Page 1 of 3 CREDIT BUBBLE BULLETIN Mortgage madness
Commentary and weekly watch by Doug Noland
Federal Reserve vice chairman Donald Kohn believes that prices of
mortgage-backed securities are likely to fall when the Fed eventually begins
selling mortgage-backed securities (MBS) from its portfolio, according to a
MarketNews International report by Steven K Beckner last Thursday.
The report continues: "He gave no indication when that might be. But Kohn,
echoing earlier comments by New York Federal Reserve Bank President William
Dudley, said the Fed may well avoid any losses on its asset holdings, as well
as on its liquidity facilities. 'These programs may be unwound without loss,'
Kohn said, commenting from the audience at a Boston Federal Reserve Bank
conference. He said the Fed entered the market 'when
prices were depressed by high premiums' and so 'the Fed could finance without
risk.' That in turn will mean they can be 'unwound without loss.'"
Federal Reserve holdings of MBS last week exceeded those of Treasuries for the
first time (US$777 billion versus $774 billion). The Fed is now well past half
way through its program to purchase $1.25 trillion of MBS - which is slated to
be completed in March. Federal Reserve credit jumped to $2.172 trillion, up
from less than $900 billion to begin September 2008.
Mr Kohn is too optimistic. My view is that the Fed is paying too dearly for
these mortgage securities and large losses are inevitable. And while
Fed-induced price distortions are not having a big impact on US housing, they
exert enormous influence on finance and markets globally. I don't expect the
Federal Reserve's MBS portfolio to be unwound anytime soon. Instead, the Fed
will live with this exposure for years to come - and will likely expand the
scope of mortgage exposure in future crisis periods. I also expect Washington's
conglomeration of mortgage risk will at some point make or break the dollar.
In the five years preceding the Lehman Brothers collapse just over 12 months
ago, the benchmark MBS yields of US mortgage guarantor Fannie Mae averaged
5.60%. A very strong case can be made that Fannie, fellow guarantor Freddie Mac
and the entire mortgage bubble pushed mortgage borrowing costs artificially
low. Over the past year, as the Fed has been building its trillion-dollar MBS
holding, benchmark yields averaged 4.30%. Fed officials have been talking
confidently of their success in unwinding various liquidity facilities that
were implemented during the crisis. Yet the most meaningful government
intervention runs unabated throughout the mortgage marketplace. Between the
Fed, Fannie, Freddie, government-backed mortgage guarantor Ginnie Mae, and the
Federal Housing Administration - it's full speed ahead into the uncharted
waters of mortgage market nationalization. It is not easy to envisage a viable
exit strategy. Few contemplate the costs.
The consensus view holds that this unprecedented - and ongoing - intervention
is fundamental to crisis resolution and sustainable recovery. I counter that
such massive market intrusions always create the backdrop for excesses and the
next crisis. Most believe inflation does not these days pose a risk and that
loose monetary policies no longer foster financial leveraging and other
dangerous excess. Indeed, most see this as an atypical backdrop with little
risk to fiscal and monetary looseness. Many argue that sticking with
unprecedented policy responses for an extended period is the appropriate course
to combat deflation. I contend that each government-induced reflationary period
comes with its own set of inflationary biases, market responses, excesses, and
risks. But they're not going to jump up and down and make themselves obvious.
Yet some aspects of policy risk are becoming more apparent. This week, China
reported 8.9% third quarter GDP growth. The Chinese economy has bounced back
convincingly, and bubble dynamics have returned in full force. Increasingly,
there is a case for a surprisingly strong recovery throughout Asia and the
emerging markets. Crude oil this week traded to $82. The Goldman Sachs
Commodities index jumped 2.2%, increasing year-to-date gains to 48.8%. Global
reflation has attained a head of steam - and the Ben Bernanke-led Fed is
falling only further behind the curve.
Of course, the counter-argument is that US unemployment is 9.7% and the
recovery is fragile. The Fed's dual mandate - price stability and full
employment - certainly provides good cover for sticking with ultra-loose
monetary policy. Besides, few see meaningful risk inherent with Fed
policymaking anyway. Nonetheless, the bottom line remains that US monetary
policy and the weak dollar are the dominant forces powering inflationary forces
globally.
It is a fundamental tenet to my thesis that the unfolding reflation will be
altogether different than previous reflations. The old sort were primarily
driven by Fed-induced expansions of US mortgage finance and Wall Street credit.
Our mortgage industry, housing and securitization markets, and bubble economy
were at the epicenter of global reflationary dynamics. The new reflation is
fueled by synchronized fiscal and monetary stimulus across the globe. China,
Asia and the emerging markets/economies have supplanted the US at the
epicenter. US housing is completely out of the mix.
Those fixated on old reflationary dynamics look today at tepid US housing
markets, mortgage loan growth, consumer spending, and employment trends and see
ongoing deflationary pressures. The Fed is wedded to the old and is positioned
poorly to respond to new reflationary dynamics. A stable dollar used to work to
restrain global finance - hence global inflationary forces. The breakdown in
the dollar's stabilizing role has unleashed altered inflationary dynamics -
forces that the Federal Reserve disregards.
