US mortgage sector braced for end of Fed help

By Michael Mackenzie in New York

Published: February 3 2010 22:46 | Last updated: February 3 2010 22:46

Cold turkey time is rapidly approaching for the US mortgage market as the Federal Reserve gets ready to end its mammoth $1,250bn buying programme at the end of March.

The prospect of such a large buyer moving to the sidelines means that the “artificial market” created by the Fed’s hefty purchases – part of a monetary policy strategy aimed at reducing mortgage borrowing costs – should result in more normal mortgage rates, likely to be at a higher level.

The question is, how much higher? There is a great deal of uncertainty among many investors on exactly how to position themselves for the withdrawal of the Fed from the mortgage market. Many want higher rates, as it makes the investments more attractive. Yet the Fed wants to keep mortgage rates low to help home-buyers.

In a survey of some of the 4,000 people attending a securitisation conference this week, 73 per cent of respondents expected spreads on mortgage-backed securities to go “much wider” when the Fed ceases buying mortgage bonds, backed by mortgage agencies Fannie Mae and Freddie Mac. But the impact is hard to pin down.

When the Fed began buying mortgages last January, the average 30-year coupon on Fannie Mae mortgage paper tumbled to a low of 3.68 per cent, having surged above 6 per cent during the worst of the financial crisis in late 2008.

Since November, the mortgage coupon has eased from a high of 4.60 per cent to a low of 3.90 per cent and is currently about 4.40 per cent.

That places the 30-year coupon about 70 basis points above the 10-year Treasury yield.

Before the financial crisis, 30-year mortgage paper tended to trade 100bps to 125bps above the 10-year note, suggesting that the market needs to sell off between 30bps and 50bps once the Fed halts its buying. Roger Lehman, a mortgage securities analyst at Bank of America Merrill Lynch expects mortgage spreads will widen modestly by some 20-30bps, and not excessively, say beyond 75bps.

“Once spreads widen by 20-30bps, there will be demand mainly from banks and money managers,” he says.

Certainly the Fed’s buying has been met with grateful selling by mortgage investors over the past year, resulting in many portfolios being extremely underweight the sector.

For example, Pimco’s flagship Total Return Fund of $202bn, managed by Bill Gross, currently has 17 per cent of its assets in mortgages after being about 83 per cent a year ago.

Kent Wosepka, money manager at Standish Mellon, says they remain “pretty underweight mortgages in our portfolios” and are watching to see how the market copes once the Fed steps away.

Gerald Lucas, senior investment adviser at Deutsche Bank, said he expected current coupon mortgage spreads would slowly widen by between 20-30bps, but that buyers should step up. “Investors are so underweight mortgages, that a widening in spreads will be contained by pent-up demand to own the paper,” he said.

Reinforcing the scenario of a modest widening in spreads is the targeted nature of the Fed’s buying.

Mr Lucas says that the Fed and Treasury between them hold about 80 per cent of the current 30-year mortgage paper with coupons of 4 per cent and 4.5 per cent.

The current Fannie Mae 30-year coupon trades about 4.40 per cent and when money managers start to buy mortgages, they will want the current paper, not older issues at higher yields.

Given the fact that the Fed and Treasury own so much of the current coupon sector, that should help limit a rise in mortgage spreads, says Mr Lucas.

Not all investors are so sure that less supply will help limit spread widening.

With the Fed and Treasury owning so much of the current mortgage coupons, there is far less available for investors and much less liquidity, which could exacerbate changes in rates.

That is particularly the case should rates rise. Under such a scenario, holders of mortgages usually sell some of their portfolio in order to maintain a balance between their overall holding and the level of rates.

This type of technical selling has in the past been violent and amid poorer liquidity conditions could easily compound an unruly sell-off.

“It seems unlikely we will have a gradual widening in mortgage spreads,” says Mr Wosepka. “That’s not normally the case in markets.”

Indeed, some analysts see the Fed’s purchases as having removed volatility from the market. Once it stops, more volatility will return, by definition. The spectre of instability and a sudden jump in rates is high on the Fed’s watch list.

Policymakers said after their meeting last week: “The Committee will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets.”

That language is considered a code for further Fed buying should rates rise sharply, say analysts and investors.

Mr Lehman says that sharply wider mortgage spreads are likely to result in the government using Fannie and Freddie to step in and stabilise the market with buying. On Christmas eve the government announced that it would provide unlimited support for the mortgage giants over the next three years rather than cap their federal credit line at $400bn.

“If that doesn’t work we would not rule out the possibility that they may step in a bigger way,” says Mr Lehman.

Additional reporting by Aline van Duyn