Did the Government Break the Mortgage Market?

If you haven't been watching the financial markets lately, you've missed quite a few fireworks. As Governments across the globe attempt to remove themselves from the markets they decided to dominate (ones only the private sector should have been involved in) we are seeing unprecedented behavior.

Let's start in Japan (where I should point out their Government is not really attempting to get "out" which is causing its own set of problems). Japan has decided to buy so many Government bonds (JGBs) that there are literally days (as in more than one business day in-a-row) where not a single 10 year JGB trades. This should scare anyone reading that sentence. Imagine being in a security (stock or bond) where you wakeup and decide you want to sell and there isn't anyone around. This has led to their Government intervening in FX markets (selling US Treasuries to generate dollars so they can sell those dollars to buy Yen) in a classic attempt to (in the short run) prop up their currency. This hasn't been done since the late 90s. This type of behavior, in layman's terms, is called wasting money.

So now to our markets. Here in the USA pre-2008 there were two giant behemoths that would "police" the agency MBS market. They had very large balance sheets, sophisticated models, and access to virtually all the information one could want in the agency markets. When the market was needing a buyer, Fannie and/or Freddie would provide the bid. When the market got too "steamy" they would sell. These OAS (option adjusted spread aka an attempt to provide relative value to MBS buyers) police kept the market functioning. Post 2008, the Fed decided to jump in and buy MBS. Why? Because simply buying Treasuries wasn't enough to push mortgage rates down after the GFC (financial crisis) due to investor concerns around prepayment behavior and extension risk (i.e. normal investors wanted to be paid more for taking more risk). Over time, the Fed drove pricing so high, and rates so low that OAS was flashing "not worth it!" to other investors. Without Fannie/Freddie there to police values, a lot less volatility was bought in the market so the markets got complacent, and the market got used to having only one unnatural buyer (a buyer who was not looking to make money but looking to fuel a housing bonanza).

Now fast forward to September 2022. The Fed, which owns over $2 Trillion of MBS, which might (IF they could find a buyer) be worth 70 cents on the dollar, has walked out the market that it was the lone buyer in, without thinking of the consequences. Do mortgage rates need to rise to help "cool" housing? Sure. But does the mortgage market still need to function? I would think so, since most states would go bankrupt without ever increasing home prices (tax money). In fact, I would argue that the Fed saved the housing market to save the Government, not the people, but that's just an opinion.

Without a large balance sheet player incentivized to be in the agency MBS market (no Fannie, no Freddie), the Fed is vacating a market that it pushed all other buyers out of long ago. This isn't the first time the Government has tried to get itself out of the QE mess, but before the Fed could even sell a single MBS this time, the market is a ghost town. Yes it is looking a lot like the Japanese market for JGBs. What do I mean? In agency MBS there is something called the "par coupon", back in the day, before the Fed ruined the market, this was literally the price around 100. However, after the Fed, the "par coupon" became 102 (because the Fed conditioned borrowers to not pay anything to get a loan and because lenders have gotten so much less efficient at doing loans post Dodd-Frank [the latest estimates are that it costs $10k for the average lender to close a loan]). As a former MBS trader on Wall Street, I saw first hand how disruptive the Fed can be. In the early 2010s the Fed broke the roll market and created a big financial windfall for large Money Managers that are now household names. How? Because they had a bazooka in the form of a big wallet and they had no idea how to spend the money without causing a problem. Now, I'm seeing similar signs in our agency MBS market. Usually, when a trader looks at the "screens" for hedges they will see prices ranging from the high 90s to 104+ (during the Fed bonanza times this was 112 or higher). However, in this market, there are prices down at 75, but barely anything near 100. So what is the "par coupon" today? As you can see from the screenshot below, its the 6% coupon. This means the highest quality borrower (with little to no risk adjustments or LLPAs), would need to pay points to get a 6.75% rate (I'm leaving some of the math out of this). It also means that the highest rate available is only 7.125% which means low(er) quality borrowers with a lot of LLPAs, likely can't even get a rate because they would have so many discount points that they can't pass the Government imposed "Points and Fees" test. So why is the max rate 7.125%? Because the 6.5 and 7 coupons (see screenshot below with the giant red question mark) don't even have prices. Why? Because there is no one willing to buy or sell those securities. Aren't Wall Street broker dealers supposed to "make a market"? Sure, but all the Wall Street regulations drove a lot of risk taking behavior off the street, drained the street of talent, and at the same time the "only" big buyer of agency MBS left the market and they forgot (or never learned) about the role Fannie/Freddie used to play in the markets. (as in making sure it functions)

So now what? As rates "settle" into a range, we might expect to see some bids showing up in these coupons. However, the liquidity will be sparse and it will take time for this market to heal itself. It will likely take serious business model updates at Lenders and consumers may need to get used to paying a lot more upfront to get a loan. It also means Lenders need to really upgrade their capital markets acumen as volatility might just mean hedges can't get done. It might be just like our Japan example, where someone shows up looking to trade something and all they see is a tumbleweed. If the market is this broken now, imagine what it would look like if the Fed tried to sell. Hold on to your hats and buckle up.