To Whom Does The Fed Intend To Sell Its MBS? Great title from The Atlantic Journal, but I had to respond

The following article appeared on The Atlantic Journal’s website earlier today. After reading it, I just couldn’t help myself and I posted a reply, included underneath. I love The Atlantic Journal and think it is one of the best publications out there right now, even though I don’t always agree with their take on things…but this was just not logical. I usually don’t reply to stories and keep my thoughts for this publications, but it touched a nerve for some reason. Anyway, here it is…

To Whom Does The Fed Intend To Sell Its MBS?

By the end of March, the Federal Reserve is set to end its mortgage-backed securities purchase program. This program was created to help alleviate the credit crunch for residential mortgages during the financial crisis. It has worked pretty well. Once the program ends next month the Fed will have approximately $1.25 trillion in MBS on its balance sheet. The Wall Street Journal’s Real Time Economics blog reports that St. Louis Fed President James Bullard favors beginning to sell this MBS soon. My question for him would be: to whom?

From RTE:

“If the economy stays on track, I’d expect that at some point we’d entertain the possibility of asset sales,” said Mr. Bullard, a 2010 voting member of the Fed’s policy-making arm, adding it could happen later this year. The Fed official said the asset sales should be very slow at first to test markets.He also believes asset sales should begin before rate increases, according to RTE. I have a few concerns.

I’ve already mentioned my fear that investors won’t be willing or able to sustain the demand necessary to keep the MBS market moving once the Fed stops its purchases. If the program is ended too soon, that will lead to much higher mortgage rates and less mortgage availability. That’s sure to drive the prices of homes even lower and make housing inventory even higher.

But not only is Bullard on board with ending the program, he’s itching to start selling the MBS. Here’s the problem: if there isn’t enough investor demand to sustain a private new issue MBS market as it is, then to whom exactly would the Fed sell its MBS? The same problem would persist in the secondary market, unless the Fed is prepared to take deep discounts, which is unlikely, because if anyone can hold assets as long as they like, it’s the Fed.

Why am I so convinced that the MBS market is still very unhealthy? Because it told me. Last week at the American Securitization Forum conference, the industry participants answered a poll about when they thought the RMBS market would begin to recover. Their answer:

Only 8% say the market will get started again prior by mid-2010. A full 66% say it won’t even happen this year. 39% think it won’t happen until late 2011! So the Fed’s influence will have to be significant over at least the next year, unless it wants to debilitate the housing recovery.

Let’s think of a best-case scenario. The Fed ends its program in March, and that 8% is right: there are a handful of investors willing to play in the MBS market again. Those investors will have to soak up all of the new issue MBS. If the Fed is also trying to get rid of its MBS, then the market supply becomes greater, leading those investors to purchase less new issue MBS. That curtails origination and raises interest rates further. And again, this is the hopeful scenario.

As much as I hate to see the Fed’s involvement in the mortgage market, I don’t see how it can stop propping it up until we’re sure house prices have hit bottom, inventory has declined to normal levels and the foreclosures are mostly finished. And that’s just when it should stop its MBS purchases. It should finally sell its MBS even further down the road — once there is ample demand again for MBS so that the market can absorb the supply shock of the release of all of those securities.

For the full article click here.

MY REPLY:

Thank you for this interesting post.

I think your assessment is correct in that Fannie and Freddie cannot continue in their current form. Additionally, the Fed has become the de facto backer of (it is estimated) roughly 95% of new mortgage originations in the country. It is a nationalization of our residential real estate market and marks an incredibly difficult situation for both the Federal government and residential real estate owners.

By keeping rates artificially low and providing financing at too cheap a rate, the Fed inadvertently (perhaps) manipulated the market and now we are left with expensive real estate and no buyers. Your solution, however, confuses me. You write that “As much as I hate to see the Fed’s involvement in the mortgage market, I don’t see how it can stop propping it up until we’re sure house prices have hit bottom, inventory has declined to normal levels and the foreclosures are mostly finished.” So your suggesting that the government continue an unsustainable policy? By extension, your recommendation puts the US taxpayer as the holder of residential mortgages. It either forces us to be bad landlords (since we can’t foreclose on ourselves, nor raise rents) or financiers of speculators and bad credits. In either way, what makes you think that Fannie and Freddie who haven’t been able to manage their finances and WENT BANKRUPT will be able to make the correct decisions going forward.

Your recipe of continued government purchases is unsustainable and will only lead to more pain as the government ends up as the only buyer at the artificially low rates it’s created. Governments propping up a market helped get us to the point we are at today.

