The Federal Reserve announced in August that the central bank would be purchasing Treasurys by using the proceeds from maturing MBS to support the country's economic recovery.
It disclosed that it will be buying approximately $18 billion in Treasury securities in nine operations until Sept. 13. According to Wells Fargo analysts, this policy response is aimed at keeping interest rates low and encouraging lending and borrowing.
However, despite the Fed's good intentions, the impact of its actions on the economy will probably remain limited. "The Fed's monetary policy can only get you so far," said John McElravey, senior analyst at Wells Fargo. "There's not much that the quantitative liquidity the Fed is offering can do if banks do not want to lend and consumers are going to take on less debt.".
The situation, Wells Fargo analysts stated, has been described as "pushing on a string" since the Fed can create excess reserves, but it cannot really force lenders or borrowers to transact.
Analysts illustrated the problem by citing the excess reserves created by the Fed's securities purchase program. Excess reserves were around $1.5 billion to $2 billion before the start of the financial crisis in September 2008.
With the central bank ramping its quantitative easing program, Wells Fargo analysts said that the excess reserves rose quickly to close to $800 billion through the middle of 2009 and then to more than $1 trillion in the past 12 months (please see chart below). The amount of excess reserves is actually 25 times the amount of required reserves in December 2007 and 16 times the amount of required reserves in June 2010. This shows how liquidity in the system, according to analysts, is not really the cause of trouble.
The real problem, Wells Fargo analysts said, is that the demand for credit is substantially lower than it was a few years ago because consumers need to rebuild lost wealth by deleveraging household balance sheets and increasing savings, while lenders for the most part are keeping tight lending standards.
As other sources said, companies are finding just about every way to increase productivity and profitability without hiring new employees. While hiring remains suppressed, consumers will not be motivated to spend more, let alone borrow.
Indeed there are factors holding the economy in general - and more specifically securitization - back that are beyond the Fed's control.
"The other thing that is keeping ABS issuance still very restricted at this point - a big part of what's going on in addition to just the slow economy and consumers not borrowing - is the tighter regulation of the ABS market," McElravey said.
Investors that he has spoken to have expressed their concern about the minimal amount of new-issue ABS supply, compelling them to invest instead in corporates or Treasury securities. For instance, previous buyers of triple-A credit cards have resorted to this strategy since there have not been that many new credit card deals being issued.
"They are buying other types of assets to keep liquidity in their portfolios, but are not pleased to earn the low yield. They do not have a lot of options at this point," McElravey said. "This is not attributable to what the Fed is doing, but it is just a product of the general economic backdrop and the regulatory regime currently in place."
Among the regulations that are hindering issuance, McElravey said, are credit rating agency reform, FAS 166/167, the restructuring of the Federal Deposit Insurance Corp. (FDIC) Safe Harbor, as well as the amount of risk retention and disclosure now required on ABS deals.
Furthermore, he added, the long and slow implementation of the Dodd Frank Act, "just makes it hard to determine what the regulatory environment will be a few years from now."
Companies, he said, are having difficulty determining how they will fund their businesses - with many of these firms dependent on securitization. "It gets harder for them to know how fast it will take for them to grow - it's a big cloud that's hanging over the market right now," McElravey said.
Impact on MBS
Barclays Capital analysts examined the two approaches that are open to the Fed. They believe that the most likely option is further purchases of Treasury securities. However, they said that this would probably have to be a large number if the goal were for the Treasury market to take notice.
The other, less conventional approach is not really about lowering yields and is targeted more toward allowing households to benefit from the current low rates. Analysts think that this type of plan would be focused solely on the mortgage market - where households' inability to access low rates is clearly a problem. A surgical targeting of the mortgage via a Term ABS Loan Facility or TALF-style SPV or even a large-scale modification/refinancing plan will prevail even with the tough implementation. However, this would need monetary and fiscal policy coordination. This is why buying Treasurys serves as a default option, Barclays analysts said.
In general, current refinancing levels are well below aggregate prepayments that the market would likely have expected, given the level of mortgage rates, said Nicholas Strand, head of agency mortgage strategy at Barclays.
Instead of instigating a massive refinancing effort, the Fed - if the economic picture gets worse or weaker - might do something along the lines of asset purchases. However, Strand said that "asset purchases may be more likely than a refinancing plan, in our view, due to some of the political and other implementation issues associated with a refinancing plan"
There are indeed various ways of looking at the implications of the Fed's moves on prepayment speeds.
"When we seek to analyze recent Fed actions and their impact on mortgage refinancing for our clients, two contrasting schools of thought emerge in our discussions," said Upendra Choudhary, senior vice president in credit services at Amba Research.
On one hand, he said, some analysts have called this a vicious cycle - as the Fed strives to keep long-term rates lower, prepayments will consequently rise; this creates more demand for Treasurys and pushes rates down further, thus giving rise to more prepayments.
On the other hand, Choudhary explained that high refinancing assumes increased supply of capital to the mortgage market from private players as the GSEs step back.
"It is not very clear if a huge amount of private capital is available to support the mortgage market," he said.
Overall, his firm views the Fed actions as neutral to the MBS market. "The Fed has clearly indicated its preference for low interest rates and an accommodative monetary policy for the near to medium term," Choudhary said. "This will keep the Treasury rates low for the next 15 to 24 months. The key question for the MBS market is: how will the mortgage rates move when the GSEs step back? Will risk capital support mortgages as it has done with corporate and emerging market sectors, or will it remain on the sidelines pushing up mortgage rates and hence lowering refinancing?"
