The US government's programs initiated during the financial crisis have generally died down. The exception here is the Fed's $1.25T agency and GSE-backed MBS purchase program, which has become the greatest remaining source of government intervention in the economy (see chart below). On paper, Fed emergency lending has decreased steadily from October 2008 and continues to decline. These figures misrepresent the massive amount of liquidity and credit-easing still occurring today. Furthermore, the MBS purchase program is unlikely to end anytime soon (it has already been extended once). The financial crisis has taken a large buyer of agency MBS out of the market: foreign holders. This makes the Fed's exit additionally difficult and risky.
David Kotok of Cumberland Advisors returned recently from a tour through Asia where he meet with central bankers, fund managers, academics, and investors. One of his conclusions is that after the financial crisis, few Asians trust the US. The reasons for this distrust are the usual suspects- rising fiscal deficits, loose monetary policy, but also that, unlike past financial crises, the recent one was entirely American. In his words, "the last two years of Madoff scandal, federal agency failure, rating agency restatement, bond insurer demise, Fed primary dealer (Lehman) bankruptcy, and mortgage securitization deception (CDOs) are all Made in the USA. We led the world into crisis. We caused it. And we haven’t fixed it."
This new attitude is evident in foreign holdings of agency MBS. Historically, the major holders of agency MBS are US commercial banks, foreign entities, pension funds, GSEs, and money market and mutual funds. Since Q1 2008, the amount of MBS held by these entities has shifted. Most notably, foreign entities, whose holdings of agency and GSE-backed MBS has decreased from $1,601bn in 2008 to $1,359bn in Q2 2009, taking the percent of total agency/GSE MBS held by foreign entities down from 21% to 17%. These large decreases have been offset by increases in holdings by US commercial banks and money market and mutual funds, but the lion's share has been taken on by the US government. The Treasury now holds $150bn, the Fed $559bn, and GSEs $949bn.
Currently, there is clearly plenty of US demand for the MBS sold by foreign entities. This demand is reflected in the surge in prices of these securities during the last six months. But when the government stops buying, even if it doesn't sell its holdings, it's a different story.
A dip in demand for agency and GSE-backed MBS will likely accelerate divestitures of foreign holders. Foreign holders differ from other large holders of these MBS in that historically, they react most strongly to changes in price. In Q3 2008, foreign holders reacted stronger than any other major holder, selling about $100bn of MBS during each of the next two quarters. In fact, this selling only slowed down, to about $8bn a quarter, when MBS prices recovered this last quarter. If sentiment on these securities reverses and prices fall, foreign holders are likely to react fast and drastically.
A sharp surge in foreign divestitures could cause a negative feedback loop and further deepen the problem. But there are other risks as well. Meredith Whitney wrote recently she expects an exit to the Fed MBS purchase program to severely impact banks.
"Whether the Fed exits gradually or abruptly, we are certain in the fact
that prices will go down meaningfully and rates will go up meaningfully. In
this case, banks could stand to take write downs on their holdings and it will
be far more expensive for consumers to secure mortgages. The Fed, of
course, could just let this program run off and hold these assets to maturity.
However, in this scenario, mortgage rates would also go up meaningfully as
banks are not inclined to originate mortgages they cannot sell to the
agencies, and therefore the overall mortgage market would shrink thus
forcing rates higher. We believe this represents one of the larger risks to the
banks and overall market over the next several months."
Agency and GSE-backed MBS held by commercial banks have increased from $932bn in Q1 2008 to $1,136bn in Q2 2009. As Whitney points out, an exit from the Fed's MBS program could cause significant mark-to-market losses at US banks. Meredith Whitney currently has neutral or sell ratings on the big 4 US commercial banks and 2 remaining broker-dealers (GS and MS).
I doubt the Fed will sell any of its MBS holdings in the foreseeable future. Even if the Fed stops buying, the effect may be less than Whitney and others make it out to be. Though I expect foreign holders to accelerate their divestitures in this case, rising yields will make these securities more attractive to insurance companies, pension funds, and money market and mutual funds. Therefore, I consider a crisis unlikely. The greatest effect of an exit to the MBS program is likely to be felt gradually in the housing market, where rising mortgage rates could dampen a recovery.
