July 21, 2022 | A while back our friend and mentor Alex Pollock wrote an important comment in Housing Finance International, “The government triangle at the heart of U.S. housing finance,” which discussed the huge expansion of the role of the central bank in the US economy since 2008. He writes:
“The U.S. central bank’s great 21st century monetization of residential mortgages, with $2.7 trillion of mortgage securities on the books of the Federal Reserve, is a fundamental expansion of the role of the government in the American housing finance system. In Economics in One Lesson (1946), Henry Hazlitt gave a classic description of those whose private interests are served by government policies carried out at the expense of everybody else. ‘The group that would benefit by such policies,’ Hazlitt wrote, ‘having such a direct interest in them, will argue for them plausibly and persistently. It will hire the best buyable minds to devote their whole time to presenting its case,’ with ‘endless pleadings of self-interest.’”
We tend to think that the early period of Fed manipulation of the mortgage markets in 2020 and 2021 was a good idea, if for no other reason than giving the mortgage industry the cash to help millions of Americans avoid default during the COVID lockdown. The alternative would have been a 1930s style debt deflation with millions of home foreclosures that would have made 2008 seem blissful by comparison.
But whereas in 2020 and 2021 the mortgage industry originated trillions of dollars in new loans, in 2022 the industry will be lucky to break $800 billion in new issuance of agency and government mortgage backed securities (“MBS”). As existing home sales fall, the issuance of MBS will likewise plummet. Home mortgage rates are over 6% and headed higher.
The decline in existing home sales carries several immediate implications, writes Glenn Schultz, head of agency MBS prepayment modeling and strategy at MUFG Securities.
“Issuance volume, at this point we are confident 2022 issuance will reach the mid-point of our forecasted range of $600 to $800 billion. Looking into 2023 we believe issuance will decline balancing supply/demand fundamentals.”
Schultz says that MBS turnover will continue to decline and prepayments will likewise moderate. He expects the rate of home price appreciation to continue at a double digit pace through 2022, however, only moderating in 2023 as supply and demand balances. Schultz says further that existing home sales will probably decline below five million units on an annualized basis due to demand destruction caused by higher mortgage rates and strong home price appreciation.
So here is the obvious question in the minds of readers of The Institutional Risk Analyst: Why is the Fed continuing to reinvest prepayments and redemptions on its $2.7 trillion system open market account (SOMA) MBS portfolio? In hindsight, the Fed should have ended all purchases of MBS a year ago, when new issuance volumes started to drop. Yet the MBS purchases continue.
We appreciate the comments from various people on our recent column in National Mortgage News, (“Faulty bank stress tests are hurting the mortgage market”), which highlights the continuing conflict between Fed monetary policy and the central bank’s regulation of large banks. Suffice to say that the latest Fed bank stress tests are so far off the mark that we cannot even construct a reasonable facsimile of the test results for JPMorgan (JPM) using the regulatory data from the FFIEC. We wrote:
“The situation with respect to the Fed and bank stress test results is more than a bit ironic. The potential losses that the Fed’s fantastic stress tests envision are the direct result of the manipulation of the housing sector and global credit markets by the Federal Open Market Committee under ‘quantitative easing’ or QE.”
So when the Fed finally stops reinvesting redemptions and prepayments from MBS, the large banks regulated by the central bank will also be selling residential mortgage exposures because of the skewed results of the bank stress tests. How is this helpful? Does the Fed’s Board of Governors really want to crater the market for housing finance by having both large banks and the SOMA as net sellers?
Looking from the perspective of mortgage lenders, it sure looks that way. Leaving monetary considerations aside for a moment, why save mortgage lenders in 2020 but kill them now by hiking the Fed funds rate? Meanwhile, between July 15, 2022 and July 28, 2022, the FOMC is scheduled to buy $6 billion in MBS.
If annual issuance of new MBS is only running at $600 to $700 billion or one quarter of 2020-2021 levels, then why is the FOMC still buying $10-15 billion per month in MBS for the system open market account? Is this meant to offset the impact of rate target increases? If so, then it's not working. Since nobody in the media thought to ask that question at the last FOMC press conference, we do not know the answer. Maybe next week.
In our last edition, we noted that the 10-year Treasury note has rallied nearly 50bp in yield since the middle of June, driving the on-the-run contract in the forward market for residential mortgages back down to 4.5% coupons for Fannie Mae MBS. If you were too short on your TBA hedge, too bad. Meanwhile the net longs are filled with joy. And all of this because of the profound lack of sensitivity of the FOMC to that most mysterious of things, market forces.
The time to taper MBS purchases for the SOMA is when market demand is high. Demand for risk-free assets such as agency and government MBS is very high at the moment, largely because issuance across the board is falling. This is bad. We applaud Fed Governor Christopher Waller for urging his colleagues to resist the temptation to hike rate targets 1% next week.
The real message to the FOMC is this: hike another 75bp in July and then let the Fed funds target sit for a few meetings while you let the SOMA portfolio shrink, slowly. The 10-year Treasury is heading toward 2.5%, high yield spreads are tightening and the dollar is strong. Take the gift.
One of the truths of American monetary policy is that the FOMC, being a creature of politics, always does too much. The FOMC bought too much Treasury debt and MBS since the 2008 crisis and, especially, since the outbreak of COVID. When you increase the money supply w/o a proportional increase in productivity, you get inflation.
Now the Fed seeks to regain virtue by over-correcting on the anti-inflation medicine, but risks recession and market contagion in the process. Just as the Fed badly needs to consider the interaction between monetary policy and large bank capital rules, the central bank also needs to better understand and articulate the trade-offs between rate target increases and changes in the balance sheet.
Chairman Powell, to his credit, has admitted that the FOMC does not understand how to calibrate changes in rate targets vs changes in the SOMA. Given this uncertainty, we think that the Fed should do less not more, with a view to reducing the level of volatility in the system introduced by the Fed’s very own “go big” tactics on QE in 2020 and 2021.
Market rates have already moved hundreds of basis points since January. More important, issuance of new securities is headed into the floor, a serious red flag for policy makers that want to see the US economy continue to function and grow.
Maybe now is the time for the FOMC and the financial community to admit that the solution to inflation may take time and also may be beyond the power of central banks to fix in the near term. That requires political courage; the courage to say “no” to the screaming mob in the political community and the media, just as former Chairman Paul Volcker had to ignore many loud critics half a century ago. Governor Waller is right. Slow down.
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