What exactly is happening in the bowels of the American mortgage market? That is a question that investors around the world have often asked in the past three years, with a mixture of bafflement and alarm.
Now they need to pose it again. For this spring, something of a paradox is hanging over the mortgage-backed securities world. At the end of this month, the US Federal Reserve is due to freeze its programme to purchase Fannie and Freddie agency MBS that it implemented in the wake of the financial crisis. Logic might suggest that could potentially deliver a jolt to the market.
After all, the reason why the Fed introduced the programme in the first place was because the US securitisation markets froze during the financial crisis, removing a vital source of funding for the American mortgage world. And thus far, at least, there is still precious little evidence that the securitisation market is ready to flourish again.
As a result, the degree of assistance that the Fed has provided has been eye-poppingly large: right now it is holding some $1,200bn of MBS, representing about half of its (currently enormously bloated) balance sheet (or about a quarter of the total stock of high quality outstanding MBS).
Yet, notwithstanding those vast numbers, the news that the Fed plans to halt these purchases has not hitherto triggered any sign of panic. On the contrary, as my colleague Nicole Bullock reported this week, the spread between the 30-year Fannie Mae current coupon bond (the sector benchmark) fell to just 57 basis points over Treasuries this week.
According to Credit Suisse, this is the lowest spread on record for this benchmark. Spreads on other MBS have been low, and falling too – also irrespective of the Fed move.
So what exactly is going on? In part, the explanation seems to reflect a type of displacement effect. In particular, in the past couple of years, the Fed (and others) have poured so much money into the system, that this has made it painfully hard for mainstream fixed income investors to get returns, without taking very wild risks.
Last year, some investors tried to deal with this problem by buying the wave of government-guaranteed bank bonds that many institutions issued to repair their balance sheets. Other investors rushed to gobble up investment grade securities or (if all else failed) sovereign bonds.
However this year, the programmes of government guarantees for bank debt are coming to an end, and the investment grade market seems very oversold. Meanwhile sovereign credit seems to pose new risks of its own. Just, look, for example, at Greece.
Thus, against that unappealing list of alternatives, dollar-denominated MBS instruments are beginning to look rather more attractive; particularly if you think that much of the bad news about the American housing market is already priced in – and, more importantly, if you are an American bank that is able to get ultra cheap funding, and thus can enjoy an immediate “carry” from holding MBS.
So far, so encouraging – or so it might seem. After all, if the financial system is going to heal itself, investors do need to rediscover an appetite for risk; and if they are becoming more willing to buy MBS, that makes the Fed’s exit strategy easier.
However, before anyone is tempted to crack open the champagne, they should think – once again – about that “displacement” effect. During the past two years, the full impact of the collapse of the securitisation market has been largely concealed from most investors – let alone American politicians – because of the sheer scale of government assistance on offer. In a sense, investors have been lulled into something of a false sense of security, because so much of the support has been highly complex – and thus hard to understand.
Now it is possible that, as the Fed slowly withdraws its assistance, investors will gradually adjust too. But it is equally possible that there could be nasty shocks ahead, particularly if money market or Treasury rates rise. After all, will investors really keep buying MBS instruments if say, Treasury rates shoot up? Have American banks even hedged themselves against the chance of a sudden 1994-style swing in interest rates? What might happen if the US Fed actually starts selling its current holdings of MBS (as opposed to simply refusing to buy any more)? And what is the future of Fannie and Freddie?
For the moment, at least, the only honest answer is that nobody truly knows. The global financial machine has been so distorted by government aid that it is frustratingly hard for anyone to be entirely sure how the cogs are working. So, right now, there is reason for American officials to feel some relief about what is happening in the mortgage world; the calm is profoundly good news. But although I very much hope it lasts, I would not be willing to bet too much money on that. I fear this may yet be a lull before a bigger storm.