Guest Post: The Latest Bubble?

From John Aziz of Azizonomics

The Latest Bubble?

Subsidies encourage the type of behaviour they are subsidising.

And the Federal Reserve’s QE Infinity is subsidising the market for mortgage backed securities by taking them out of the market at a price floor.

Unsurprisingly, the market for mortgage-backed securities is near all-time highs:

And Wall Street is doing some wild and wacky things.

UBS has just launched a 16-times-leveraged MBS ETN. The ETN, called the ETRACS Monthly Pay 2x Leveraged Mortgage REIT, offers double the return of the Market Vectors Global Mortgage REITs Index – itself an investment vehicle 8x leveraged to mortgage-backed securities.

The idea appears to be that with the Fed acting as a buyer-of-last-resort that prices will take a smooth upward trajectory and that 16:1 leverage makes sense for retail investors as a bet on a sure thing.

Of course, back in the real world, there is no such thing as a sure thing. As Pedro Da Costa recently noted, banks are sitting on the proceeds of MBS purchases, rather than passing on the money to customers in the form of lower interest rates. As the New York Fed’s William Dudley recently noted:

The incomplete pass-through from agency MBS yields into primary mortgage rates is due to several factors—including a concentration of mortgage origination volumes at a few key financial institutions and mortgage rep and warranty requirements that discourage lending for home purchases and make financial institutions reluctant to refinance mortgages that have been originated elsewhere.

Those leveraging up on MBS might want to consider the implications if the Fed were to change its QE3 transmission mechanism — a transmission mechanism that William Dudley is willing to admit is broken — and buy other assets instead of MBS. Without a buyer of last resort with a printing press, prices would seem to be at current levels unsustainable. And those junk MBS products that the market is leveraging up on now in the hope that the Fed will buy them all will be left out in the cold. Such an event would bad news for anyone leveraged 16:1 on MBS.

But such an event would be an ingenious pump and dump, shifting the burden of junk MBS off Bulge Bracket balance sheets and onto the books of not only the Fed — which has already sucked up huge swathes of toxic junk — but also small-time speculators looking to book leveraged gains, but who end up taking the hit.