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 dollar roll financing in 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, dollar roll financing costs in the agency mortgage market remain elevated, averaging nearly 60 bps above one-month Libor. We have seen implied 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.
Given the historical relationship between Fed rate cuts and the 30-year U.S. fixed mortgage rate, the Fed would need to lower rates an additional 150 bps in order to push the mortgage rate lower by 50 bps. However, by simply reinvesting the proceeds back into mortgages, we believe the Fed would provide monetary easing and drive longer-term rates (such as mortgages) lower while still saving room to cut the policy rate. One issue with continued easing is the risk of bubbles being created – the idea that lower rates simply pull demand forward and increase risk-taking. The reinvestment of mortgage proceeds creates little risk. This policy could stimulate demand by giving homeowners more disposable income and simultaneously increasing their savings rate. This is because when a mortgage has a lower interest rate, the balance on the loan amortizes at a faster pace.
For example, a homeowner who has a 4.5% interest rate on an original $300,000 mortgage loan would pay approximately $1,418 per month. However, only about 25% of that payment would go to paying down the loan in the early years. In contrast, with a 3.5% loan, the monthly payment would decline by $161 per month, to $1,257, and the payment of the principal component would increase to 35% of the total payment, helping pay off an additional $1,000+ per year in debt.
While we recognize that U.S. consumers have generally fared well over the last year, we also recognize the housing sector has been a net drag on GDP as residential fixed investment has shrunk. While mortgage rates have come down from their 2018 highs, they have not dropped as much as the rally in the U.S. Treasury market would suggest, based on historical trends – due in part to the infusion of MBS rolling off the Fed balance sheet. If the Fed reinvested those mortgages instead, we could see more consumers purchasing or refinancing at more attractive rates, and MBS spreads would tighten closer to historical levels.
The Fed has written about the potential benefits of buying and owning mortgages: A 2018 article published by the New York Fed notes that mortgage purchases may “reduce the interest rate spread between mortgages and Treasury debt, and thus stimulate the housing market more than other sectors.” The article also says that “with MBS purchases, the Fed removes some risks from the market, a move that may be stimulative in that it allows the private sector to take new risks by investing in the real economy.”
The Fed this year pivoted on the policy rate, citing global uncertainties and the pervasive miss on inflation over the last decade as the catalyst for their rethink. We believe the Fed could rethink its balance sheet policy as well. By reinvesting rather than running off the mortgages, the Fed could align its approaches to monetary easing. We believe this could help reduce volatility in capital markets while lowering mortgage rates for consumers.
Fixing financing markets would likely be positive for MBS pricing, and this is precisely the mechanism to create lower rates for homeowners. While MBS with certain coupons would rise in relative value, we expect others would benefit less, or potentially even underperform, depending on how mortgage and refinancing rates change.
This would create opportunity with the mortgage market, both among the coupon stack and within specific collateral stories, and is another reason why we believe the importance of active management is as great as it has ever been in the agency MBS space.
Reinvesting in mortgages is a powerful tool for the real economy that the Fed has used in the past. With a slowing economy, reinvestment could help solve many of the problems the Fed is facing. It remains to be seen if the Fed is prepared to pull this tool back out, and use it effectively as they have in the past.
Explore our latest thinking on interest rates and their investment implications.
Mike Cudzil is a generalist portfolio manager and Dan Hyman is head of agency MBS portfolio management.