Inside The Fed's Buying

The focus of this post will be mortgage backed security (MBS) purchases. On March 18 of this year, the Fed announced that it would purchase up to $1.25 trillion of Agency & GSE MBS this year. The purpose of this was to free up funds for mortgage issuance; the Fed was to provide mortgage market liquidity.

There is a major risk with his plan: Wall Street does not have the same motives as The Fed. Wall Street traders want to make money so they get bigger bonuses, The Fed think they can save the economy by pushing down mortgage rates. As a result, you have a market that is not acting rationally and will be prone to move in a volatile fashion (witness the last few weeks in the mortgage market, rate are up at least 0.30%).

Since MBS are subject to prepayments, their prices are sensitive to prevailing interest rates. If you own MBS, you want the market to be as docile as possible. Large upward moves in rates decrease the value of your cash flows and extend the effective life of the MBS, increasing risk. Also, large downward moves in rates encourage refinancing behavior, which shorten the effective life of MBS. This mitigates the benefit of the cashflow being worth more in a falling rate environment.

So we have a buyer (The FED) that does not have to act rationally because they can withstand losses that other market players would not tolerate.

In graph 1 tracks the coupon rate of the Fed MBS purchases. It is clear that the bulk of their buying has been 4.0% & 4.5% coupon MBS. Graph 2 tracks the relative rate environment since the program has begun. Notice that the Fed has not materially change the average coupon, even though the rate environment has move higher. Of course, The Fed is paying a lower price for those securities, but that is not the only concern. The Fed is sending conflicting signals to the market with regards to valuation.