Sunday, September 9, 2012

The twist, redux

Fannie Mae current coupon minus 10-year US Treasury note
Much has been written about the possibility of further Large Scale Asset Purchases (LSAPs, or QE) by the Fed. One of the main points of focus has been speculation about where those, if any, additional purchases will take place. One of the more probable, in my opinion, options is what has been called the "MBS Twist" by various analysts and strategists, including Harley Bassman of Credit Suisse. The "MBS Twist,"--a reference to the decision by the Fed to transact monetary policy by changing the maturity structure of its holdings, originally in 1961, and  most recently in August 2011--would be a balance-sheet neutral operation in which the Fed sells MBS holdings with higher coupons to buy so-called "current coupon" (trading closest to, but not exceeding par) MBS. This would mean selling bonds in which the embedded short call-option is in-the-money to buy bonds where the embedded option is at-the-money and longer-dated. This should, in theory, reduce the market clearing price of the embedded option which would be seen as a compression of implied volatility in the market. The idea behind this action is to compress the spread of current-coupon Agency MBS over treasuries (pictured right) and hope the compression in spread is eventually passed on to borrowers in the form of lower yields to incentivize home purchases or loan refinancing. 

Purchasing power of a $1,000 payment at various interest rates
Mortgage debt outstanding (source)
In theory, this is a pretty clever plan. Lower rates increase the purchasing power of a monthly payment exponentially (illustrated left). This helps support housing prices and increase the purchasing power of buyers. It also allows means people with existing loans can refinance, save money and hopefully spend that money on goods and services and drive the recovery in aggregate demand. Unfortunately, although I think the "MBS Twist" is highly probable, I have very little faith in its power to stimulate the economy. As it has been tirelessly repeated through the economic blogosphere, we are stuck in a balance-sheet recession, and people are continuing to deleverage (see center left) even when, as my friend David Schawel has pointed out, it might not be in their best interest.

The "primary-secondary" spread, the difference between the
yield borrowers pay, and what MBS yield.
 While borrowers continue to deleverage,  any impact from lower rates will be limited and as mortgage debt outstanding continues to fall, the marginal stimulative power of monetary policy, unfortunately, diminishes.

Additionally,there is evidence to doubt whether lower MBS spreads will be passed on to customers or whether the banks will keep the windfall. Despite current coupons trading at record tight spreads, the "primary-secondary" spread remains, not only stubbornly high, but near all-time record highs! (see lower left). Proponents of the MBS Twist insist that the Fed can put pressure on the "primary-secondary" spread and push savings to borrowers by increasing (more in a second) their purchases of current coupons, but to me it is clear that the problem lies in the demand, not supply, side of loans. This is why, unless we see further expansion of H.A.R.P. (Home Affordable Refinance Program) which increases the pool of homeowners eligible for refinance, I think the ultimate effect of an "MBS Twist" on aggregate demand will be limited and the ultimate economic beneficiaries will be banks and security holders who see their securities increase in price.

That being said, I want to make it clear that I believe there is a very high probability of an "MBS Twist." I believe that with inflation declining, unemployment stubbornly high and total gridlock by the pathetic cowards and liars that make-up the legislative branch, Chairman Bernanke will continue to lead the effort to maintain the recovery on-track with the tools available to the Federal Reserve, limited as they may be. And judging by the first chart in this post, I am not the only one to think so. One of the reasons that I find the "MBS Twist" or a new round of MBS LSAPs as the most probable form of additional easing is that the Fed is already doing the MBS twist. Every month the Fed receives cash-flow representing interest and principal on their approx $530 billion in Fannie Mae 4.5-5.5% pools from the first round of LSAPs. The portion of that cash-flow representing principal repayments is reinvested into current coupon MBS in order to maintain the size of the Fed's balance sheet. In other words, every month, the portion of the Fed's MBS portfolio held in the new Fannie Mae 3s increases. The fact that this is something that is already happening makes me think that simply speeding up this process would be a natural extension of present policy.


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