Fed Expected to Keep Tapping the Mortgage-Bond Well

Wednesday, 01 May 2013 07:23 AM

 

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Top Federal Reserve officials are happy with the boost their asset purchases are giving the housing market, suggesting mortgage bonds could trump Treasurys when the U.S. central bank tinkers with its bond-buying program.

While much of the public debate has focused on if and when the Fed will cut back on its bond buys, more and more policymakers are taking sides in the debate over which assets the central bank should concentrate on.

No changes are expected when the Fed wraps up a two-day policy meeting on Wednesday.

Editor's Note: Economist Unapologetically Calls Out Bernanke, Obama for Mishandling Economy. See What They Did

Economists widely agree it will continue with monthly purchases of $40 billion in mortgage-backed securities (MBS) and $45 billion in Treasurys in an all-out effort to spur borrowing, investing and hiring across the United States.

But if some doves at the Fed have their way, the central bank might trim its Treasurys purchases first if it decides to start tapering stimulus. Similarly, the central bank could end up holding MBS longer if and when it eventually decides it is time to sell off some assets to shrink its balance sheet.

While some hawkish officials say improvements in housing should lead the Fed to stand down on mortgage bonds, the dovish officials have held sway on policy since the Great Recession.

Boston Federal Reserve Bank President Eric Rosengren is among those who say near-record low mortgage rates and rebounding home sales reflect the success of directing stimulus toward housing, arguing if anything for more rather than less.

"I always take Rosengren's views as mirroring those of the Fed chairman ... and the chairman has not made many concessions to the hawks yet," said Christopher Rupkey, New York-based chief financial economist at Bank of Tokyo-Mitsubishi.

"MBS probably helps the housing market strengthen and maybe it should be the last to be cut," he said.

WORRIES ON MARKET FUNCTIONING

On the other side of the debate are a number of hawkish policymakers, like Richmond Fed chief Jeffrey Lacker.

These officials object to the policy, in part, because they do not think the Fed should aim to prop up a particular sector of the economy. Funneling credit, they say, is the market's job.

They also worry the Fed could become so dominant in the agency mortgage market that investors would be scared off, possibly raising borrowing costs and undermining the policy.

At $5.7 trillion this market of securities backed by Fannie Mae, Freddie Mac, Ginnie Mae and the federal home loan banks is not much more than half the size of the $10.9 trillion market for Treasurys.

Simon Potter, who oversees trading at the central bank's New York headquarters, said in March that demand for MBS had not yet overwhelmed supply. But he too warned of trouble if it ever did.

CRUX OF THE CRISIS


Arguably, purchasing MBS rather than Treasurys more directly influences the economy through the rate Americans get on mortgages.

Last week, the average 30-year fixed rate mortgage hit a near record low of 3.4 percent, down from 3.55 percent when the Fed launched its latest stimulus effort in September, according to Freddie Mac. That cheap financing is having its effect: housing starts breached the 1-million unit-rate mark in March for the first time since mid-2008.

There is also a simple logic to stimulating housing. The housing collapse hurt by destroying construction jobs and by destroying household net worth and as a result spending.

Rekindling housing throws that negative cycle into reverse, giving what San Francisco Fed chief John Williams has called an "oomph" to the economy.

Housing investment was less than 3 percent of GDP in 2012, but typically is about 5 percent, suggesting plenty of room for growth; all housing services typically account for 18 percent of GDP, above the 15 percent seen last year.

Williams credits Fed policies, including both MBS and Treasury purchases, with helping to push mortgage rates down about 1.5 percentage points since the Fed's first mortgage-bond purchases back in 2008, and notes that the decline has helped boost home sales and puts money in consumers' pockets by trimming monthly mortgage payments.

"As far as getting the most bang for your buck going forward," said Andrew Szczurowski, an MBS portfolio manager at Eaton Vance, "mortgage purchases are the more appropriate transmission mechanism as there are still millions of borrowers who sit in mortgages (well) above market rates."

FED'S FRONT LINES

The central bank buys about a quarter of all coupon Treasurys that are issued each month.

But the Fed has snapped up about half of all the newly issued MBS since it resumed buying them in September. That portion could rise, possibly imperiling markets, if refinancing activity declines as the economy improves and borrowing costs rise, dissuading people from refinancing and leaving the market with a smaller supply of tradable securities.

To reduce that risk, the Fed focuses its buying on the most plentiful securities, making a market malfunction an "unlikely" prospect even if refinancing falls, New York Fed's Potter said.

Potter oversees a group of traders and portfolio managers at the New York Fed who are watching for signs the market is buckling under the central bank's demand.

They hold three meetings before 9:30 a.m. each week day, sometimes with Fed policymakers calling in, to discuss overnight news and the day's buying plan before traders head back to their computers to start bidding on bonds.

All the needed Treasurys are bought from dealers by 11 a.m. while, in a neighboring room, the MBS are purchased over the course of about 20 trades throughout the day.

So far "there seems to be little evidence" the buying is sapping liquidity or straining either of the markets, Potter told the Forecasters Club of New York in March.

Even so, a recent New York Fed poll of Wall Street banks showed most expect the Fed to have stopped buying MBS by March 2014 even as it continues to buy some Treasurys.

The question of which of the securities are more efficacious will also surface in the years ahead, when the central bank might decide to shrink its balance sheet, now worth some $3.2 trillion, to a more normal size around $1 trillion.

Unlike Treasurys, MBS have monthly prepayments that could help the Fed reach that goal sooner. That could convince officials to buy more of them now and to not rush to sell them off in the years ahead.

In addition, minutes of the Fed's last meeting in March showed several officials favored holding on to MBS, or selling them only very slowly, to lessen any market disruption from sales. Meaning, the Fed could be in the housing market longer than many now anticipate.

Editor's Note: Economist Unapologetically Calls Out Bernanke, Obama for Mishandling Economy. See What They Did

© 2014 Thomson/Reuters. All rights reserved.

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