The first rule of trading in capital markets: before entering a trade, have an exit strategy.
More than 15 years after the Federal Reserve began its policy of quantitative easing (QE), actively trading in mortgage-backed securities (MBS) to indirectly subsidize mortgage rates, the U.S. central bank still appears to lack an exit strategy.
“The Fed could not figure out how to get out of the MBS over the 10 years before the pandemic and it has come to the same thing now,” says Michael Fratantoni, the Mortgage Bankers Association’s (MBA) chief economist.
Which isn’t for the Fed’s lack of trying. In early 2022, the Fed’s balance sheet was just shy of $9 trillion in total assets. As part of its strategy to combat inflation, since the first quarter of 2022 the Fed has engaged in a policy of quantitative tightening (QT), reducing its holdings of U.S. Treasury bonds and agency MBS by allowing them to mature, without reinvestment, at a monthly, maximum rate of $60 billion and $35 billion, respectively.
As historically unique as the Fed’s decision was to expand its balance sheet in reaction to the Great Financial Crisis (GFC) – particularly by becoming an active investor in the U.S. housing market – so historically unique is the Fed’s ongoing effort to shrink its balance sheet. At a press conference on May 4, 2022, following the Fed’s announcement that it would begin QT that June, Fed Chairman Jerome Powell noted, “I would just stress how uncertain the effect is of shrinking the balance sheet.”
As a market participant, regulator, and policy creator, the Fed has an outsized influence on the mortgage industry. Whenever the Fed changes its behavior or acts, the effects of those changes reverberate through the mortgage universe more than other parts of the economy. However, it wasn’t always like this. The Fed has signaled that it would like to have less direct influence.
In an ideal world, the Fed has said it would like a Treasury-only portfolio – no MBS.
How Did We Get Here?
When the Federal Reserve was established in 1913, one of its main goals was enabling banks to maintain emergency cash reserves for providing overall stability to the system. The Fed’s mandate evolved over time to include responsibilities of shaping and implementing monetary policy.
Before the GFC, the Fed held less than $1 trillion on its balance sheet, with U.S. Treasury bonds comprising the majority of its assets and the currency in circulation representing the Fed’s main liability. During the GFC, the Fed’s decision to drop borrowing rates to near zero proved not quite strong enough to stimulate the economy. So, the Fed experimented by buying more Treasuries and, for the first time, MBS, under its newly devised, stimulative, QE program.
In the decade after the GFC, the Fed’s balance sheet swelled from less than $1 trillion in 2008 to around $4.5 trillion in 2015 (Chart 4). The question of how the Fed would implement QT – reducing its holdings of Treasuries, and more specifically MBS – pre-dates the COVID-19 pandemic.
CHART 4: Fed balance sheet (Source: Federal Reserve)
The Fed first announced its intention to reduce QE in the future in May 2013, leading to a “taper tantrum” in the bond markets. At mere mention of the Fed’s withdrawal, bond yields surged on the fears that markets would crumble. The Fed then embarked on another purchasing spree, adding roughly $1.5 trillion to its balance sheet through 2015.
A few years later, however, the Fed did begin engaging in QT, reducing its balance sheet from roughly $4.4 trillion in September 2017 to roughly $3.7 trillion in September 2019.
However, the COVID-19 pandemic forced the Fed to pivot toward economic stimulus once again. The central banks’ policymakers chose to engage in a similar program as was deployed during the GFC: drop the Fed funds rate to nearly zero and provide QE. This time, the Fed’s balance sheet ballooned from $4.2 trillion in total assets in February 2020 to nearly $9 trillion in March 2022.
Did QE Make QT Impossible?
As the COVID-19 pandemic unfolded in 2020 and 2021, the mortgage industry benefited greatly from the Fed’s decision to drop the Fed Funds rate to nearly zero (Chart 3)and inject huge amounts of liquidity into the market with direct payments to households and favorable borrowing programs.
