Amongst the additional stimulus measures being pondered by analysts ahead of Tuesday’s FOMC meeting is a possible quantitative move which would see the Fed reinvest paydowns from its MBS portfolio back into the sector or by buying Treasuries.
But according to Barclays Capital there are issues here. Especially when it comes to reinvesting in MBS securities. As they noted this week:
Furthermore, the reinvestment of paydowns into either treasuries or MBS could present difficulties for these markets. The Fed’s initial announcement that it would purchase treasuries as part of QE stoked concerns that the Fed was monetizing debt leading inflation expectations to rise.
However, the risk of further treasury purchases, with real yields already very low, is that inflation expectations could continue to rise, leading overall nominal yields higher this time. However, if inflation expectations were to rise just slightly as a result of this course of action, we could see almost no effect. Clearly this would seem to be an undesirable outcome.
On the mortgage side, reinvesting paydowns is fraught with problems as well. The extent of the Fed’s mortgage purchase program has removed enough float from the market that fails have become a serious issue. In many coupons, investors are unlikely to get delivery as there are few bonds available. While it is possible that the Fed could focus purchases in lower coupon bonds, it could run the risk of damaging liquidity in those lower coupons as well.
This is one of the reasons why high coupon bonds, especially those currently trading over par, were so disproportionately moved by last week’s government mortgage forgiveness rumours — since such plans would immediately render their premiums unjustified.
As Reuters commented at the time:
High coupon bonds have a long way to fall should such a massive policy shift induce a sudden spike in refinancing and prepays. Bonds are repaid at par, but high-coupon bonds current trade between 7-1/2 and 9-1/2 points over par.
It’s also one of the reasons underpinning the NY Fed’s decision to initiate an MBS coupon swap back in June, so as to swap those unsettled securities, which were trading at historically high prices due to limited supply, for other agency MBS that were more readily available for settlement.
In the meantime, of course, we’ve also seen the Fed start testing its MBS reverse repos too — another move that should ease supply squeezes in some securities in the market.
But just to visualise the scale of the supply issue, the NY Fed provides the following chart that reflects the number of settlement fails at primary dealers across various securities since 2006:
And it seems the MBS fails build-up from around the third quarter of 2009 — just as treasury fails are countered almost completely.
But just in case there was any doubt about the scale of the tightness in the MBS market here is a chart reflecting the recent pick-up in MBS fails specifically:
Meanwhile, BarCap also provides the following chart reflecting the rate at which large banks have recently been adding to their MBS holdings:
No wonder there’s been a supply squeeze, eh?
Related links:
Mortgage investors scale back – FT
The Great Mortgage Refinancing, by the numbers – FT Alphaville
‘Free stimulus’ via refinancing, debate grows - WSJ Developments
The slow death of Hamp, the summer of delinquencies – FT Alphaville