Two open questions come to mind. First, when will the new global reflationary
dynamics meaningfully impact the US inflation outlook? Second, what impact will
the prospect of foreign central bank tightenings have on US market yields?
US market yields are not priced for a global reflationary backdrop. Notions of
a "new normal" and a central bank content with an extended hiatus tug US and
global yields artificially down. Fragile US underpinnings have global markets
convinced both that the Fed will err on the side of ultra-loose monetary policy
and that dollar weakness will constrain global policy tightening. The brunt of
global reflationary forces may have shifted overseas, but the US remains firmly
at the epicenter of market distortions.
Nowhere do price distortions have more impact than in the mortgage arena. While
Washington and the media focus on Wall Street compensation and regulatory
reform, an incredible amount of mortgage risk quietly shifts to the American
taxpayer. Beyond the Fed's $1.25 trillion of MBS, Fannie's and Freddie's "books
of business" continue to expand, while the FHA and Ginnie Mae balloon their
exposure to risky mortgages. In the short-run, this process reduces systemic
stress and boosts market liquidity. The markets remain quite happy with this
dynamic - for now.
The secular bear thesis and the next round of financial crisis don't require a
wild imagination: The US economy underperforms in the new global reflationary
backdrop. The Fed stays ultra-loose for too long - along with timid Chinese and
other central bankers around the globe. The US fixed income marketplace -
especially MBS - becomes too predisposed to artificially low Fed funds and
market yields. Historically low US yields - in the face of booming
Asia/emerging markets - continue to weigh on the dollar. Dollar devaluation and
global dynamics set the stage for an inflationary surprise. And any jump in
inflation fears would find US bond and mortgage markets especially poorly
positioned, with the US economy extraordinarily vulnerable to any spike in
yields. A crisis in a rising rate environment would be especially problematic
for a Fed and Treasury confronting trillions in mortgage credit and
interest-rate risk. Foreign holders of our mortgage paper could lose big if
market prices and the dollar move against them simultaneously. And it's safe to
say that the Federal Reserve wouldn't be profitably unwinding its MBS
portfolio.
WEEKLY WATCH
For the week, the S&P500 slipped 0.7% (up 19.5% y-t-d), and the Dow
declined 0.2% (up 13.6%). The Banks dropped 1.7% (up 4.9%), and the
Broker/Dealers were hit for 4.0% (up 52.8%). The Morgan Stanley Cyclicals
gained 0.9% (up 64.2%), while the Transports were hammered for 5.4% (up 7.6%).
The Morgan Stanley Consumer index declined 1.0% (up 18.9%), and the Utilities
dipped 0.8% (down 0.5%). The S&P 400 Mid-Caps declined 0.9% (up 30.3%), and
the small cap Russell 2000 fell 2.5% (up 20.3%). The Nasdaq100 gained 0.8% (up
44.7%), and the Morgan Stanley High Tech index added 0.5% (up 59.4%). The
Semiconductors dropped 2.0% (up 49.1%). The InteractiveWeek Internet index
gained 1.0% (up 67.2%). The Biotechs dropped 5.8% (up 35.5%). Although Bullion
added $2, the HUI gold index was hit for 3.6% (up 42.1%).
One-month Treasury bill rates ended the week at 3 bps, and three-month bills
closed at 6 bps. Two-year government yields rose 5.5 bps to 0.955%. Five-year
T-note yields surged 10 bps to 2.42%. Ten-year yields were 8 bps higher to
3.50%. Long bond yields added 5 bps to 4.30%. Benchmark Fannie MBS yields rose
4 bps to 4.40%. The spread between 10-year Treasuries and benchmark MBS yields
narrowed 4 to 90 bps. Agency 10-yr debt spreads were little changed at 4.5 bps.
The implied yield on December 2010 eurodollar futures was unchanged at 1.77%.
The 10-year dollar swap spread declined one to 17.75 bps; and the 30-year swap
spread was little changed at negative 7.0 bps. Corporate bond spreads were a
little wider. An index of investment grade bond spreads widened 2 bps to 140,
and an index of junk spreads widened 3 bps to 570 bps.
Investment grade issuers included Citigroup $7.5 billion, JPM Chase $1.0
billion, Boeing $1.0 billion, Navistar $1.0 billion, Terra Capital $600
million, Southern Co. $300 million, and Black Hills Power $180 million.
Junk bond funds enjoyed inflows of $262 million (from AMG). Junk issuers
included Crown Castle $500 million, Meccanica $500 million, Murray Energy $500
million, Boise Paper $300 million, Headwaters $320 million, Viasat $275
million, Rite Aid $270 million and Mohegan Gaming $200 million.
I saw no converts issued.
International dollar-denominated debt issuers included Petrobras $4.0bn,
Temasek $1.5bn, Santander $1.5bn, Westpac Banking $1.0bn, Navios Maritime $400
million, Controladora $350 million, TAM $300 million, Lumena Resources $250
million, and MDC Partners $225 million.
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