Complacency seeps in as Fed stops buying MBS
By Agnes Crane and Antony Currie
Investors seem remarkably relaxed about the end of the U.S. Federal Reserve’s $1.25 trillion program to buy mortgage-backed bonds guaranteed by Fannie Mae and Freddie Mac.
Just a few months ago many worried that, without the central bank’s continued intervention, home loans could become expensive enough to scare off prospective buyers and send the market into a renewed slump. Now they’re regarding the Fed’s exit as little more than a minor blip. But that could be a sign that complacency is seeping back into the financial system.
Granted, there are reasons to explain investors’ sanguine view, and timing has much to do with it. For starters, a lot of traditional buyers of these agency mortgage bonds have either stayed on the sidelines or bought far fewer bonds than their portfolio allotments allow. They, along with index funds, now account for 18 percent of the market, down from 25 percent before the Fed stepped in, according to Credit Suisse.
But many don’t have too many other investment opportunities right now that match their stringent criteria, meaning they may move into any gap left by the Fed. Banks with cash to spare after boosting their capital levels are obvious potential buyers, too, as JPMorgan <JPM.N> boss Jamie Dimon pointed out at a conference last month.
Bondholders are also about to receive a windfall. Credit Suisse estimates that Fannie and Freddie will put $136 billion back into mortgage bond investors’ hands between April and June as they purchase bad loans from the pools of mortgages underlying existing bonds. That should take the sting out of the Fed’s withdrawal. Assuming investors plow that money back into the market, those dollars would be enough to replace the central bank’s recent buying volume for three to four months.
All in, market-watchers seem to think the end of the Fed program should have little impact. Many expect mortgage bond spreads, or risk premiums, to widen by only 0.15 to 0.2 percentage point, only a marginal retreat from the roughly 1.5 percentage point decrease in spreads since the height of the panic in November 2008. There’s just too much money waiting to pounce on any weakness in the market for spreads to increase more than that, the argument goes.
That may be true. But here’s the dilemma. Should investors lap up mortgages, they won’t exactly be picking them up cheap even if prices do drop a bit as expected. Over the last 15 years, mortgage spreads over a blend of Treasury maturities have averaged around 1.45 percentage points, about where they’re expected to settle without the Fed’s help. That’s hardly bargain territory.
What’s more, the Fed seems to be slowly changing its tune about keeping the mortgage bonds it has bought. In public appearances last week, Fed Chairman Ben Bernanke and several of his colleagues appeared to put greater emphasis than previously on asset sales as a way to help end the central bank’s extraordinarily easy monetary policy.
No one expects the Fed to unload its holdings any time soon — it would be reckless given the housing market is still fragile and unemployment persistently high. But since the Fed now owns about 25 percent of the outstanding stock of mortgage bonds, any talk about actually selling should be a cause for greater concern than the Fed simply ending further purchases.
Interest rate risk also looms large. As the economy improves, rates can only rise. That means fewer American borrowers will repay their mortgages early and investors will be left holding bonds for longer than expected — potentially causing a mismatch between funding and asset maturity. What’s more, it could cause bond prices to fall, creating losses, at least on paper. Sure, investors can hedge the interest-rate risk, but there has never been a perfect hedge for mortgage bonds.
Finally, funky behavior in financial markets should give investors pause. Not only did market yields shoot up unexpectedly last week, but rates on interest-rate swaps — the mortgage market’s primary tool for hedging interest rate risk — fell below Treasury yields, a rarity that could make hedging less effective. Alarm bells aren’t ringing yet, but it’s a timely reminder that even for investors who are relaxed about the Fed pulling out of mortgage markets, more traditional risks still lie in wait.