Mortgage Backed Securities – What Happens When The Training Wheels Come Off?

Calculated Risk points to an interesting but short article at Bloomberg by Meredith Whitney in which she postulates that once the Fed withdraws its support for the mortgage backed securities market, mortgage rates will move up and the banks will be faced with more writedowns.

CR plots the historical spread of of the 30 year mortgage versus the ten year Treasury and comes to the conclusion that the Fed’s intervention has amounted to somewhere around a 50 BP subsidy so far. He then postulates that we could expect to see rates increase by this amount once the Fed exits the market.

Now let me say that I bow to no one in my admiration for CR. When stretched for time, it’s the only blog I read and it’s always the first blog I turn to. The author gets the data and then reaches well thought out conclusions and doesn’t seem to let personal bias intrude on his analysis. Having said that, I think he may be underestimating the potential effect on rates that may occur when there is no more Fed support.

If you read me often you will have seen this quote before. From George Will, “History tends to repeat itself until it doesn’t.” That is the problem that I have with CRs chart on this one. It presupposes that the world hasn’t changed and that the historical relationship between Treasuries and mortgage rates will persist.

Maybe it will and maybe it won’t. It might not because the world has changed. We’ve not seen before the unprecedented political interference in the market for mortgage securities that we have witnessed over the past 18 months. Contract law has been stretched to the point of breaking and what was normally considered standard procedure for resolving mortgage defaults has been turned on its head.

I have no idea as to whether or how much investors have been harmed by government actions and I suppose that no one at this point in time can generate any verifiable numbers. I’m not sure that, in fact, that makes much difference.

When the Fed does withdraw, the risk premium that investors demand is once again going to be subject to market discipline. Now it might not be more than it has been historically or it might be significantly higher. Simply put, investors may well look at this market, the ongoing problems of very high default rates, the yet to come reckoning with option ARMs, the shoddy underwriting by FHA, the continuing problem with underwater mortgages, unrelenting unemployment and the rising tide of populism in politics and decide that the risk premium needs to be much higher.

In short, the risks inherent in investing in MBS, even those guaranteed by the U.S. government have changed significantly, involve significant political risk and are largely unquantifiable at this point in time. It shouldn’t come as a surprise if the premium that investors demand doesn’t match historical norms. Personally, I think that the first few auctions absent Fed support could be pretty dicey.

CR could be right and I could be totally off track on this one but it seems to me that we are venturing into uncharted territory. The chance that having been effectively nationalized at this point in time, the prospects of the market for MBS moving smoothly back to an unsubsidized base seem to me to be open to question.  At the least I think the Fed could be providing some sort of floor for much longer than we suspect.

Put it all down to unintended consequences and don’t be surprised if it doesn’t take years of government support to wean this puppy.