Rates will have to rise; the only question is how much liability will the US taxpayer have to bear.

FT.com on direct bidders for Treasuries

The FT.com ran the following story about direct bidders in the Treasury market. In essence, the article points out that there are more than double the proportion of direct bidders than usual (usual about 7-8%, current about 17%). It goes on to mention that a large bidder is trying to keep its moves out of the dealers hands. A deflationary play? Covering? Hedging some position? There are only a handful of bidders who can muster up that kind of buying power (either a government entity, like the Fed or China, or a powerhouse player like Blackstone or PIMCO), so the question is what to do with the information. As you know, I have been short treasuries through TBT for a few weeks and am staying put for now. Will keep an eye out.

The FT: Treasury bids drive speculation Auctions of US Treasury notes this week have attracted
extremely strong buying from domestic institutional investors, fuelling speculation that “one big bidder”
has decided to defy the conventional wisdom on Wall Street that US government debt is due for a fall.
The surprising demand for Treasury notes has come in the form of “direct bids”, the term used for US
institutional investors who bypass the so-called primary dealers that underwrite government bond sales.
On Wednesday, direct bids accounted for 17 per cent of the sales of $21bn in 10-year Treasury notes,
far higher than the recent average of 7.4 per cent. It was the highest percentage of direct bids in a 10-
year Treasury auction since May 2005.
On Tuesday, direct bids accounted for a record 23.4 per cent of the bidding for $40bn in three-year
notes, up from an average direct bid of 6 per cent.
Market participants say the unusually high level of direct bidding suggests that a large investor is
looking to accumulate Treasuries without alerting the primary dealers on Wall Street to its intentions.
“It appears to us that someone is trying to hide their apparent interest in owning these auctions
from the rest of the market,” said David Ader, strategist at CRT Capital.

Click here for full article.

Placing speculative limits is BAD – now if only the Fed will heed it’s own research

In a recent paper published by the New York Fed, Erkko Etula shows that speculators help stabilize commodity markets. To quote:

Taken together, my results highlight the importance of speculative capital for the stability of commodity markets. In this way, the paper not only contributes to the broader literature on limits of arbitrage pioneered by Shleifer and Vishny (1997), but also shows that recent arguments in favor of speculative
trading restrictions have been starkly misguided.

Another interesting outgrowth of this research is that Etula is able to model some of the volatility of commodities based on the flow of funds report. For those trading in the options arena, especially those using quant based approaches, this might point to an interesting factor to test further. For the full report click here.

CPI and Earnings and Current Account

So let’s review:

1. CPI notched up 0.4%, mainly driven by a rise of about 4% in energy. Click here for a summary from CBS Marketwatch. Here’s the official BLS statement:
   On a seasonally adjusted basis, the CPI-U increased 0.4 percent in November after rising 0.3 percent in October. The index for all items less food and energy was unchanged in November after increasing 0.2 percent in October.
2. In the meantime, real earnings were flat, or negative after taking into account the CPI:
   (From BLS) Real average hourly earnings fell 0.5 percent from October to November 2009. This decline stemmed from a 0.5 percent increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) more than offsetting a 0.1 percent increase in average hourly earnings. Over the year real average hourly earnings decreased 0.1 percent.
3. At the same time, the current account deficit widened to $108 billion in the third quarter. At 3% of GDP, it’s still way below 2005 when it was 6.5% of GDP, so hopefully the trend is improving, although still ugly. http://www.marketwatch.com/story/current-account-gap-widens-in-q3-2009-12-16

All in all, certainly not inflationary on the surface, so the Fed, afraid of being labeled 37′ers, will have no motivation to move on interest rates.

Notes from underground – Yra Harris

Treasury auction “sloppy”

The government didn’t get the subscription levels it was hoping for, yields are up, and the market is facing a new reality. We have come to depend on foreign purchases of our debt. The recent norm has been about 45% of buying coming from foreign lenders (foreign governments, banks, etc.). In contrast, this auction had only 35% coming from those same lenders. (http://www.marketwatch.com/story//treasurys-under-pressure-before-10-year-note-sale-2009-12-09) Where are they? In my mind, sovereigns need to buckle down and keep their cash on hand in case they need it for domestic spending. In that case, they wouldn’t want to pile it into UST. Yes, they are probably afraid of currency fluctuations and the US credit rating, but I think they are more afraid that 1. they get no return on their money and 2. they might actually need it.

