The Fed’s $3T Mortgage Backed Securities Problem

The Federal Reserve’s purchased mortgage backed securities in 2020 for the first time since its Quantitative Easing policy in the Great Recession. This was part of the central bank’s response to COVID-19.

When the Fed purchases mortgage backed securities, it does so with clear goals in mind. They have every intent of influencing the financial markets. This time, the goal was to manipulate long term interest rates.

We don’t have many historical analogs that we can look to in order to understand the current QE program, since this is a new type of policy. We do, however, have clear identifiable human markers: greed, mania, and irrational exuberance. There’s a good chance this leads to a housing bubble.

How the Fed’s Care Free Spending Impacts Interest Rates

Purchasing MBS by the trillions puts clear downward pressure on long term interest rates.

Sending Demand Through the Roof

When the Fed buys mortgage backed securities, it increases the demand for MBS. Especially when you’re buying $3T worth of bonds, the impact on price is no joke. All this demand jacked up the price for mortgage backed securities. Remember, with fixed income, higher prices = lower interest rates. So as these bonds became more expensive, their yields began to fall.

Increased Liquidity

Think about what you could do with $600 billion dollars. I’m not sure I could spend that much money in one lifetime. The Fed spent it in 2 months on mortgage bonds. Injecting that much cash into a shadow market increases liquidity. Banks can lend money more easily, which lowers borrowing costs in the credit markets.

An Interest Rate Death Spiral

We just discussed that massive purchases in MBS lead to higher prices and lower yields. Investors will start to see this and run for the hills. Who wants to own something that’s more expensive with a lower yield? All these people now need to find new investments. Since they owned MBS, let’s assume they will stick to fixed income.

These investors are going to look for “safe” investments. They’ll probably move into highly rated corporate bonds or long term Treasuries. This new demand is going to… you guessed it! Drive up prices and send yields spiraling lower. Now you’ve got multiple asset classes that are overpriced.

Signaling Effect

Have you ever had trouble building credibility with a client? And then your boss comes in, lays down his authority to the client, and all is fixed? That’s essentially what the Fed does to Mr. Market here. Large scale asset purchases by the Fed signal to the market that the bank is committed to providing extended monetary policy support.

When the central bank signals to the market that they are here to stay, it shifts market expectations. This changes the expected path of future short term interest rates, and leads to lower inflation expectations.

Can All of This Create a Housing Bubble? Maybe.

Mortgage backed securities are closely linked to mortgage rates. A drop in MBA yields can lead to… (shocker) lower mortgage rates. When rates come down, guess what happens. More people buy homes. Johnny, his mother, and his cousins will all be trying to refinance or get their hands on a brand new shiny home.

All this activity leads to higher home prices. These higher home prices lead to more refinances. When people refinance, what do you think they do with all that extra cash? Hint: they don’t save it.

They’ll spend it on the new iPhone, or a big Christmas present for their kids. More spending = more velocity of money = more economic prosperity. Until… the Fed raises interest rates. And the music stops. Then all the people who financially over committed realize they have no savings. And no way to weather the spike in monthly payments from the adjustable rate mortgage after their teaser rate expires.

Will this happen? I have no idea. What I do know is that the Fed raised interest rates at the fastest clip in 30 years. And mortgage rates are at a 20 year high. If you want to short this crap, you’ll need options approval. The music hasn’t stopped yet, but I think we are getting close to the end of the song.