What Will Happen When the Fed Starts Unwinding its $1.75 Trillion Mortgage Portfolio?The Fed is the single largest holder of MBS today, so there is no question that its pullback will have important implications for the mortgage market.Once the Fed actually starts to slow its MBS reinvestments, the spread could widen at least 0.2 to 0.25 percentage points.
In their blog post, "What Will Happen When the Fed Starts Unwinding its $1.75 Trillion Mortgage Portfolio," HFPC Co-director Laurie Goodman and Research Associate Karan Kaul researched different options for the Fed in winding down its holdings in the MBS market. Freddie Mac (OTCQB:FMCC), Fannie Mae (OTCQB:FNMA), and Ginnie Mae are the largest issuers of mortgaged-backed securities pass-throughs.
The Federal Reserve currently owns nearly 30 percent of the market that allows global capital to fund U.S. mortgages: the agency mortgage-backed securities (MBS) market. The Fed began buying MBS in 2009 to support what was then a fragile housing market. With the economy now improving, it is widely expected that the Fed will begin pulling out of the MBS market in late 2017 or early 2018. According to Goodman and Kaul, the Fed has a few options in doing so.
The Fed is the single largest holder of MBS today, so there is no question that its pullback will have important implications for the mortgage market. But how the Fed approaches this will matter almost as much, with consequences for housing affordability and beyond.
A minimally disruptive strategy would be to gradually phase out reinvestments of principal pay-downs. A more aggressive option would be to cease reinvestments entirely. Once the Fed has ceased reinvestments, it could let the securities run off over time or sell them in the open market-the most aggressive option and something the Fed has said it is not considering.
If the Fed chooses the first option-phasing out reinvestments-Goodman and Kaul said it will also need to decide how much need to be invested, the pace at which that amount should be reduced, and how to allocate the reinvestment reductions across all the government agencies.
I would go with the minimally disruptive strategy. The Fed prefers this and I'd rather limit potential complications.
"If reductions focus on conventional MBS (those backed by Fannie and Freddie), any impact will be felt more by conventional borrowers," Goodman and Kaul wrote. "In contrast, if reductions focus more on MBS backed by Ginnie Mae, any impact will be felt more by first-time homebuyers, low- and moderate-income borrowers, and veterans, who depend heavily on FHA and VA loans (which are exclusively pooled into Ginnie Mae securities)." I would like to see the smallest disruptions for all homebuyers.
No matter which option the Fed chooses, their pullback from the MBS market will likely influence future mortgage rates, Goodman and Kaul wrote: "But even at a slow pace, unwinding will, over time, undoubtedly reduce a major source of demand for agency MBS," they wrote. "Therefore the Fed's withdrawal will surely put some upward pressure on mortgage rates, although it will hardly be the only factor." I don't see how this can be avoided. When the Fed which is the
#1 buyer unwinds a large chunk of its portfolio including MBS and other treasury securities, it will result in more supply and less demand and thus higher rates on those securities. It is truly a balancing act so to speak.
Ed Yardeni, the strategist at Yardeni Research, warns that investors need to start paying more attention SOMA according to this article and I agree.
SOMA stands for "System Open Market Account," and this often overlooked section at the bottom of the Fed's FOMC meeting minutes contains the central bank's holdings of U.S. Treasuries and mortgage-backed securities, plus a few other asset categories.
The 3/15 FOMC meeting minutes (released on 4/5) paves the way for a change, possibly in the next meeting's statement (on 5/3), to wording stating that the Committee will begin allowing holdings in the SOMA to mature off of the Fed's balance sheet. Such a change would signal the Fed's increased confidence in the strength of the U.S. economy and desire to continue to remove financial accommodation.
When the great unwinding begins, bond yields could be pushed higher. Were it not for the SOMA reinvestments cushioning the impact, bond yields might have moved higher than they did in response to the Fed's three 25bps interest-rate hikes since December 2015. So yields could face some upward pressure once the SOMA starts to contract.
According to this Bloomberg BusinessWeek article, talk of the Fed pulling back from the market has bond dealers anticipating that spreads will widen. Goldman Sachs Group Inc. sees the gap increasing 0.1 percentage point this year, while strategists from JPMorgan Chase & Co. say that once the Fed actually starts to slow its MBS reinvestments, the spread could widen at least 0.2 to 0.25 percentage points.
Mel Watt, the Obama appointee who heads the FHFA and essentially controls Fannie and Freddie, has the authority to order the companies' boards of directors to suspend the dividend payments. He came close to doing so at the end of March, just before Fannie and Freddie's last payment was due, according to people familiar with the matter. A group of senators wrote Watt a letter that week, warning him against stopping payment, and Watt decided to make it according to this Bloomberg BusinessWeek article.
Imagine what it would be like to be short Fannie or Freddie and then the net worth sweep ends in late June? Between a short squeeze and a huge increase in the value of the shares, I suspect there would be a huge party for Fannie and Freddie investors. I suspect Fannie and Freddie could move sharply higher even before the end of June if there are damaging documents among the 11,000 documents being released as part of the Fairholme lawsuit against the U.S. Government or if one day Treasury Secretary Mnuchin decides he is finally ready to set Fannie and Freddie free. Mr. Watts could also get nudged by high ranking members of the Trump administration plus you never know what will turn up if/when H.R. 1694 is signed by President Trump into law.
FNMA closed Friday up 2.23 percent on Friday April 28 at $2.98 on 66 percent of normal volume. The stock exhibited some range contraction during this trading session as price had the narrowest range of the last seven sessions. Due to the stock's strong uptrend, it may remain overbought for a while. If you're looking for a reason to sell, don't put too much weight on it being overbought. I believe it may have begun the next leg up which could take it to $4.00 in the near term and well over the $5.00 52 week high by the end of June, especially if the net worth sweep is ended by then.
In midafternoon trading today, FNMA is trading at $2.83, -4.87%, FNMAS is at $7.63 +4.09% and FMCKJ is at $7.30 +2.10%. FNMA reversed directions in the morning and is pulling back a bit today at the psychological $3.00 level.
Disclaimer: I own Fairholme Fund and indirectly own Fannie Mae and Freddie Mac preferred shares, which have a large position in Fairholme Fund.
Disclosure: I am/we are long FAIRX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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