The Fed Has Officially "Spread" Itself Too Thin

Recently there has been much speculation that the US government will do anything, anything, to rekindle the housing bubble. Even if that means providing Option ARMs at blue light special prices and hiring Angelo Mozillo as Mortgage Czar (we hope we are kidding about the latter). Yes, those very same Option ARMs which banks' balance sheets are still expecting to be neutron bombed by, courtesy of the long gone days when there was private sector mortgage origination risk. Now that all the mortgage exposure is borne by taxpayers, we decided to analyze how the ARM spread to the traditional 30 Year Mortgage has moved throughout the year. Somehow we were not surprised that the 30 Yr - 1 Yr ARM spread for Freddie Mac just hit a record wide this past week. The government is presumably actively encouraging borrowers to approach the GSEs, and using the same NINJA protocols, to ask, nay, demand, an Adjustable Rate Mortgage. Who cares what happens one year down the line? Certainly not the US government which has $3 trillion in T-Bills to roll by this time next year.

First, we present a chart of the Freddie 30 Year compared to the Freddie 1 Year ARM for 2009. The spread which was at 6 bps at the beginning of the year, after briefly crossing into negative territory in April, has ballooned to a record wide of 60 bps.

The situation in the 5/1 ARM camp is even more obscene: the absolute spread has collapsed from 5.49% at the beginning of the year to 4.37% (and at times being tighter than the corresponding 1 yr ARM spread): a 112 bps contraction! There is no point in charting this.

It is mighty obvious that reading between the lines, and courtesy of the near-vertical yield curve, Uncle Sam is pushing every deadbeat "homeowner" in foreclosure to go ahead and get a mortgage with FNM and FRE. And not just any mortgage, but a 1 or 5/1 ARM if possible. Did we learn anything from the subprime bubble and subsequent collapse in housing? Not a thing... except how to get the US taxpayer to pay for it all when it collapse the next time around.

Another observation is the spread tightening between the 10 Year TSY and the 30 Year Freddie Fixed as well as the 1 year ARM. What is notable is the near 1.000 R2 that lasted thru late May, followed by a very dramatic divergence in spreads at that time. Did the government have a closed door meeting in early June informing the GSEs they are now supposed to peddle ARM mortgages to anything with a pulse and a signature? That sure did not work out too well for New Century and all of its peers. 

As we progress into 2010 keep an eye out on this divergence. In its "all in" gamble to get every renter back to homeownership status, the ARM spread, both absolute and relative, will be the most indicative light of just how much money the Fed and the administration are willing to burn in order to extend and pretend until there is nothing left to either extend or pretend.

Last but not least, also keep an eye out on underlying core interest rates. While the move in the Treasury curve is a whole new topic altogether, from here on out near term rates can only blow out (zero is a hard bottom). This will likely wreak some major havoc on not only the current and future ARM contingent, but the fixed mortgage population. Observe that the 30 year Freddie has not budged since the beginning of the year: it started the year off at 5.01% and is now at 4.94%. This has occurred even as the 10 year has blown out from 2.21% on January 8 to 3.75$ today: a massive 154 basis points. It appears the 30 year Fixed (wholesale or otherwise) is the primary bastion behind which the mortgage vigilantes are fortified: if they can retain it, look for the next round of action to happen in the 1 Yr ARM and 5/1 ARM arena.

And for those who are interested in some of the regime change observations form a macro perspective, the chart below demonstrates just why it is that mortgage securitizations may not be all the lucrative or even interesting to securitizers going forward: the key take home from this chart is that while the Mortgage spread return as a percentage of total return has collapsed from 40 bps to sub 20 bps, so has securitization, and for a reason. Remember: securitization is merely a massively leveraged way to express an "off balance sheet" bet. If you assume that leverage multiple was between 20-40x, the potential return has been cut in half from 8-16% down to 4-8%. At these return expectations, investors are willing to put money into HY and other fixed income funds (and judging by mutual fund flows, are actively doing so). The Fed has singlehandedly eliminated the "risk" in the mortgage market, and as long as it continues intervening in it, will make the much needed resecuritization phenomenon impossible. Bernanke has created the biggest Catch 22 imaginable, guaranteeing that the longer the Fed continues in being the market in mortgages, the less likely it is that the private sector will ever get involved.