We’ve discussed the short Treasuries trade for a while and are still holding on to our TBT position. We are in an environment where we could see a stronger dollar and declining Treasury prices simultaneously. In the past, a strong dollar led people to park their cash in Treasuries, but now, I think people will want to hoard their cash (deflationary) and not lend it to the government. It will be good for the savings rate – at least that. In every other respect it will pose big problems. For one, it’s deflationary, which scares the Fed. Interest rates rising may lead to another leg down in real estate (I believe this is happening already, and can be especially troublesome with the tighter lending standards).

One of our readers talks about “deflation in wants, inflation in needs”. I think he’s probably right on a relative basis, as needs will go down less than wants, but overall, both will be impacted. Yesterday, Kroger reported that even without writedowns, profits would have been down 26% (http://markettalk.newswires-americas.com/?p=6822), so the needs vs. wants might not be so clear-cut.

So the disconnects continue, and the fear of deflation continues to haunt Bernanke. But maybe, just maybe, deflation isn’t that bad. Maybe deflation is the economy’s way of rewarding the savers, despite all attempts to reward the over-spenders. Maybe for those who have savings and cash on hand, the time might come in the not-too-distant future when spending and investing (namely, putting your cash to work) will make a lot of sense. See also: Mike Shedlock’s piece from a couple of months ago (click here).

Ron Paul 1, Fed 0

Ron Paul is out there on a lot of issues, but he’s definitely won a round against the Fed. Regardless of whether you believe there should be a Fed at all, a limited Fed, an all-powerful Fed, or whatever, Tim Geithner and the current Fed aren’t what they used to be. Even more importantly, the Fed is also taking the administration on an uncomfortable ride. Between Copenhagen, New Jersey, Guantanamo, and watered down Healthcare, the Obama administration’s coat-tails do not look so cozy these days. What will this ultimately mean for the Fed? I don’t think anyone knows yet how it will impact the Fed’s ability to act in times of distress. Had this legislation been in place during LTCM, how would the situation have unfolded? Lehman/Bear/AIG? I don’t know, but once this bill passes, I think there will be plenty of opportunities to put the new restrictions to the test.

http://www.marketwatch.com/story/panel-votes-to-audit-feds-balance-sheet-2009-11-19

Bill Gross out with a new commentary

His conclusion – .01% yield on cash is pathetic, all other options are scary, so play it in between and buy utilities at 5-6% yield with limited upside growth. For the full reading, click here.

Notes from underground – Yra Harris

Bond dealers warning about Fed bid

When the top bond dealers in the country tell you to watch out, you might want to listen.  “Bond dealers who advise the U.S. Treasury on its massive borrowing needs gave the government something new to worry about today: The Federal Reserve.” The article continues…

In a presentation to the Treasury by its borrowing advisory committee, which represents the Securities Industry and Financial Markets Association, bond dealers warned the government that its borrowing costs could start rising even before the Fed formally moves toward raising interest rates.

One source of upward pressure would be the slow unwinding of the Fed’s program to buy $1.25 trillion worth of mortgage backed securities through March of next year. Those purchases have helped to drive down rates on mortgage backed securities and on many other securities as investors search for higher yields in other places, the bond dealers said. As the purchases wane, rates will go up across bond markets, corporate bonds, mortgage debt and Treasury debt.

“Federal Reserve purchases have taken an enormous amount of supply out of the market this past year across fixed income markets, but next year, financial markets should expect even greater issuance with no support. Such an outcome could pressure rates,” the dealers said.

The dealers offered cautions about another Fed program in development. The Fed is preparing to use something called reverse repurchase agreements, or reverse repos, to drain cash from the financial system when it wants to tighten monetary policy.

Under the program, the Fed will use its large holdings of Treasury bonds and mortgage backed securities as collateral for loans from financial firms. In essence, it will shift from being a massive lender to a massive borrower, and take money (or reserves as it is known in central banking parlance) out of circulation in return. The dealers said the reverse repos will compete with other short-term investments and put upward pressure on Treasury bill rates when it is started.

It’s not clear yet when the Fed will start using reverse repos. The dealers said they believed the Fed will start using reverse repos to drain cash from the financial system before it raises interest rates, possibly as soon as the first quarter of 2010. Fed officials, on the other hand, aren’t convinced that will be the case. There’s a good chance they won’t use the program until they’ve started raising interest rates, which might not be for several months.

