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MBS Life After Quantitative Easing

Originators and lenders need to pay heed to possible impacts.

Rob Chrisman
Insider
Rob Chrisman
Federal Reserve Chairman Jerome Powell

Remember in the “old days” when the Fed didn’t sop up all the new issuance, and then some, of residential agency mortgage-backed securities? When rates were allowed to fluctuate with the market, and weren’t artificially held down? Pre-Quantitative Easing? We find ourselves in that environment, and then some, and originators and lenders need to pay attention.

In the past the Federal Reserve wasn’t generally known for its transparency. That has changed in recent years, and now nearly every week Fed Presidents are out speaking and voicing their thoughts on the economy and the direction of interest rates. Based on the fact that payrolls are very strong as we move through the summer of 2022, but economic growth is moderating, and inflation is well above its targeted rate, analysts believe that the Fed will begin to sell small pieces of its mortgage-backed security holdings at some point this year. Key numerical indicators and public statements from various Fed officials over the last month or so back this up, as it appears that the U.S.’s economic recovery, after being buoyed by an improving housing market and increases in household spending, is outweighed by inflation concerns. 

Interest rates continue to be a discussion topic in the lending industry. Jobs and housing drive the economy in the United States, and the U.S. economy added a stronger than expected 372,000 jobs in June. The unemployment rate held steady at a healthy 3.6%, giving the Fed no reason to deviate from its plan for aggressive rate hikes. Investors may have backed off a bit from overriding recession fears, as the strong jobs report and a recent sharp decline in prices for oil and other commodities allowed for a somewhat higher possibility that the U.S. economy could achieve a soft landing. Investors cheered signs that the central bank was committed to preventing price pressures from becoming entrenched, even if that came at a cost of slowing the U.S. economy.

In addition to the employment statistics, the Federal Open Market Committee released the minutes from its last meeting. FOMC policymakers judged that an increase of 50 or 75 basis points "would likely be appropriate at the next meeting (later in July)" given the current economic outlook. They also "recognized the possibility that an even more restrictive stance could be appropriate if elevated inflation pressures were to persist." With the potential for the firmer policy to slow growth, Fed officials also removed language from the June policy statement that "indicated an expectation that appropriate policy would result in a return of inflation to 2% and a strong labor market."

There was also discussion on steps to shrink the central bank's balance sheet, a strategy known as quantitative tightening. Not only has the Federal Reserve been buying securities issued by the U.S. Treasury, but throughout much of 2020, 2021, and even into 2022 the Fed has been purchasing agency mortgage-backed securities. Many believe that the Fed will begin to sell these holdings, in which case the laws of supply and demand suggest that prices of MBS will go down, and rates up.

The majority of observers tend to focus on employment data, but the current state of inflation will dictate the moves by the Fed. In terms of target numbers, the Fed is going to be wary of any rate that isn’t 2.5% at this point. The figures to look for are those released as part of the Personal Consumption Expenditures index, which provides a broad measure of price changes in consumer goods and services, and though they rarely result in dramatic headlines, there’s no question that they too play a role in the Fed’s moves.

Predicting exactly what MBS spreads are going to do if and when the Federal Open Market Committee chooses to sell its MBS holdings is tricky. At least the end of QE1 some years ago provides a template. Looking at the expiration of QE1 in the second quarter of 2010, spreads saw steady widening due to the end of the purchase program, with paydowns from the Fed portfolio entering the market, European macroeconomic trends (which prompted widening in most spread products), and convexity flows from servicers serving as other influential factors.  It’s reasonable to predict that spreads would follow the same trajectory.

Origination volume will probably drop off as rates rise, reducing overall MBS supply, but demand is projected to change as well. Overseas investors and money managers, from whom demand declined over 2012, could very well improve following the end of asset purchases, and analysts are reasonably confident that REITs will emerge as the primary source of new demand, followed by banks. These predictions are of course very prone to change, as it appears at least for the time being that the Fed will be focused on taming inflation without plunging us into a recession. It could be a bumpy landing.

This article was originally published in the Mortgage Banker Magazine August 2022 issue.
Rob Chrisman
Rob Chrisman

Rob Chrisman began his career in mortgage banking – primarily capital markets – 35 years ago. He is on the board of directors of Inheritance Funding Corporation, of Doorway Home Loans, of AXIS Appraisal Management, and of the California MBA. He is also a member of the Secure Settlements Advisory Board, an associate of the STRATMOR Group, and of the Mortgage Bankers Association of the Carolinas and its membership committee.

Published on
Aug 16, 2022
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