For all the good the Federal Reserve's $1.25 trillion of mortgage bond purchases have done, they've also left part of the market broken.
By acquiring about a quarter of home loan bonds with government-backed guarantees to bolster housing prices and the economy, the Fed helped make some securities so hard to find that Wall Street has been unable to complete an unprecedented amount of trades. Failures to deliver or receive mortgage debt totaled $1.34 trillion in the week that ended July 21, compared with a weekly average of $150 billion in the five years through 2009, according to Fed data.
The difficulty of executing transactions may eventually drive investors away from the $5.2 trillion mortgage bond market, which has historically been the most liquid behind U.S. Treasuries, potentially causing yields to rise, according to Thomas Wipf, who chairs an industry group that is trying to address the problem. The unsettled trades also stand to exacerbate the damage caused by the collapse of a bank or fund.
"You're adding systemic risk into the market," said Wipf, the chairman of the Treasury Market Practices Group and the head of institutional securities group financing in New York at Morgan Stanley. "Investors are taking on counterparty risk in trades they didn't intend to take on."
An incomplete agreement can lead to a "daisy chain" of unsettled trades because a broker-dealer acting as a buyer in one transaction may fail to deliver those bonds as a seller in another, according to Alexander Yavorsky, a senior analyst at Moody's Investors Service. Investment banks are required to hold capital against both sides of the trades, which also makes the agency mortgage-backed market less attractive to make markets in, according to Wipf.
"From a broker-dealer perspective, this uses your credit resources, this uses your balance sheet resources and it uses your capital resources," he said. "It's a drag on the business."
The Fed was willing to accept some trading disruptions as a byproduct of its mortgage bond purchases because its primary aim was to bolster the housing market by reducing financing costs, according to Yavorsky. If reduced liquidity in the mortgage market persists and causes investors to seek other assets, that would run counter to the Fed's goal of buoying demand for the securities. The program began in January 2009 and officially ended in March.
"The program was a major success and kept home prices from really collapsing," Scott Simon, head of mortgage-backed securities at Pacific Investment Management Co. in Newport Beach, Calif., said the day it ended. At the same time, it's left mortgage bond prices too rich for Pimco, which reduced the world's biggest bond fund's holdings of the securities to 16% in June, down from 83% in January 2009.
The central bank and private investors helped send yields on Fannie Mae's 4.5% mortgage securities down to 2.86% on July 30 from 5.95% on Nov. 24, 2008, the day before the plan was announced, data compiled by Bloomberg News shows.
Propping up the home-buying market "is probably a more compelling consideration for them than fails" in the mortgage-backed securities market, Yavorsky said. "The risk and reward, if you will, are not entirely comparable in magnitude and social implications."
The Fed's purchases "were undertaken to broadly support mortgage and housing markets and were conducted with an eye towards limiting adverse effects on liquidity, given the importance of healthy, functioning markets," said Federal Reserve Bank of New York spokesman Jeffrey Smith. "We are supportive of the TMPG's efforts to identify best practices in these markets, including practices that limit fails."