While the UK’s Treasury tries to force-feed liquidity into the system by literally making banks lend and snapping up asset-backed securities, the Fed is still busy buying up $600bn of the mortgage-backed stuff. The question is, will it work?
Recall that the Fed is trying to do achieve two things: “credit easing” by using the asset side of its balance sheet to replace a contraction in private credit flows and the stabilisation and eventual recovery of the economy. One way to do this is by making housing more affordable and providing money to consumers through easier mortgage refinancings — hence the Fed’s $500bn MBS buying programme (plus $100bn in GSE debt).
All well and good in theory, but there may be some difficulties. For a start, as Deutsche Bank’s Mustafa Chowdhury and Marcus Huie note in a piece of research out today, despite the $600bn programme, Americans still aren’t refinancing their mortgages.
We think that, despite historically low fixed rate mortgage yields, refis will fall short of the 2003 highs. Our estimate is that prepayments will reach around 20%, far short of the 60% level achieved in 2003-2004. Primarily this is the result of falling credit quality of mortgages due to declining home values. LTV ratios have gone up, making many borrowers ineligible for a new refinanced loan. In addition, borrowers’ FICO scores have deteriorated with the increase in the jobless rate and its effects on the timeliness of borrowers’ payments…
We conclude that the Fed’s buying of MBS and agencies is likely to have limited overall impact. If the goal is to help consumers by arresting the decline in home prices and add to permanent income through refis, the Fed program will only have a relatively small contribution toward that goal. (Ed: See DB chart below).
If buying MBS doesn’t work then there’s something else the Fed could try.
Treasury buying “is unlikely now,” said Brian Fabbri, chief North American economist at BNP Paribas in New York, given the Fed’s current goal of lowering borrowing rates.
“The most direct way to accomplish that is to buy mortgage paper and to buy commercial paper,” Mr. Fabbri said, “and then, if that doesn’t work, to buy Treasurys.”
That’s something that’s becoming increasingly plausible. The Congressional Budget Office has forecast the 2009 deficit will be something like $1.186 trillion — and that was before the announcement of Obama’s stimulus package. Financing that much depends on continued buyers, of which foreign central banks have been a big one (see second chart from DB below).
We’ve argued before that as non-US central banks intervene to prop up their own domestic economies, funding the US deficit may become increasingly difficult. OECD indicators, we noted last week, are pointing towards a swift collapse in Chinese GDP growth, with a scary read-through for US Treasuries.
Indeed, the latest TIC data reported a net outflow of $21.7bn in November — the second consecutive month of net outflows (see chart from Bank of America below). Foreign net sales were something like $56bn in the month, with $37.1bn coming from “foreign official institutions” (i.e. central banks). As Bank of America’s Robert Sinche and John Rothfield note:
… selling related to USD strength and efforts by foreign governments to intervene to sell USDs and buy domestic foreign currencies. Following the intervention, securities positions often are liquidated, and that appears to have been the driving force behind foreign official selling of US Treasury/Agency securities in November.
For the 12 months through November there’s still a net inflow of $458bn — but that’s less than half of the amount purchased in the prior period.
No one wants to scare-monger about the state of the US’s finances — but these are genuinely scary times.
The government is ramping up its financing needs and Treasury issuance at a time when traditional buyers are starting to back away. One way for the US to solve that is to have the Fed start buying long-term Treasuries, as it’s been considering. Operation Twist redux.
Related links:
Tide turning for treasuries – FT Alphaville
The perfect storm – FT Alphaville