Something strange is happening in the market for mortgage-backed securities: the largest buyer by far is about to leave the market and no one seems to be blinking an eye.
When the Federal Reserve announced in September that it would begin slowing its MBS purchases and cease them by the end of the first quarter, mortgage bankers winced. They feared that without the Fed to prop up the market, the prices of such securities would sink, causing their yields, relative to benchmarks like Treasury bonds, to soar. Such an increase would in turn cause mortgage rates to jump, sapping demand for home loans in an already-weak housing market.
"Throughout the second half of last year, mortgage bankers were freaking out," said Tom Millon, chief executive of Capital Markets Cooperative, a Ponte Vedra Beach, Fla., company that provides secondary marketing services to banks. "Most of my clients were saying, 'How are we going to protect ourselves against this?' "
But it appears that the industry's worst fears were unfounded.
The Federal Reserve confirmed March 16 that it will indeed complete its purchases of $1.25 trillion of agency MBS by the end of this month, and prices have barely budged. The spread between the yields of the 30-year Fannie Mae current coupon and five-year Treasuries has been relatively steady, hovering around 200 basis points for the past several months.
And that has a lot of analysts and investors mighty confused.
"I'm trying to get my head around it," said Christian Cooper, an interest rate strategist at Royal Bank of Canada's RBC Capital Markets. Since the Fed has been warning for some time of a withdrawal, "it has been a known entity, but they are basically the only known buyer out there," he said.
The Fed said in November 2008 that it would begin purchasing "large quantities" of mortgage-backed securities guaranteed by Fannie, Freddie Mac and the Government National Mortgage Association — one of a number of measures the central bank took at the height of the financial crisis to get the economy back on solid footing and heal the battered housing market.
In short, the Fed became the largest buyer of MBS and effectively lowered mortgage rates, spurring a wave of refinancings and other mortgage lending activity.
Bankers, however, were concerned that once the Fed removed itself, the market wouldn't be strong enough to stand on its own.
"Initially, when the Fed announced it had a more firm date to withdraw, there was a lot of concern that you would have volatility as well as an upward shift in yields," said Jim Deitch, chairman and CEO of American Home Bank in Mountville, Pa., a division of First National Bank of Chester County, a $1.4 billion-asset community bank. "We're breathing a big sigh of relief that the market has been able to absorb this news."
Deitch said he constantly watches what's going on in the MBS market "because it's where our product ultimately goes and where mortgage rates are set."
Market participants point to several reasons for the relative stability. For one, the traditional MBS buyers that were pushed to the sidelines when the Fed came in are ready and waiting for their chance to get back into the market.
"As the government has become the world's largest buyer of mortgage securities in the last year, they've effectively squeezed all other buyers out of the market," Cooper said. "The natural mortgage-backed securities buyer has been accumulating cash, effectively waiting for the program to end."
Scott Colbert, the director of fixed income at Commerce Trust Co., a unit of Commerce Bancshares Inc. in St. Louis, agreed.
"I do think there are a lot of people like us with cash on the sidelines that didn't buy securities that will buy [into] the market," said Colbert, who manages $13 billion of assets.
Analysts also said that Fannie and Freddie's planned repurchases of their delinquent loans from their securitized pools is helping buoy the market.
On Feb. 10, Freddie announced that it would repurchase nearly all securitized loans that were 120 days or more past due, or about $70 billion of loans, during the month of February. The principal payments on these loans would be passed through to investors on March 15 and April 15, Freddie said at the time.
Fannie also said that day that it would purchase a significant portion of its $127 billion of delinquent loans, but that its purchases would take place over the next few months. On Thursday, Fannie released more details about its plans, including its intent to buy about 220,000 delinquent loans from MBS pools this month.
The repurchases make the market more attractive for buyers, analysts said. With the delinquent loans gone, the ones that are left for buyers will be "easier to understand" and "more highly valued," Colbert said.
Also, the principal that is being returned to investors can be reinvested back into the market — in addition to all the other money that has been waiting to pounce.
"What wasn't anticipated was how much cash would go back into the market once the Fed stopped buying," Cooper said. "So instead of the spreads widening dramatically, it's more likely MBS spreads will stay in a very tight range for the foreseeable future."
The unexpected firming of prices may be self-reinforcing. Colbert said investors who had made bets that mortgage-backed securities would decline in value are being forced to buy them now to cut their losses. "There were a lot of shorts that assumed the spreads would have to widen," once the Fed stopped its purchases, Colbert said. "Some of those shorts are covering their shorts, so that's helping to keep the spreads."
Not all analysts are convinced the coast is clear, however. Some say a pop in MBS spreads is possible after March 31, once the Fed has actually left the market. But any spike will likely be short-lived and minimal.
"We could see some spread-widening," said Walt Schmidt, senior vice president and manager of structured product strategies at First Horizon National Corp.'s FTN Financial Capital Markets. But "it's not going to be a bloodbath where mortgage spreads widen out 50 basis points or something like that."