Chart 3: Fed funds rate (Source: Bloomberg)
However, the Fed’s dropping of the Fed Funds rate to nearly zero and assisted QE during the pandemic caused the entire mortgage market to purchase or refinance into historically low mortgage rates, creating a “lock-in effect” whereby potential sellers are discouraged from selling their homes – or else pay dramatically higher financing costs. Artificially lowering rates has kept housing inventory artificially low, artificially depressed demand, and artificially raised prices.
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The Fed has a dual mandate of price stability and sustainable employment. As a direct result of the Fed’s stimulative measures and fiscal policy action, exacerbated by supply chain issues and labor shortages, inflation rose during the pandemic. To control inflation, the Fed significantly tightened monetary policy. Beginning in the first half of 2022, the Fed increased the Fed Funds rate from nearly zero at the beginning of 2022 to 5.25% by July 2023. It has since remained elevated at that level.
CHART 1: IMB Profitability (Source: MBA)
As a result, the majority of mortgage lenders have experienced profitability carnage over the past eight quarters. Independent mortgage banks (IMBs) and mortgage subsidiaries of chartered banks reported average net losses of $2,109 per loan in the fourth quarter of 2023, per the MBA’s quarterly performance report (Chart 1). The Fed’s tighter monetary policy has caused a significant increase in mortgage rates due to an increase in Treasury rates and a widening of the Treasury-mortgage spread. The Fed and traditional banks have been net sellers of MBS for the past two years, meaning money market managers and real estate investment trusts (REITs) have been buying more MBS. Money managers usually need higher returns, which is reflected in the widening of the spread. Increased interest rate volatility has also resulted in widening of the Treasury-mortgage spread (Chart 2).
Government investment in MBS markets has helped keep mortgage spreads artificially low in the decade following the GFC. So far, though, the trend has reversed with QT, leading to worse results for the mortgage industry. The Fed has reduced its balance sheet by about $1.4 trillion since it began QT in June 2022. While Treasuries holdings have shrunk by almost $1.1 trillion, MBS have only reduced by roughly $293 billion owing to a dramatic slowdown in mortgage prepayments.
“Our industry does best with stable long-term rates that are sustainably low, and we can make money all day long at 5-6% rate, if they stayed at that level for 10 years,” says the MBA’s Fratantoni. “That would be a perfect market for us. Wild swings are not helpful because we cannot ramp up fast enough during refi booms and cutting is always miserable.”
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As the Fed continues along the path of QT and signals that interest rates will remain higher for longer, one wonders if there’s a level where the Fed would be forced to stop the current cycle of quantitative tightening. In early May, the Fed announced a tapering of its QT program, from $60 billion in Treasuries-runoff per month to $25 billion, starting in June. MBS tapering will continue at the same speed of runoff at $35 million per month. Fed Chair Powell made it clear during that press conference that the Fed is looking at the health of the financial system when making decisions about the size of its balance sheet, rather than simply implementing monetary policy.
The Fed will be wary not to repeat the mistakes of past tapering efforts and will have to communicate policy changes effectively so as not to spook the markets. Policymakers need to
balance the tapering schedule with the availability of sufficient bank reserves in the system, in addition to potential liquidity risks. Policymakers must also remember that monthly balance sheet runoff is being partially offset by the inflated face value of its inflation-protected holdings.
Slowing QT should be a net positive for bond yields as well as mortgage spreads, but Fed actions have unintended consequences for the mortgage industry. In my view, the longer run size of a Treasury-only portfolio will be driven by the rate of growth of the financial system and structural factors impacting the demand for reserves by the broader banking system.
This article originally appeared in Mortgage Banker Magazine, on the week of June 10, 2024.
Preetam Purohit, CFA, CQF, FRM, is currently the head of hedging and analytics at Embrace Home Loans. He has more than 12 years of experience in fixed-income trading, hedging, analytics, risk management, and capital markets.
