Thursday, October 1, 2009

The Debts of the Spenders: Putting a Floor on the Fed's Mortgage Bond Purchases

I promised to write an update on the RMBS story last week. B/c of personal developments I didn't have time. In retrospect that turned out to be actually a good thing since there have been a lot of major developments this week that will add to a more fleshed out post.

Here are the original stories for those searching for perspective:


Let's start w/the basics.

The NYFRB (New York Federal Reserve Bank) is the designated branch in charge of buying and selling securities in order to effect monetary policy. Specifically, the NYFRB is in charge of the POMO (Permanent Open Market Operations) and TOMO (Temporary Open Market Operations) that handles the buying and selling of Treasuries, Agencies, and Agency MBS (mortgage backed securities).

The Fed's quantitative easing mandate calls for it to buy MBS, treasuries, and bonds issued by certain federal agencies in order to keep interest rates low. In the securitization process, banks originate loans before pooling them into a MBS. This means that the interest rate banks can sell the instrument determines the rate at which they can offer a loan (minus a spread of course, someone's got to make a profit right?).

The NYFRB has been targetting the 4-5.5% interest rates during its operations:


B/c this is the rate that is closest to origination value and closest to the par value. If you click on the Fed's web site "Purchase archive" at the bottom of the page, you can pull up a history of all its operations. Note how for most of 2009, Fed managers were targetting 6 and 6.5% interest rates as opposed to the 5 and 5.5% rates of the two most recent operations. This means the Fed's goal of reducing or at least stabilizing low rates for 15 and 30 year mortgages has largely been successful. Read another way, it also means the Fed could be winding down its purchases.

Note in the accompanying graph that this reduction in lower interest rates coincides with a nice rally in the ABX market (chart from Markit's Series 7 ABX.HE AAA bond; series is a reference to the most recent tranche).

However, the end result of this massive government intervention in the markets has been dislocation of prices. RMBS have been artificially elevated in value. And private fund managers that were initially bullish on the market (due to the Fed's interventionist policies) have turned somewhat bearish.

Accrued Interest notes that Vanguard's creation of a separate index devoid of Fed interventions is the trigger that will start a spread dislocation. Other funds will start to follow and begin to separate themselves from the market. Volatility might actually increase b/c many sellers have grown accustomed to the Fed being the main (sometimes only) buyer.

In other words, there might be a potential fall in prices.

Even Bill Gross thinks RMBS are overpriced while the 5-10 year Tsy are not. Note that he is not bullish on the longer term notes (>20 years).

But it doesn't necessarily have to be that way. Most of the appreciation factor has already been factored in. Yet, the notes will still deliver a steady yield. The Fed's POMO Agency MBS program ends in roughly 6 months or the end of March 2010. However, the Fed has repeatedly stated that it is open to unconventional measures to keep interest rates low.

The WSJ also published an article on the Obama Administration's promises for another $35 billion in ADDITIONAL housing loans. This is a straight bailout of Freddie and Fannie again to the tune of $20 billion in bond purchases plus an extra $15 billion in funding.

Most of it is scheduled to hit the low and middle income sectors but maybe there will be some splashover effect on higher end housing.

Finally, my original point stands. B/c of higher capital reserve requirements, many financials will be required to convert their bonds (debt) to equity when the time comes in order to satisfy regulators. Unfortunately, I cannot give more specifics on this since even the regulators have yet to come to an agreement on what constitutes adequate measures.
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