US Federal Reserve intervention in the Mortgage Backed Securities market

The housing market collapse about two years ago led the US Fed to step in and buy MBSs worth about one trillion dollars. Now, the Fed is planning to unload its MBS while buying Treasury bonds at the same time. As the Fed buys Treasury bonds, Treasury yields should decrease, everything else remaining same. As the Fed unloads MBSs, MBS yields should increase, everything else remaining same. Will additional MBSs be issued and sold in this environment ( in addition to the ones already on the market or in the possession of the Fed ) ? Will additional MBSs be lapped up enthusiastically by investors, as they were before the crisis unfolded ? Probably not to the same extent as before the crisis, since the risk perceptions have changed. The “fundamental” price of an MBS is based on the expected cash flows from mortgage loan repayments. Market madness and bubbles can drive the prices to levels very different from “ sane “ valuations. However, the current environment is unlikely to sustain this kind of madness. The “ fundamentals “ have once again become paramount. With high mortgage default rates and an uncertain economic environment, MBSs are no longer the prized assets they used to be before the crisis. So, there will be much less enthusiasm for any new MBS issue.

What are the current realities in the housing market ? Housing starts are depressed. Sales of new houses are low. And all this while mortgage rates have fallen through the official recession and even after the end of the official recession. People’s affordability perception for new homes has changed due to the current economic difficulties. Therefore, the effective ( economic ) demand for new mortgages has most likely gone down, driving the market mortgage rates lower.

Moreover, the ability to repay a mortgage is very much a function of the interest rate on the mortgage, in addition to the individual’s expected income levels and assets. The market may have gone into a mode where the mortgage-issuers are issuing new mortgages only to individuals with high credit-worthiness and at interest rates that ensure repayment. It is difficult to gauge from the available literature if this is a factor or not.

Also, the higher default rates and the previous crash of the MBS market means that investors will be less interested in buying new MBSs. Therefore, much less new money will be available for lending on the housing market. The fact that interest rates have gone down despite this dynamic means that one or both of the factors described in the previous two paragraphs are applicable to the current housing market.

So, back to the original question. Will the Fed’s unloading of 1 trillion dollars ( at current, pre-unloading valuation ) worth of MBSs over a year or a year and a half or over whatever length of time the Fed wants to do it lead to a second housing surge, if not a boom ? In other words, is the stage being set for a mini-boom ? In ideal environments, the value of an asset should reflect the actual expected cash-flow from holding the asset. The fact that the Fed was able to distort this process by buying the MBSs in the first place is cause for concern. Now, the Fed is going to distort the prices by making MBSs artificially more attractive than the fundamentals warrant. Either investors will respond to this madness or they won’t. If they do, the stage may well be set for the issuing of new MBS, a mini-bubble and a possible second financial crisis. If they don’t, the Fed MBS sales will not be worth 1 trillion dollars. The Fed will then adjust the amount of its Treasury bond purchase to keep the total cash injection to the 600 billion dollar value it announced. Hopefully, fundamentals will carry the day in the MBS market.

Which raises the question, why does the Fed need to unload the MBSs at all ? Since its cash injection aim can be achieved through purchase of Treasury bonds, why distort the MBS market yet again ? Hopefully, the MBS market will go by the “fundamentals” rather than by factitious momentum created by the Fed.

Also, it may be high time for debates into market failures in laissez-faire economies. A money-printing entity that responds to the failures of economic entities encourages moral hazard in different shapes and forms. However, as long as the mechanisms to prevent such market failures do not exist, these interventions will continue to be a necessary evil. Regulation over overly complicated derivatives is one way of preventing the market from losing touch with reality. Also, some optimists will argue that the simplest fix to the problem is to make sure that lending euphoria is curbed by strict evaluation of credit-worthiness. Why did this strict evaluation not happen prior to the last crisis ? Is it because the lenders weren’t careful enough ? Or is it because their calculations were thrown off by the impact of the recession on the cash flows of families ? The timeline shows that the slump in the housing market happened before the beginning of the official recession. So, most likely, the methods used to evaluate credit-worthiness were themselves flawed. The public still does not have a clear answer as to whether the housing glut was created due to the inability to implement good credit-worthiness criteria for extending loans.

Feasibility analyses may need to be done on possible insurance schemes that help cover for such exigencies. If reasonable and affordable insurance schemes cannot be devised, then it may be necessary to completely revise economic paradigms in order to prevent this kind of failure.