American Capital Markets: Productivity, Ingenuity, and Invention

"The American, by nature, is optimistic. He is experimental, an inventor and a builder who builds best when called upon to build greatly."

-- John F. Kennedy 

Here we are, just a few days away from the end of the Fed's MBS purchase program and I'd like to share a few thoughts on what we might expect as the much anticipated event grows closer.

Let's start by considering the goal of the MBS purchase program begun last March. Many people believe that the Fed was forced into buying MBS because there were no other willing investors. This is an oversimplification to say the least. By placing Fannie Mae and Freddie Mac into conservatorship - and thereby eliminating the confusion over the government guarantee - the government restored liquidity to the MBS markets well before the outset of the Fed's MBS purchase program. But given rising concern over home price deflation and the resulting implications for banks and the economy, mortgage rates were still considered too high. Since maintaining cheap access to home finance is considered an important element of any plan to break the cycle of falling home prices, tighter credit, and falling employment, the main objective of the MBS purchase program was to temporarily drive mortgage rates lower than the market clearing levels being achieved between non-government players. In so doing, the Fed was combating home price deflation and creating a refinance event that would put cash directly into consumers' hands. And it would be hard to argue that this was not a prudent course of action at the time. But with the official program end date growing closer and home price stability and full economic recovery still ambiguous, exactly what to expect next is unclear.

I think it's safe to say that if the end of Fed MBS purchases results in a reacceleration of home price declines, the Fed will not stand idly by. There's no magic to the original $1.25 trillion budget or the March 31st end date. If economic conditions call for the program to be extended, the Fed need only continue to grow its ‘balance sheet' by making another trip to wherever it is they keep the stores of U.S. currency that can be commandeered to buy more MBS. But there's a limit to how much of this they can do and we already see signs that this solution could be creating investor anxiety over future inflation and currency devaluation. So it's sensible to expect the Fed to try every prudent means to avoid more MBS purchases and if they are successful, here's what we might expect.

Over the past year, the Fed's purchases have accounted for anywhere from 30% to 130% of the new MBS supply created by originators such as ourselves. When the Fed buys that much new supply, it produces a substantial shift in the market ecosystem and their exit will produce yet another major shift in the forces acting on that system. In order to better understand all the changes that might take place, recall that a mortgage-backed security is essentially a blend of a ‘regular' coupon paying bond - like a Treasury bond - and prepayment options sold to the underlying borrowers (we say an MBS investor is ‘long' a coupon paying bond and ‘short' mortgage options).

When the Fed buys large amounts of agency MBS, they have shocked the market ecosystem in two ways: first, they have bought a large amount of ‘regular' bond equivalents out of the system and second, they have ‘sold' a lot of mortgage options. But why should we consider the Fed's involvement a ‘shock' to the system? After all, wouldn't other investors have been doing the same thing if the Fed hadn't gotten involved? The answer lies in the difference between how the Fed acts once it holds the MBS vs. how alternative investors might act and it's this shift in behavior that will drive the changes we'll feel in our business.

The most important difference between the Fed and other MBS investors is that the Fed doesn't hedge. It hedges neither the sensitivity of MBS prices to yield changes (called "duration") nor the embedded mortgage prepayment options it has ‘sold' to borrowers. In contrast, many private investors hedge one or both of these risks and when they do, they create a sort of ‘balance' to the ecosystem - much like the flow of water from the earth to the clouds through evaporation and back to the earth through rain. For example, some types of MBS buyers will buy offsetting options to hedge that particular risk in their MBS and when they do, they leave the total system closer to neutral with respect to optionality. Likewise, many MBS buyers will hedge the price sensitivity of the ‘regular' bond component by selling another bond against it. So when the Fed buys large amounts of MBS without hedging either the regular bond component or the embedded option, they are effectively removing large amounts of duration out of the system and dumping large amounts of mortgage options into the system thereby creating a drought of the one and a flood of the other. It's natural that the system finds a new equilibrium with respect to the price of both duration and mortgage options and we have benefited over the past year through lower overall MBS yields and lower hedge costs. Let's take a look at what will happen to yields and hedge costs post-Fed.

Combined with very stable MBS prices, the increase in overall net MBS option supply generated by Fed  purchases has put significant downward pressure on the value of MBS options. This will change next month and the MBS options our industry needs in order to hedge our risks to become not only more necessary, but more costly. This will also mean upward pressure on MBS yield spreads over Treasuries as the value of borrowers' prepayment options increase and MBS investors require a greater yield premium to compensate them for having ‘sold' those options to borrowers.

Likewise, some amount of new bond duration will need to be absorbed by the private markets as originators go about the business of making new MBS but the Fed is no longer a dominant buyer. The size of the impact this will have on yields is largely a function of the amount of MBS supply being created vs. the appetite of the markets for duration on April 1. The good news here is that the Fed will be retiring at a  time when new issuance is the lowest it has been in a year and private investor demand for bonds of all forms is extremely high. That's very good news for us and likely means that in the short run, the duration supply impact on MBS yields will be muted.

