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.

Back to The Fed: Bigger and Badder......

....that's bad meaning bad, not bad meaning good....that is.

The Term Asset-Backed Securities Loan Facility (TALF) was recently expanded to include commercial mortgage backed securities (CMBS). These loans are to be made on a a non-recourse basis: The Fed can't go after any other assets of the borrowing institutions aside from the pledged assets. In other words, if the assets that the borrower is funding tank, they can walk away and let The Fed clean up the mess. The Fed has all of the credit risk but limited profit potential. This is not what a central bank should be up to.

http://nreionline.com/finance/news/fed_extends_talf_0520/


As a result, CMBS have rallied off their lows since there will be a lender of last resort. However, there is smoke on the horizon:

Coming soon: a wave of CMBS downgrades

http://ftalphaville.ft.com/blog/2009/05/26/56245/brace-yourselves-for-a-wave-of-cmbs-downgrades/


http://www2.standardandpoors.com/portal/site/sp/en/us/page.article/2,1,9,5,1204846937857.html

In order to be eligible, the CMBS must have a AAA rating from at least 2 rating agencies. From the way it sounds, S&P is prepared to dramatically reduce the number of AAA ratings they have assigned. So much for the TALF......

So What Do Those Previous Posts Mean?

What they are intended to reflect is the uber-shuffle of borrowing that is underway. The reason why inflation will not be a problem is because Treasury issuance is replacing private sector borrowing. The Fed and Treasury Department have become the last resting place of the junk that was sitting on bank balance sheets.

These assets are still over priced, there is no private sector bid at current marks. Interbank financing has only rebounded because the banks have guaranteed financing, not because they want to play nice.

Meanwhile, Back at The Fed (II)....

The above graph tracks data as of April month end. The ratio stands at $16.69 as of 5/20/09.

Meanwhile, Back at The Fed....

From the Federal Reserve statistical release H.4.1 (5/21/09):

• Leverage
• The Federal Reserve System holds $49.84 in assets for each dollar of capital

• Securities Holdings
• Holdings of U.S. Treasury Debt have decreased by $80.4 billion in 1 year
• Holdings of GSE debt have increased by $76.7 billion in 1 year
• Holdings of GSE /Agency MBS have increased by $431.5 billion in year

• Liquidity Programs
• Term Auction Credit totaled $428.8 billion
• Commercial Paper Funding Facility totaled $157.1 billion
• Other Loans totaled $126.3 billion (of which $45.7 billion is their loan to AIG)

• Non Recourse, Secured Loans
• Maiden Lane LLC: $25.7 billion
• Maiden Lane LLC II: $16.2 billion
• Maiden Lane LLC III: $20.4 billion

On the liability front: deposits from depository institutions (The Fed’s liability) totaled $955.2 billion, a $927.5 billion increase from a year ago. These deposits account for 72.4% of the growth on the liability side of the Fed's balance sheet.