In a recent post, we posed the question: as the Fed’s portfolio shrinks, who will buy? In this report, we dig a bit deeper and look at the differential market impacts based on whether the loans on the balance sheet roll off (as in, for example, a refinance transaction) or are sold off.
In the first case, we assume that a mortgage in a pool the Fed holds is extinguished, and a new mortgage is created through a refinance transaction, or via a home sale followed by the purchase of a new home financed by a new purchase mortgage, or through a buyout that generates a new modified loan. This case describes the situation described in the earlier post: a mortgage on the Fed’s balance sheet disappears, and some other investor has to pick up the new loan. The question here is how much higher the yield on the new pools has to be to attract sufficient demand from private investors. These new loans tend to have characteristics that investors find attractive, including a coupon which is near the most liquid part of the market (the current coupon).
The second case is quite different. In this instance, the question is how much higher the yield has to be (lower price) for the existing mortgages being sold to find buyers, not for a new mortgage with the most desirable characteristics. In this case, it’s not just a matter of who has the capacity to increase their holdings, but how much additional yield investors will be required for characteristics that are less than pristine. These are challenging issues that we can’t offer precise solutions to, but one way to approach the issue is to see how different the Fed’s portfolio looks from those held in the private sector.
To conduct this exercise, we look at two characteristics. The first is the coupon distribution of what the Fed holds vs. the portfolios held by private investors. This rather technical exercise can be conducted by supplementing the data provided in the Agency disclosures contained in our Pool-level Analyzer with the central bank’s holdings provided by the New York Fed. In fact, the distinction is quite notable for 30-year fixed-rate mortgage pools:
With talk of taper at the top of the monetary policy discussion, it is worthwhile to dig a bit into the role of the Federal Reserve in the functioning of the MBS market. As is well known, the onset of the Covid-19 pandemic resulted in a resurgence of central bank purchases of Agency mortgage-backed securities (MBS).