Thus, he said, the key driver for refinancing is not the Fed's move, but the ability of the GSEs to keep supporting the housing market and the future return of private sector capital.
Future Fed Moves
Whatever the Fed's action would be, Barclays analysts said that the mortgage basis would be doing poorly in either scenario.
According to analysts, if the Fed announces another trillion-dollar Treasury purchase operation, it would likely put pressure on the basis. Meanwhile, if the Fed focused on increasing refinancings, it would also hurt an MBS universe filled with premiums.
Following the Fed's announcement that it would be reinvesting MBS paydowns into Treasurys, intermediate to longer-term Treasury rates went down, and Treasury and MBS spreads were pushed wider, Strand said.
Analysts have also deliberated on how much impact the Fed's actions would have on the general economy.
"I think the Fed has made it very clear that it is going to maintain a near-zero interest rate regime for the foreseeable future," said Amba's Choudhary. "While Fed targeted rates are the starting points, they are not the most relevant for these sectors."
At the moment, Choudhary said that the GSEs are doing a very good job of extending mortgage credit, leading to low-end-consumer rates as well as providing attractive refinance options.
However, he said that if these institutions claw back, then it is unlikely that private sector capital is capable and willing to support the housing market. This is why the, "evolution of mortgage market intermediation is the key to MBS market outlook," Choudhary said.
Missed Opportunity
Although the Fed acquired $1.2 trillion of mortgage securities at a time of duress on the U.S. financial markets, "this was not the business of the Fed and clearly its policy is to exit from it," said Michael Youngblood, a principal at Five Bridges Advisors. "One understands the rationale that was clearly stated by Fed Chairman Ben Bernanke and the Federal Open Market Committee, but the timing of this action is unfortunate."
Youngblood said that the irony is that just as the Fed was reaping the fruit of its policy to buy mortgages, it undercut its own success by buying Treasurys through the amortization and prepayments off its mortgage portfolio. This inevitably lead to the widening of the mortgage basis or the gapping out between the current coupon and the current 10-year note.
"This will lead to relatively higher costs of mortgage credit," Youngblood said. "It just seems to me a singularly ill-timed action by a central bank whose behavior has been exemplary throughout the crisis."
What this essentially does, according to Youngblood, is to widen mortgage spreads and dampen the demand for credit. Further worsening the situation is that this move by the Fed, he said, is coming at the same time as the implementation of the Dodd Frank Act, which inhibits bank-sourced installment credit to borrowers. For instance, Youngblood cited the case of Capital One, which has raised interest rates by nearly 2% on its prime customers as a response to the implementation of the Dodd-Frank Act.
The Fed's action basically brought on these difficulties and "perversely engineered a double whammy," Youngblood said.
The Office of the Comptroller of the Currency, he added, has encouraged the tightening of underwriting standards through thorough inspections and by requiring that borrowers qualify for a mortgage under the fully indexed rate. The Fed, by pushing down mortgage rates relative to Treasurys, has made it more expensive for mortgage lenders and servicers that own mortgage servicing rights to hedge their mortgage holdings. "It's the perfect trifecta of pressures to raise mortgage credit and inhibit demand," Youngblood said.
The Fed, he noted, could have explored other alternatives to deal with its mortgage portfolio. He cited the fact that Ginnie Mae has historically transferred mortgages that it owns to Fannie Mae or Freddie Mac. The Fed could have moved some of the mortgages in its portfolio to Ginnie Mae, which in turn, could have given professional management of the cash flows to Fannie and Freddie. The securities could have been reinvested, and the agencies could have issued debt with different weighted average lives to match-fund them.
"The Fed missed an elegant point," Youngblood said. "They could have taken advantage of Fannie's and Freddie's portfolio managers and systems, having the largest portfolios in the world amounting to $4 trillion of MBS." He said that in this scenario, Ginnie Mae could actually serve as the nominal holder of securities, and it could issue debentures to fund.
Consumer ABS
In the Wells Fargo report, analysts said that they do not recommend a policy of "fighting the Fed." With the Fed's future policy path uncertain, they suggest that investors look past corporate bonds for yield and have increased exposure to consumer ABS.
In light of this environment where the Fed has kept rates low to help foster economic activity, McElravey said that one of the consequences is the rally that the market has seen in Treasury securities. This has, according to McElravey, made consumer ABS attractive.
With rates low and the yield curve flat, investors, he said, could buy coupons that are similar to 10-year corporates but do not have to necessarily take on the duration exposure.
He said, for instance, that three-year triple-A ABS would provide something close to what a 10-year corporate would offer. "At the margin, instead of taking credit risk at the short end, the trade off is less price risk on the securities," he said.
Additionally, Wells Fargo analysts said that they are seeing improving ABS credit trends, and that they are staying constructive on the credit risk, credit enhancement levels and robustness of ABS structures. They also think that ABS' shorter duration should make market risk limited in a portfolio that already has longer-maturity corporate bonds when the market has to face the inevitability of the Fed's securities purchase program ending.
Despite improved credit fundamentals, however, the main sentiment in the market right now is caution.
"Our clients currently have a very cautious view of ABS across all sub-sectors," Amba's Choudhary said. "While I agree that consumer deleveraging is leading to an improved credit profile, significant headwinds still remain."
The factor most of his firm's clients are keenly watching is the U.S. unemployment situation, and until this improves, "ABS is likely to remain a low priority area for investing," he said.
