Investors Uncertain How Markets Will React To End Of MBS Purchase Program

As the Federal Reserve’s year-long mortgage backed securities program comes to a close this month, many investors and analysts are concerned that the Fed’s withdrawal could lead to …

As the Federal Reserve’s year-long mortgage backed securities program comes to a close this month, many investors and analysts are concerned that the Fed’s withdrawal could lead to significantly higher mortgage rates and weaken economic recovery. See the following article from Money Morning for more on this.

Anxiety surrounds Tuesday’s Federal Open Market Committee (FOMC) meeting as the central bank’s year-long mortgage-backed securities (MBS) purchase program nears its scheduled March 31 close, opening the door for mortgage rate increases and surprising market fluctuations.

The Fed spent billions of dollars on MBS guaranteed by Fannie Mae (NYSE: FNM), Freddie Mac (NYSE: FRE) and Ginnie Mae weekly for the past year, topping out its portfolio at $1.25 trillion.

As the program ends, investors and analysts are speculating that mortgage rates could rise – and rise fast.

“It’s a trillion-and-a-half-dollar check that won’t be there as the Fed withdraws from the market,” said Pimco’s Bill Gross in an interview with TIME magazine. “How that affects the markets, I just don’t know. I’m not eagerly anticipating the answer, but I think it holds some surprises in 2010 – not just in mortgage securities but stocks as well. We could miss the money, put it that way.”

The Fed’s MBS purchase program started in 2009 to give a much-needed push to a battered housing market. This was a significant policy change because before 2009 the Fed had never purchased agency MBS. The central bank has cut down weekly purchases in recent months, trying to prepare the market for the purchasing void it will leave, hopefully to be filled by private investors and banks.

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“A host of factors – muted loan demand, low appetite for credit risk, a steep yield curve, large cash holdings, and shortage of other spread products – point to increased MBS demand from banks. International demand could also rise as risk aversion abates and reserve growth picks up,” said Barclay’s Capital.

Now with a massive portfolio under its belt, the Fed has the power to tighten credit when it deems necessary, which probably won’t be any time soon. Selling the securities would devalue the rest of its agency MBS holdings and send yields higher, reversing the effect of the program.

“Selling agency MBS could be a useful tool, but it would also be outright reckless,” Christopher Sebald, chief investment officer at Advantus Capital Management, told Reuters.

Most analysts expect the Fed to hold on to its portfolio until 2011, but the bonds may be exchanged with U.S. banks in the meantime as a liquidity-draining strategy.

The Fed has considered extending the program but most expect it to exit as planned. But if economic growth or mortgage markets significantly weaken, the Fed might have to consider revisiting its purchase plan.

“Based on our forecasts for the second half of the year, they may have to reinitiate it, and that will be difficult to do once they stop because it then becomes a political hot potato,” said Gross.

Fed watchers expect little else to change at Tuesday’s meeting, even though there’s speculation the Fed’s easy money policy has gone on too long, encouraging asset bubbles.

“I think bubbles are something the Fed needs to watch,” David Wyss, chief economist at Standard & Poor’s Financial Services LLC, told CNNMoney. “But I don’t see much evidence that is the dominant issue for the Fed compared to 10% unemployment and lack of sustainable growth.”

Analysts will also be listening closely for more details concerning the exit strategy that’s supposed to be moving forward in months to come.

When it comes to interest rate hikes, some believe the Fed will wait a couple more meetings before changing its language from “an extended period.”

“They’re getting close to one. They’re going to change the language before they do anything else,” says Robert Brusca, chief economist at Fact & Opinion Economics, to CNBC.

The Dow Jones Industrial Average rose 17.46 points, or 0.16%, yesterday (Monday) to close at 10,642.15, while the Standard & Poor’s 500 Index slid 0.52 points, or 0.05%, to close at 1,150.51.

This article has been republished from Money Morning. You can also view this article at
Money Morning, an investment news and analysis site.

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