Fed Has Created Overpriced Mortgage Securities

Thursday, September 24, 2009

1084294_vector_graphic_2The Federal Reserve Board’s commentary yesterday included an extension of time to complete its purchases of $1,250 billion in mortgage securities issued by Federal National Mortgage Association (FNMA or Fannie Mae) and Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). To date it has accumulated over $850 billion worth, and they want to slow down the purchases in anticipation of being able to “smoothly” withdraw. All well and good, except the actions behind the numbers show the Fed has created an overpriced market, meaning its withdrawal could have adverse effects.

The Federal Reserve has the role of “lender of last resort,” and it has done so in many ways over the past year. A challenge in such times is to avoid reaching too far, attempting to alter natural market valuations or create economic stimulus. In years past, such efforts have had negative consequences.

Unfortunately this is the position it has gotten into with housing. Here’s what has happened and why there is a problem…

Housing’s triple whammy (falling prices, increasing foreclosures and mortgage securities downgrades) brought the mortgage market to a standstill, with adverse effects throughout the financial industry. The Fed stepped in to provide needed support so the market could function.

At the same time, Congress, viewing the great imbalance of demand and supply in the housing market, sought ways to increase demand (e.g., the first-time buyer’s tax credit) and decrease supply (e.g., the rewriting of mortgages to prevent foreclosure).

Congress enlisted the Fed’s support in attempting to improve “housing affordability,” the ratio of mortgage payments to income. With a recession in the making, income wasn’t going to rise, so there was the desire to get mortgage payments down. This led to two actions:

  1. Increased participation by FNMA, FHLMC and Federal Home Loan Bank by increasing allowable mortgages and providing needed capital. The Fed joined in by committing to buy up to $200 billion of their securities. Thus far, they have bought $129 billion.
  2. Reduced interest rates. Here is where the Fed really stepped in, with its $1,250 billion mortgage securities purchase program.

The size and aggressiveness of these moves resulted in most mortgages being purchased by the government agencies this year, and in the Fed buying about 80% of all the mortgage securities issued. This latter activity shifted the Fed from providing underlying support to taking over the market. The result: “Fed buying has made yields on [mortgage securities] unattractively low.” (The Wall Street Journal, September 24, 2009, page C-12, “Federal Reserve Extends the Print Run) Analysts expect yields to rise 0.25% when the Fed leaves the market, causing mortgage security prices to fall and mortgage rates to increase.

So, now looks like a good time not to own mortgage securities.

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John Tobey on Seeking Alpha

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September 2009