Launching the QE2

No, it’s not another luxury liner.  There are enough of those floating all-you-can-eat buffets already.

I’m talking about the successor to Quantitative Enhancement.

This is big for amREITs, and warrants an alert.

The higher the premium at which they own their portfolios, the more risk to principal the amREITs are about to feel.

See the dividend histories of 2003/2004 to get an idea what happens during a strong bond bull market to those “riskless” amREITs.  Even though the value of the MBS they hold kept going up, the prepayments by people refinancing cause several of the amREIT favorites to take big losses and cut their dividends.

I’m sure a few people who read this blog post through the break were laughing at their computer screens and saying to me “What makes you think these suckers are going to be able to refinance?”  You’d be right, as far as that goes.

On the other hand, the real issue is early return of principal on premium bonds, no matter what caused that early payoff.

My buddy Jody Shenn over at Bloomberg just sent me his latest article.  It describes how they are going to deal with the logjam of future foreclosures in the Fannie/Freddie MBS programs.

Of course, some will start thinking this is horrible when they see the big numbers.  My response as a taxpayer is “about time.”  The last thing I wanted was to subsidize either investors or former borrowers living rent free.

Let’s make no mistake — paying out 5% or 6% on MBS when a goodly chunk of the borrowers were delinquent is a pure transfer of wealth from the taxpayer to the investor.

When Fannie or Freddie “buy out” a loan from an MBS pool, all they are doing is fulfilling their contractual obligation to pay the principal on the note, and shutting off the obligation to pay month interest.  At that point they are free to work out something with the borrower, foreclose and sell, or even rent (I hope they don’t do the latter, as tempting as it might sound to get our money back with maybe even a positive return over time.)

Agency MBS have had an amazing run since last spring.  I guess that happens when the Fed is in there buying more than the originators can produce.  Needless to say, we were all worried about where things might go when the Fed stops buying, just the way the gold bugs and Dollar bears point to the fact that China doesn’t even have to sell to make things tough on the debt front.

If Fannie and Freddie stop the bleeding on just 10% of their outstanding book of MBS, that would remove hundreds of billions of Agency MBS from the market, and, on average, turn into a 0.3% loss on any portfolio that has a current cost basis of 103%.

Sounds like no big deal, right?  Wrong.  That could easily amount to a third of the net carry for a quarter at an amREIT that was collecting a net interest margin around 300 basis points.  It might also leave them overhedged, which can spread additional margin pressure over the subsequent quarters or even years.

By the way, the latter is less likely, simply because all the people managing these amREITs have lived through the prepayment storms already.  I don’t know of any seasoned professionals that would be foolish enough to be “100%” hedged.  The most we carried when I was responsible for the risk management on a trading portfolio was around 70%.

There are other technical reasons for underhedging MBS related to the effect that has the mathematical misnomer “negative convexity,” but I did promise to hold the math to a minimum in case you’ve been imbibing spirits of the holidays.

I just wanted to get this alert out there, because there may be consequences when the institutional investors consider the risk of large scale loan buy-in at the Agencies.


PS:  On the plus side, removing that much product from the MBS market (forever) will definitely mitigate the negative effect of the Fed finishing up its Quantitative Enhancement program.  Won’t that be a surprise for all those bond bears positioned for rates to rise in the long end of the curve?

3 Responses to Launching the QE2

  1. Patrick says:

    I posted an article to Seeking Alpha earlier questioning the possibility of accelerated buyouts now that FAS 166/167 are removing the financial implications of the buybacks. With the portfolio ceiling raised, you can bet this is going to be THE talk of the Q4 earnings calls. Of course, if rates rise on the long end of the curve as MS is predicting, once the MBS supply is sopped up, what will the amREITs do with all the capital returning to their books?

  2. Eric iousa says:

    I maybe getting lost here, it seems to me the GSEs get money form the Treasury which gets its money from the UST market. So, if this is partially to “mop up” some of the FEDs MBS QE, isn’t there just going to be that much more UST to be bought? Is the FED going to buy it? LOL. What is your opinion on the large amount, Zerohedge had something saying 2.2 Trillion is needed next year, how is this going to get done? The FED, others getting “crowded out”? Is there enough money for most Central Bankers to stop QE and get all needed bonds financed? I suppose the banks could use the “new” savers, lever the new deposits and buy some of it.

    • hhill51 says:

      Since this particular tranche of Fannie/Freddie spending will buy delinquent mortgages, there will be long-term losses to be realized on those balance sheets.
      In the capital market, though, the effect will be to return principal early to the investors (including the Fed). Maybe they knew this was coming, so that’s why the Fed purchase program was so heavily weighted toward the lower coupons. Still, my fading memory says the Fed bought a pretty good chunk of 5.5’s and 6’s.
      I thought the big error was to guarantee CP and over-the-limit bank debt, and even longer term Dealer paper. They basically recapitalized half the debt world as gov’t guarantees.
      As far as I am concerned, the “crowding out” was by letting the pure private label MBS, corporates and CMBS trade to 15% to 20% yields, which repriced all the underlying assets just as effectively as if they had been foreclosed and sold.
      If government was just a buyer of last resort, and didn’t hand out free money in the form of guarantees, the overall cost would have been lower, IMO. And it would have allowed the non-government securitization business to restart. With everything wrapped by Uncle Sam, who needed to take any risk from other dollar paper? Unfortunately, the end point is an economy about half the size of the pre-crisis economy, since the world simply wouldn’t absorb more than that from that one “name.”

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