Could the Fed Pivot on Balance Sheet Policy for Mortgage Securities?
After several years of gradual tightening in monetary policy, the Federal Reserve has pivoted toward easing. Policymakers have cut the fed funds rate twice already this year (in July and September) and left the door open for further cuts, and they stopped allowing U.S. Treasury securities to run off the Fed balance sheet. Also, the Fed announced plans last week to begin adding to reserves by purchasing about $60 billion of T-Bills per month starting 15 October. However, this is unlikely to help the troubled mortgage financing markets.
We believe Fed officials have another lever to pull to ease monetary policy: They could decide to reinvest the $20 billion in mortgages that they are currently allowing to run off the balance sheet every month. If the Fed were to consider this approach, we think it would benefit many consumers – including homebuyers and homeowners – and help fix the repurchase (repo) markets in the mortgage markets, which remain at distressed levels.
Since October 2017, the Fed has been decreasing the size of its balance sheet in mortgages. It is currently allowing up to $20 billion in mortgage-backed securities (MBS) to run off its balance sheet every month – and those securities are absorbed by the private sector. We estimate this excess net supply of up to $240 billion in MBS per year has raised borrowing costs for homeowners who access credit through government-guaranteed mortgages by about 40-50 basis points (bps). This rise in mortgage rates to homeowners relative to the Treasury rally has made agency MBS cheaper and more attractive to relative value investors.
While mortgage rates are low, they could be a lot lower based on the move in U.S. Treasury rates. Additionally, while the Fed has committed to improving financing in the Treasury markets, agency financing rates remain elevated, averaging nearly 60 bps above one-month Libor. We have seen financing rates this high only in the financial crisis.
To be sure, factors beyond the Fed’s purview have contributed to MBS underperformance: Poor financing levels have hurt market pricing; the newly introduced Single Security ”race to the bottom” has led to accelerated prepayment speeds; and interest rate volatility has led to higher realized convexity costs.
Still, we believe the Fed is the largest driver of weakness in the MBS market. If the Fed reinvested in the mortgage market, it would go a long way toward alleviating the stress in MBS markets, and reduce rates to homeowners and would-be homeowners alike.