Monday, December 21, 2009

John Taylor says that the Fed could sell its MBS without having a material impact on interest rates

His blog post is here. I will download the paper when I get into the office tomorrow ( I can only download NBER papers while on campus).

But one thing from the blog post strikes me as strange: he uses spreads on agency debt as his measure of credit risk. But the very fact that the Fed has purchased MBS could produce a perception that the government is standing behind the debt--as the Fed exits, so too might this perception. I would also imagine that the low current interest rates mean expectations about prepayment are unusual at the moment, and that the most common methods for pricing the mortgage call option might not be appropriate either.

The point is that it is very difficult to separate total mortgage interest rates into the term-adjusted risk-free interest rate, the credit spread and the prepayment spread. More after I actually read the paper.

[update: I just read the paper. Taylor describes it well in his blog post, which means that I have not seen anything to change my mind that it is not very convincing. More to come soon].


Bruce Krasting said...

Fannies Subordinated debt was all bought in in July as part of the Feds QE effort. I can't imagine how you could use non existing bonds as a basis for this calculation you have made.

The Fed is buying 20% of all agency MBS. Any you think that has not had an impact on the price of mortgages?

The Agencies (including FHA) are 95% all all new mortgages. They control pricing. There is no real alternative to an Agency mortgage.

Absent the Fed action and absent an explicit guaranty by Treasury Agency MBS would be trading today at a comfortable 8% and we would have no housing market and one hell of a recession.

David Merkel said...

You can get the paper here.

I haven't read it yet, but as a practitioner, I find the result ridiculous, and not worthy of a bright guy like John Taylor.

Various Fed officials and other economists have done analyses and argue that the program has compressed rates 0.50-0.75%. That feels about right to me. When you suck up a lot of supply of bonds that are seemingly safe in a crisis, rates do fall.

It should than be no surprise that the MBS will be difficult to unload without moving the market. The market will start to front-run the Fed when they sell, just as the market did when the Fed bought.

Adding insult to injury, the negative convexity hedgers will likely create an ugly overshoot, as they did back in mid-2003.

This is another reason why academic economists should hang out with the practical economists that work in the markets. It would keep them grounded in things the practical economists learn because they have to make money from the markets.

David Merkel

David Merkel said...

I think the central error of the paper is controlling the risks, and looking at the option-adjusted spread over agency yields. That spread tells us how rich/dear MBS is to how the GSEs fund. What that says is that Fannie and Freddie can't make much money by borrowing, buying morgages, and originating MBS.

The Fed sucked in so much paper out of the market -- Treasuries, Agencies, and MBS. That pulled down the belly of the curve for a while, though now the market has digested that, and then some. The curve is steeper than ever now.

Those are my thoughts, for what they are worth. I don't think this will end well.

Anonymous said...

No one wants this stuff. Instead of cleaning up their act, and issuing squeaky clean mortgages to restore bank reputations, they continued to issue loans with standards that no one else in the world adheres to.

The central bank wants the US to borrow the surplus overseas savings to keep the world economy moving. However, they also de facto want overseas savers to loan to people who don't repay. Lending to people who don't repay is not a viable long run strategy. Overseas savers have figured this out, and want nothing further to do with absurd lending standards.

Repeat, no one wants this junk, even with the taxpayer guarantee. The standards are high default prone.

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