But the dealers’ broader point is right and worrying. In 2010, the Fed could well shift toward a tighter monetary policy, and financing a mammoth budget deficit could get even harder.

http://blogs.wsj.com/economics/2009/11/04/bond-dealers-to-treasury-look-out-for-fed/

We’ve talked about the false bid in the bond market, with the Fed and Treasury completely distorting the market. It gives banks, like Goldman Sachs, the ability to borrow at lower rates than the Federal government! Problem is, as this article highlights, that without the Fed buying treasuries, the market would lose the bid and rates would go higher faster than anyone in the administration want. The fear of being early in pulling the QE out of the market ala 1937 is driving ridiculous risk taking and will eventually need to be washed out of the market. At the rate we’re going, that might happen sooner than anyone wants to admit.

Notes from underground – Yra Harris

Notes from underground – Yra Harris

Chris Wood from CLSA says Emerging Asia to be prime beneficiary of Fed policy

I had to post this. It is a perfect example of how 2 people can look at exactly the same thing and come out with different conclusions. Chris Wood from CLSA is great and I love his research. He contends that the easy money coming from the US will flow to produce a bubble in Asia. I agree on some level, although I think it also helps prop up the bubble here in the US. What I take issue with is his use of the word “beneficiary”. He implies that Asia will benefit from the US policy, where I see it as incredibly dangerous for Asia. Unlike the US, Asia does not have the institutional depth to deal with the inevitable crash implied by Wood’s bubble. Social unrest will be the most dangerous force at play in Asia if and when the US easy money policy abates. I do not think they are benefiting from the policy; on the contrary, I think they are being put at risk and the money flowing there is ephemeral and fickle. Hong Kong real estate prices, in some places calculated to be $8,000 PER SQUARE FOOT will come down sooner or later. If they just equalize with New York’s $1,000 per square foot, it will represent an 85%+ loss. It will either come from the currency or the property, but it will come. That doesn’t sound like so beneficial to me. Here’s the full article from Wood:

Is the U.S. Economy Turning Japanese?
Easy money from the Fed hasn’t translated into more consumer lending by banks.
By Christopher Wood

Happy days are here again in world stock markets. Yesterday’s profit-taking notwithstanding, the Dow Jones Industrial Average is flirting with 10000 and the S&P 500 is up 60% from its March low. Still, if risk-seeking behavior has returned to financial markets, much of it is funded by borrowing increasingly cheap U.S. dollars. There is also very little evidence, if any, that consumption and employment are really recovering in America.

With the U.S. government stepping in to keep markets from clearing, today’s U.S. economy in many ways resembles the post-bubble Japanese economy of the 1990s. Ultra-loose monetary policy and low demand for credit, combined with high unemployment and consumer deleveraging, could lead to a prolonged slump.

Consumption, which still accounts for 71% of total nominal GDP in America, is still weak, and there remains little reason to expect it to pick up in a healthy fashion. Aside from the well-known and related issues of high household debt and negative equity in houses, the latest U.S. employment data have highlighted the still dismal state of the job market. Average weekly earnings of production workers rose by only 0.7% year on year in September as the average number of weekly hours worked fell to a record low of 33 hours. This marks the lowest annualized weekly earnings growth since the data series began in 1964.

Meanwhile, there’s an unhealthy reliance on government for growth in America’s increasingly command-driven economy. This is clear from the severe slump in car sales post “cash for clunkers.” U.S. auto sales declined by 35% month on month in September to an annualized 9.2 million. It’s also clear from the enormous role now played by government in the residential mortgage market. Government-guaranteed mortgages accounted for 98% of total mortgage-backed security issuance in the third quarter.

The reality of an increasingly command-driven economy in America means that government policy is likely to become the key determinant of where investors should place their money. For example, the near-term prospects for the housing market in the U.S. will be strongly influenced by whether the federal government extends its first-time home-buyer tax credit when it expires in November. Like cash for clunkers with autos, the risk is that such a program is simply buying demand from the future.

The other risk is the same as subprime mortgages—encouraging people to buy houses who may be better off renting. This is suggested from the growing delinquency rates on Federal Housing Administration (FHA) approved loans since the FHA has taken over from Fannie Mae and Freddie Mac as the prime way of increasing U.S. taxpayer exposure to future residential mortgage defaults. The default rate on FHA-insured mortgages was already running at 8.1% in August, up from 5.7% a year ago.

Then there’s the government involvement in the U.S. financial sector. Over the past two years the federal government is estimated to have lent, spent or guaranteed around $11 trillion to the financial sector, broadly defined. This is due to Washington’s slavish adherence to the absurd notion that financial institutions can be “too big to fail,” be they called Fannie Mae, AIG or Citicorp.

