After a few days of calm, extreme volatility returned to the mortgage-backed securities market last week, as the Federal Reserve (now owned by Black Rock) allowed the prices of mortgage-backed securities to fall sharply.

The spread between US Treasury bonds and mortgage-backed securities jumped as the Fed withdrew from a market that it had supported with massive purchases over the past week.

The Fed’s sudden reversal Tuesday morning shows that its no-limit purchases of mortgage-backed securities (MBS) – a $12 trillion market – may backfire badly.

Forced sales of MBS by leveraged funds alarmed the Fed, which said that it would buy at least $700 billion in government and mortgage bonds, and may have bought double that amount before the end of this week.

That is a warning that the US central bank’s attempt to stabilize fixed income markets is far from finished, and that aftershocks may continue.

The Fed’s action temporarily stabilized the MBS market, although the spread between mortgages and Treasury bonds remains extremely volatile. But the Fed’s fire hose might wreak havoc in two ways.

  • By reducing interest rates to zero for overnight money and to less than a percentage point for most safe securities, the Fed gave homeowners the opportunity to pay their mortgages early. That presents a risk to lenders who have no way to hedge it.
  • It triggered a wave of margin calls by Wall Street broker dealers to mortgage lenders who had tried to hedge prepayment risk by selling MBS short.

Mortgage bankers are sounding the alarm that the Federal Reserve’s emergency purchases of bonds backed by to home loans are unintentionally putting their industry at risk.

Tinkering with the US mortgage market, the second-largest fixed income market in the world after US Treasuries, is tricky. Most mortgages are re-packaged as securities and sold to investors.

Homeowners’ mortgage payments are bought, sold, stripped, and securitized in the secondary mortgage market. Many are divided into slices, or “tranches,” which assign different parts of the cash flow to different investors (for example, interest-only tranches and principal-only tranches.

Because most mortgages are resold as MBS, the secondary mortgage market is extremely large and very liquid. One important function of this market is hedging. In fact, originators that aggregate mortgages before selling them typically hedge their mortgage pipelines against interest rate shifts.

When lenders issue new loans, they often simultaneously short mortgage-backed securities. This is done because the loans might fall in value before a banker can sell them to Fannie Mae and Freddie Mac. The bet against mortgage bonds helps protect the lender if that happens.

If rates were to rise as a result of MBS prices declining, the lender would be still obligated to offer the mortgage rate that the home buyer locked in.

In an unstable market environment, the Fed, in an emergency effort to forestall mortgage market dislocation, has been purchasing hundreds of billions of dollars amount of MBS, causing their price to rise sharply and swiftly. That forced enormous losses on lenders who had sold these securities short as a hedge.

The result is chaos in the mortgage banking industry, and a shutoff in new origination. That in turn will suppress home purchases in an already-weak market. The Fed tapped Black Rock to manage bond purchases.

If the pain were to spread to a “systemically important financial institution,” a costly taxpayer bailout would be required, as in 2008.

That explains why the Fed suddenly reversed course Friday morning and allowed mortgage prices to fall sharply, as an emergency measure to relieve the mortgage bankers.

Asia Times / ABC Flash Point Economic Blog News 2020.

4.7 3 votes
Article Rating
Previous articleMilitairen bewaken Curaçao na fatale aanslag op Venezolaanse Coast Guard
Next articleSt.Martin on Total Lock Down
Notify of

Inline Feedbacks
View all comments
04-04-20 11:19

If I would print money to save my debt, it is called fraud, and I will end up in jail?

Lady Shadow
Reply to  Gangster
07-02-23 15:58

This in the end will lead to the destruction of the petrodollar?