Bernanke’s (new) Conundrum – Negative Convexity

The Atlanta Fed put out a report on the status of the Fed's purchases of MBS. The report confirms that 91% of the anticipated $1.25 Trillion of paper has been bought. This leaves about $110b of buying power left for the Fed. There is only nine weeks left until the anticipated time that this program will end. This implies an average of only $10b of intervention per week. The most recent purchase was for $16B. Look for that weekly number to fall pretty quickly from now on.

The following graph clearly shows the STEADY accumulation of Agency paper.

Now look at the following graph. If you print this out and check with a ruler (I did) you will see that the lowest point on the brown shaded area is 1,200 and the upper band is at 2,400 (1,200 total). The legend states that brown are both Agency Bonds and MBS. From the report you get those numbers to be Bonds = $175B and MBS = $1.14T, for a total of $1.31T. Significantly higher ($110b) than you might have expected looking at the graph. There is a simple reason for the apparent discrepancy. It is called Negative Convexity.

A portion of all long term mortgages pre-pay prior to the stated maturity. There are many factors that influence this. People die, get divorced, send the kids to college and downsize. But the most significant factor in the amount of prepaid mortgages is prevailing interest rates. If rates are low on a historical basis, people who have good credit will refinance and achieve a lower monthly mortgage cost. These are the conditions that we are in today and have been for the past year. The MBS securities that the Fed has purchased are very diverse. They include primarily older, higher coupon mortgages. Ones more likely to prepay.

I asked a friend who does this type of thinking for a living to give me some thoughts on how quickly the Feds portfolio was shrinking due to natural prepayments that are occurring. I think his words are better than mine:

"Tough to say exactly how much paid down, but if we say GSEs have paid at 25% cpr in the past year (all pay differently and are well correlated to coupon, or WAC of borrower), then that implies 25% of principal is paid down over a year. You’re pushing 20% over 9mos…

typical speeds are in the low teens, if not high-single digits, except in times of high re-fi / default activity… I’d say you could feel good about using a 20-30% cpr weighted avg…. of course, they did not buy ALL their MBS 9mos ago – would have to weight that accordingly.

off the cuff, I’d say 10% principal back to them would be a good number….

From this professional you get a pretty good estimate of the prepay as being 10%. That would come to $110B. This estimate goes a long way toward explaining the discrepancy between what the Fed has purchased and what the principal balance is that they currently own.

Some thoughts on this phenomenon:

-My friend suggests that going forward the prepay could be as much as 20% PA. Well that would mean something in the order of $250B over the next year. That would, by itself, be a very deflationary force. It is too big a number. It would be happening at a very bad time. Pure economics would suggest that the supply of available mortgage credit would fall sharply as a result. The Fed does not need to do repo’s to suck up excess reserves. They just have to collect the prepays that are coming.

-If you buy into this you have to assume that the amount of prepays in the current month will be approximately $18b (1.1T * 20% / 12). The Fed is buying $16b a week or $64b a month. So in January the net is only $46B. Follow this dotted line and you will see that by early March the purchases net of prepays will be a negative number. This will be the starting date of the true reversal of the QE process. March is much sooner than people are thinking it will occur.

-The Fed will make Net purchases totaling $1.25T. But they will never have a portfolio of that amount. It has to be less. By the numbers they will end March with approximately 1.14 - 1.16 Trillion. And the portfolio will be shrinking by $20B per month thereafter.

This is a scary thought. This could well be the basis of a back door, Sneaky Pete “QE 2.0 Lite”. If the intention were to purchase and maintain a portfolio size of $1.25T they would have to make additional purchases of $100B and continue the buys on a monthly basis of approximately $20B. This would not be a change of policy (ahem). It would be refining and maintaining the existing policy. If the Fed tried to do that (I doubt they will) there would be uproar. But once Bernanke is back “in”, there really is no way to get him or his love of QE “out”.

The following is the language from the Fed on the Agency MBS purchase program. I draw your attention to two words. Total and Anticipating. I think there is wiggle room in this statement on some revisions to both the timing and amounts involved. Ugh!

“On September 23, 2009, the FOMC announced that the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and gradually slow the pace of these purchases, anticipating they will be executed by the end of the first quarter of 2010.”

Side Story – We Get Humped

Please look again at the graph of assets from the previous discussion. Look at the brown section that represents the Fed’s holdings of BOTH Agency MBS and Agency Bonds. That line is not a steadily increasing number. It seems to go up and down quite a bit from the inception of the program to the end of chart.

A major reason for this is how the Fed conducts its activities and how they report them. The Fed, on a weekly basis has accepted tenders for MBS. Of the amount tendered they report two numbers, Gross and Net purchases.

The Gross number is the one recorded in this graph and accounts for a substantial amount of the variable nature of that data. Most notable on the graph are the two obvious ‘humps and valleys’ in the March - April period. Behind these humps is this data. From March 19 – April 2 the Fed bought gross $196B, sold forward $94B and retained $96B. From April 16 – April 30 the Fed bought gross $175B, sold forward $100B and retained $75B.

As you can see the Humps are unique to the graph. There is a reason. March was a terrible month. Global GDP was in freefall. The stock markets were again hitting decade lows. We thought that Citibank and BoA were maybe going out of business. Bernanke has admitted that during this period he questioned whether the system would survive.

So anything that the Fed did during that terrible period that is out of trend is worth noting. What is the impact of these forward sales? The answer lies below the brown area. Look at the grey and dark blue levels. You see the reverse Humps. The forward roll transactions had the impact of temporarily absorbing the inventory of the primary dealers and the money center banks. It had the impact of creating liquidity for the PDs so that they could absorb some of the other things that were falling in price. (Stocks and bonds). The amounts were bite sized. My estimate is that these dollar rolls put $100b in PD hands for about six weeks. My guess is that the street got fat on the pricing.

Does this matter? Not really. That they Fed put some dough in the hands of the street when they needed it was probably the right strategy at the time. It was one of the many steps taken back then to calm things down. Any impact that it had, is long since gone.

I think this is just another of those ways that the Fed can maneuver things. They have extraordinary power. We don’t even understand what they can do. The Fed has full disclosure policy on most of what it does. They provide information on the forward rolls. Take a look and see if their explanation makes sense. To me, it as clear as mud.

"As the investment managers (NY Fed) conduct dollar rolls they simultaneously buy and sell agency MBS securities for different forward settlement dates. To date all sales for the SOMA have been associated with dollar roll transactions. These transactions have not represented any outright sales of agency MBS from the SOMA."

Yeah Ben. But why the big numbers in March? Answer: When the market needed a boost, you delivered.


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