The End is Nigh

by Larry Levin

The end of the Fed's massive mortgage buying program, QE or Quantitative Easing, is upon us. With respect to this program I mentioned yesterday that "the end is nigh" and on ZeroHedge a recent post does a nice job covering it.

Beginning in January 2009, and every single business day since then, the Fed has been buying up Mortgage Backed Securities (in a very non transparent market). The program, which ends tomorrow, will have transferred $1.25 trillion of MBS "on behalf" of the US taxpayer, representing the single biggest asset on the Fed's balance sheet, and backing up such liabilities as currency in circulation (yes, that dollar in your pocket is collateralized more than half by rapidly devaluing, and in many cases cash flow non-producing houses) and excess reserves. Ironically, this year's biggest April fool's joke may end up being not only quite scary but very much true: on midnight of the night of March 31 into April 1 the Fed's MBS program ends, and the market will be on its own for the first time in over one year. What happens next is anyone's guess but here are some suggestions.

From Market News, here is a list of the things that the mortgage market has going for it and against it:

POSITIVES:

1) Fast and real money accounts are known to be very underweight or short the MBS market. Some have already covered recently as option adjusted spreads have widened. Others will wait for widening in nominal spreads. How long they will wait is a big unknown;

2) The recent backup in Treasury prices caused foreign investors to have renewed interest in the market, particularly for Ginnie Mae paper. A further drop in dollar prices could encourage other investors to come back into market;

3) Banks have been supporting the market for a while now and, with short-term interest rates low, they are expected to continue to pursue the carry trade. As long as the Fed's low interest rate policy stays in effect for an extended period, this is widely fostered investment strategy;

4) Freddie Mac already finished its delinquent loan buyback program. But Fannie Mae's buybacks take place over the next several months and are likely to amount to about $150 billion. Surely some of this money will be reinvested in MBS;

5) The housing market still shows no signs of a turnaround and credit is still very tight. This should keep new origination supply very manageable in the absence of the Fed buying. If and when it ever picks up again, it is hoped the MBS market will have its sea legs back on;

6) The Fed has been buying all the lowest coupons around, the coupons no one wanted. But The government-sponsored enterprises' buybacks and the ongoing changes to the government's Home Affordable Modification Program (HAMP) have recently wreaked havoc with the higher coupons. Consequently, that is pushing some investors into the lower coupons;

7) Finally, the market strongly believes if the housing and/or the mortgage markets got in severe trouble, the Fed would have no choice but to begin buying assets again.

NEGATIVES:

1) When everyone is on the same side of the boat, it often ends up badly. In other words, the idea that the investment community is heavily short does not guarantee success;

2) Even with a short investor base, the market still lacks a "backstop" bid like it used to have in the old days when the GSEs would buy MBS when they widened out to attractive levels. Without the Fed, and with the GSEs crimped, who will become the new backstop bid;

3) It may not happen for a very long time, but eventually the economy will recover and the Fed will raise rates. Over time, 10-year note yields are expected to rise. If that is the case, why buy any fixed income product now;

4) How high 10-year rates get down the road is anyone's guess. But market sources say the end of the Fed MBS buying, heavy Treasury supply and the potential of a boycott by overseas investors in the Treasury market could send yields from the current 3.87% to 4.25% or even 5.25% over time;

5) It is highly doubtful that the Fed will sell any of its huge MBS holdings for a very long time. But the possibility is there and it has made the market very nervous;

6) Before the Fed sells assets, it would likely do reverse repurchase operations with its MBS holdings. Market sources say that will most surely raise the cost of carrying MBS securities;

7) Because the Fed was such a large buyer of MBS and it did not hedge its positions, hedging convexity has not been something the market has worried about for well over one year. But now that the Fed is no longer buying, the new duration that comes into market will have to be hedged. Indeed, part of last week's selloff was blamed on convexity selling.

With the Fed having gone all in and then reraised tenfold courtesy of fractional reserve banking, there is no way that the Fed will allow house prices to drop further, which is why we are particularly partial to the option that the Fed will immediately reinstitute QE at the first hint of mortgages at or approaching 6%, as a 1% widening in mortgage rates will be the equivalents of a several hundred billion loss in household net worth. And the administration can not have that in an election year.




Previous Day's Trading Room Results:

Trade Date: 3/30/10

E-Mini S&P Trades*
(before fees and commissions):

1) B/away buy @ 8:33am at 1170.75 = b/e, -1.25, -1.25 (3 lots)

2) FT sell @ 9:35am at 1171.25 = +.25, b/e, b/e (3 lots)

3) PP sell @ 11:01am at 1168.00 = +.75, +.50, +.50 (3 lots)

4) Algorithm positions (12)

5) "Reading the Tape" positions (6) ...combined Secret's, Algo, & "Reading the Tape" total...-9.00




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