On MBS, Fed needs to point to the exit

September 21, 2009

When the medication is flowing, it’s hard to see straight.

Amid the giddiness in the markets and the cheers for the end of the recession, what often gets ignored is the fact that government stimulus is still fueling the reflation of financial markets.

Yes, the U.S. government has started to retire some programs — its backing of money market funds being the most recent. But there’s still a question mark about how it plans to wind down one of its largest supports — its $1.25 trillion mortgage-backed securities purchase plan — that is due to expire at the end of the year.

That’s dangerous, since a bungled hand-over of the market back to the private sector could derail a still fragile housing market.

This week, Ben Bernanke and his colleagues on the policy-making Federal Open Market Committee are sure to discuss how best to wind down its purchases of mortgage bonds guaranteed by state-run Fannie Mae and Freddie Mac. Some officials have already started to debate publicly whether they should pull the plug on the program before it reaches its $1.25 trillion limit.

But they shouldn’t wait to decide until November, as some now expect. They need to prepare investors elbowed aside by the government intervention. They should do this by laying the groundwork for an eventual departure, to avoid sudden spikes in mortgage rates that have been kept artificially low this year.

Unlike other initiatives, such as the Federal Deposit Insurance Corp’s insurance of bank debt, and the various lending facilities to nudge investors back into areas that had gone haywire during the financial crisis, the Fed’s direct purchases of MBS has done the opposite — it has squeezed investors out of the market.

“There’s a crowding out effect,” notes Walt Schmidt, a mortgage strategist at FTN Financial.

Foreign central banks, which had been big buyers, have cut their holdings of MBS and agency debt by roughly $200 billion over the last year, preferring instead to put their money in Treasuries.

Outflows have been even more impressive among households, according to Fed data that lumps domestic hedge funds and other groups that are difficult to track into this category. Their holdings have plummeted from $820.1 billion to $129.5 billion at the end of June.

The Fed has been there to soak up that selling, buying more than $860 billion through September 16. This has helped push risk premiums to around 1.42 percentage point over Treasuries — well below the nearly 3.0 percentage points peak seen in 2008. These risk premiums influence mortgage rates.

The Fed, therefore, needs to be precise about how it plans to end the program, since it could take some time — and much higher risk premiums — to fill the void.

Surely, a gradual approach is best to avoid abrupt disruptions, but it needs to get started, given its outsized influence on the market.

This week’s FOMC statement is as good a place as any to start. It will give policy makers ample room to fine-tune purchases to smooth the transition to what will surely be higher mortgage rates.

It will also act as a much needed reality check in broader financial markets that are confusing the medicine with the cure.

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