigh before proceeding. (Is this sentence not a masterpiece of trepid understatement?) I’ll leave it at that and turn instead to very thoughtful remarks published over the weekend by J.P. Morgan Securities mortgage strategists. They see another side of the problem – the effect on the secondary market. Say Matt Jozoff and crew at JPM, “… to grow the program substantially further in size would have threatened the existence of a liquid, privately traded agency MBS market.” In brief, they refer to the fact that Fed purchases consumed over 95% of 2009 30-year fixed rate issuance from Fannie and Freddie (my estimates), leaving very little tradable supply in lower coupons behind. This – and who will buy after the Fed leaves – is a topic I’m give wider treatment in the March HousingWire Magazine. The JPM strategists continue to point out they never believed the Fed was “attempting to defend a specific level of mortgage rates.” That would have been a project with little hope of success. “Indeed, we believe the Fed would have needed to be prepared to buy substantially more MBS to defend such a rate.” Reasoned thus, the Fed’s decision to depart the MBS market in March is “reasonable.” What does JPM see as that departure approaches? A tractor beam pulling mortgages closer to the equilibrium level “where the private sector will support them.” JPM thinks that’s about a point in price cheaper for very rich coupons like 5s and 5.5s. 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.