All of the above behavior invites legitimate comparisons with post-bubble Japan, where banks took years to be cleaned up as a result of regulatory forbearance. The same kind of forbearance is preventing America’s increasingly distressed commercial real-estate market from clearing. Similarly, as was the case with Japan, monetary-base growth has exploded in the U.S. over the past year courtesy of the Fed, while bank lending is declining. This is why there is every reason to fear that America is already in a Japanese-style liquidity trap.

True, Japan’s bubble economy was much more about corporate-debt excesses, most of it borrowed against land or property collateral, rather than personal debt, as is the case in the U.S. But if the comparisons between the two countries are far from precise, the Japanese example shows how investment behavior changes if a deleveraging deflationary trend becomes entrenched.

This can be seen in the dramatic change in Japanese institutional investor asset allocation between government bonds and equities. Japanese insurance company and pension fund share of assets in domestic stocks peaked at 37.2% in fiscal 1988 (which ended March 1989, near the height of the bubble) and has since collapsed to 6.4% at the end of fiscal 2008, while their share of assets in Japanese government bonds surged to 36% in fiscal 2008 from 3.2% in fiscal 1990.

By contrast, in America institutional investors remain overweight equities and underweight government bonds. This will change radically if the U.S. truly is in a deleveraging cycle. Still, the process will take time. It was not until 1998 that Japanese insurance companies and pension funds had a greater percentage of their assets in government bonds than equities.

This is why Wall Street should make the most of the rally in U.S. stocks while it lasts. The next bubble in asset markets will not be in the West but in emerging Asia, led by China. The irony is that the more anaemic the Western recovery proves to be, the longer it will take for Western interest rates to normalize and the bigger the resulting asset bubble in Asia. Emerging Asia, not the U.S. consumer, will be the prime beneficiary of the Fed’s easy money policy.

Mr. Wood, equity strategist for CLSA Ltd. in Hong Kong, is the author of “The Bubble Economy: Japan’s Extraordinary Speculative Boom of the ’80s and the Dramatic Bust of the ’90s” (Solstice Publishing, 2005).

Zombie banks? No, Zombie Governments…

We have quoted Eric Sprott before, and I continue to view his analysis as prescient. His new article walks through the analysis of the US government debt burden. There are so many games being played behind closed doors, and so many big numbers being thrown around, that its great to have it summarized and the implications outlined. The main issue, as any borrower knows, is how far and how long will the line of credit be extended. The secondary issue, assuming that the line ends somewhere, is what happens next? Historically, governments have used a variety of methods to alleviate the debt: devaluation on a collosal scale, default, or war. The first, works only if you can devalue relative to other currencies, which seems unlikely given that the rest of the world would like to devalue alongside the US. Default seemed impossible just a few years ago, but Sprott points to it as within the realm or reason and shows why. Lastly, we have war, which to me seems like a real possibility. Even if not the traditional war, we have currency wars starting, we have resource wars heating up, and we have multiple physical wars going on that could grow, especially if Iran goes awry. Anyway, read and comment…http://www.sprott.com/Docs/MarketsataGlance/MAAG_10_2009.pdf.

A few must reads:

1. The Hussman letter: Hussman basically sums up and sheds light on something we have spoken of consistently, namely, the valuations we are seeing in the market at this point are not consistent with beginnings of prolonged bull markets. At best, there are trading opportunities, but do not fear sitting this inning out: http://www.hussmanfunds.com/wmc/wmc091019.htm
2. Banks: The facade will eventually break down and bank earning and bank stability will be revealed as a sham. Madoff will look like a drop in the bucket. Pretty much across the board, earnings calls are showing that loan books have shrunk (lower supply of credit) and the securities portfolios have grown. Now i can assure you the banks are not investing in housing. Most of the securities books are….you ready?….Treasuries. So banks are doing what they do, borrow short, lend long. Earnings go up, but no economic activity is stimulated! This is how the fixed income groups at JPM, GS, C, etc. are making a bundle; the Fed is helping them re-equitize through good ol’ NIM (net interest margin – borrow at 15 bps, buy 10 yrs at 400 or 340 or 320…it’s still a good deal). http://www.marketwatch.com/story/hedge-manager-sprott-sees-trouble-when-easing-ends-2009-10-20
3. What happens when a country imposes currency limitations? Yup, disconnect from reality that will mean someone is making money and someone is losing. In this case, Brazil is imposing limits on foreign buying of currency. Afraid of the competition from a declining dollar? Some have noted that this is a net benefit to Brazil, but I beg to differ. It might be a short-term driver, but currency limitations tend to backfire. Let the nationalistic games begin. http://www.bloomberg.com/apps/news?pid=20601087&sid=aex4NXE25Y0E