What's the net affect of all this likely to be on April 1? At this point, my guess is that the affect will be hard to detect; maybe 10 to 15 bps higher mortgage yields given the size of the recent sell-off that's already taken place in Treasuries (more on that in a minute). As an indicator of what we might expect, in June of  last year, Fed purchases slowed to just 20% of new MBS supply resulting in MBS yields widening close to 40 bps vs. Treasury yields. But that was under very different circumstances: far more new issuance supply than we see today and far less risk appetite on the part of investors so we should expect the impact to be much lower today. But with any significant shock to a system, we simply don't know in advance what the consequences will be and the risks of a bigger move in rates are not insignificant. We'll likely go through periods of small shocks followed by periods of market calm as the market learns to reabsorb these risks and watches carefully to see how the Fed reacts to rough patches. But there is a more troubling trend afoot that could have much more meaningful and lasting consequences for the direction of rates.

I'm sure you've noticed recently that Treasury bond yields have been heading higher. What you might not have noticed is that the yield spread between interest rate swaps and Treasury bonds - the spread that compensates investors for taking the counterparty risk of large banks - went negative last week. This spread is almost always positive since no bank should be considered a better counterparty credit than the U.S. Treasury. But last week's inversion could be an early indicator that investors are starting to perceive little difference between the credit worthiness of private corporations and the U.S. Treasury. The inversion of these yields also came during a week when a five year Treasury auction didn't go well, ten year Treasury yields spiked above 3.90%, and healthcare reform was passed. Of course, there were other unusual developments in the swaps markets last week that could have contributed to the narrowing of the spread, but the concern we cannot escape is that we might be reaching the point of market indigestion of our public debt.

Sovereign risk - the risk that nations default on their debts - is rising as a concern among investors around the world. As we've discussed before, replacing consumer spending with government spending in times of economic contraction is a reasonable short-term strategy and it has probably done us a great deal of good during this recession. However, if the public debt created either in that process or for other reasons becomes too large, or government spending fails to resuscitate the heart of the private economy, then governments are left with two very unsatisfactory alternatives: increase taxes to pay the debt (which further suppresses economic activity) or "inflate" the debt by printing money to pay it off (which devalues the currency). Investors around the world - many themselves sovereigns with their own economic concerns - are closely watching our economic recovery as well as the signals we give regarding our debts. While the  ove in Treasury yields this week, along with the inversion of swap spreads, was certainly not of a size to cause serious immediate alarm, the risk that the dollar loses its' status as a reserve currency is a risk with such an enormous consequence that even when multiplied by a very small probability, it needs to be taken seriously.

Making it difficult to read the market's signals accurately is the fact that in other parts of the financial markets, things appear very upbeat. Stocks are rallying and riskier bonds of all types are in great demand. But we need to understand the source of this demand before we take it as a signal of strength. In recent statements the Fed has signaled that it intends to leave short rates (Fed Funds) low for an  extended period of time'. With short rates expected to stay low and the yield curve steepening, investors are putting money to work by borrowing shortterm cheaply and investing in riskier assets. Therefore at least some of this surge in demand for risk can be explained once again by Fed intervention, this time in the shape of the yield curve. If this is a driver of today's demand for risk, then when short rates rise, one should make sure to get out of way as investors rush to the exits.

Of related concern is the extent to which our current ability to service our national debt depends on those debts being financed short term. This is a bit like a borrower asking for a 1/1 ARM so he can afford the payment on a bigger house; it works fine so long as short-term rates stay low. But as longer-term Treasury rates move higher, the Treasury will be tempted to fund itself using a larger mix of short-term debt. If the Treasury is financed with too much short-term debt, it could complicate the Fed's ability to manage short-term rates as it deems necessary.

Is it possible for this story to end well? Yes. It ends well if/when we begin seriously signaling fiscal restraint and the private economy revives to the extent that the increased tax base is more than enough to service our debts. Have faith, the U.S. has done this successfully in the past. We've earned our way out of similar situations through economic growth and productivity advancements that allowed us to pay our debts comfortably. We only need to make sure the public debt does not become so large than the amount of economic growth necessary to repay it is unachievable. And more importantly, we need to rediscover what it is that really makes America great and we won't find that by continuing to look only to Washington for our answers.

The economist John Maynard Keynes wrote in a 1934 letter to The New York Times, "I see the problem of recovery [from the Great Depression] in the following light: How soon will normal business enterprise come to the rescue? On what scale, by which expedients, and for how long is abnormal government expenditure advisable in the meantime?" Even the man often cited as the prophet of big government spending saw government intervention in financial crisis as an "abnormal" expedient necessary only to prime the pump of private enterprise.

While we are fortunate to have so many smart and dedicated people in our government, the spark that will ignite the next era of U.S. economic growth will come from the efforts of individual Americans. Hard work, creativity, thrift, and above all a willingness to take risks: these are the productivity-driving traits that we Americans have in greater abundance than any other country on earth. And it's time again for us to focus on reawaking these traits and less on the next promising program from Washington. It could involve some short-term pain, but the end of Fed intervention should be welcomed as a sign of normalcy in the capital markets and as part of a larger signal that it's time to ‘build greatly' again.