The WSJ published a story today implying the Federal Reserve was considering the idea of reinvesting MBS prepays back into new production TBA MBS. Read "reinvesting" as the Fed resuming their large scale asset purchase program.

Quotes from the story lead us to believe the "leak" originates from someone inside the St.Louis Fed (coughcoughBULLARDcoughcough)...but no real source is ever cited and the street won't be fooled by hearsay and rumor.  If this story was leaked by a voting member of the FOMC, it is a HUGE shift in policy tone, especially when you consider the fact that the Fed just finished debating whether or not they should be SELLING some of their MBS assets.

Here are a few excerpts from the story:

Fed Mulls Symbolic Shift                                                          
Officials to Consider Putting More Money Into Bond Market as Recovery Wavers

By JON HILSENRATH                                                                   
Federal Reserve officials will consider a modest but symbolically important change in the management of their massive securities portfolio when they meet next week to ponder an economy that seems to be losing momentum.

The issue: Whether to use cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead. Any change—only four months after the Fed ended its massive bond-buying program—would signal deepening concern about the economic outlook. If the Fed's forecast deteriorates significantly, it could also be a precursor to bigger efforts to pump money into the economy.
Whether the Fed makes any move next week depends in large part on economic data, particularly the government snapshot of the jobs market due Friday. Since Fed officials last met in June, data on consumer confidence and spending have softened and job data haven't improved. But overall financial conditions have improved somewhat, with a rebounding stock market.

Fed officials aren't sure buying more mortgages or bonds would have a big effect on rates. Mortgage rates and other long-term interest rates already are very low. It also would saddle the Fed with an even larger portfolio to unwind later.

As mortgages are refinanced and mortgage bonds mature or are prepaid, the Fed's holdings shrink. The Fed's mortgage holdings inched down from $1.129 trillion in mid-July to $1.117 trillion at month's end.

The Fed's mortgage buying pushed investors to buy other assets, including corporate bonds and stocks. Any extension of that program, even in the form of reinvestment, could help support the recent rally in such riskier assets.

We actually brought up the idea of the Fed resuming their LSAP (large scale asset program) last week when we were searching for reasons to believe the 3.50 TBA MBS market would liquiefy and mortgage rates would go even lower.

From that post:

I've been thinking a lot lately about the question: Can Mortgage Rates Go Any Lower???

I've approached the question from several angles. The "double-dip" great recession option is still on the table. That means we can't rule out the idea that benchmark Treasury yields might return to record lows and take mortgage rates along for the ride. That theory doesn't hold much water in my opinion though, this is largely due to technical considerations surrounding the securitization of mortgages.

But there's a wild card we haven't talked about in while: If the economy does "double-dip", the Federal Reserve has made it clear they will "act accordingly" to prevent the spread of contagion. With the Fed essentially out of conventional policy bullets,  the door is open for more quantitative easing, aka more MBS purchases.

If that scenario played out, the "best execution" 30 year fixed mortgage rate could move as low as 3.75%. The one hang up I have with this outlook is the fact that we already experienced an environment like this and mortgage rates failed to move lower than current levels. Remember last year when the Fed was buying MBS and benchmark Treasury yields were at record lows?

One reason why this time might be different though:  the competitive lending environment. A loan pricing war amongst the major lenders...

Let's say mortgage rates don't decline further and refinance demand eventually exhausts itself. If this were to happen and purchase activity didn't pick up enough to offset the production slowdown, lenders would be looking for ways to stimulate activity and the Fed would be looking for ways to redistribute wealth around the economy. A new wave of re-refinances would occur if mortgage rates fell to 4.00%. Two birds, one stone?


Please do not confuse the above exploratory comments with our actual stance. That post was intended to outline a hypothetical scenario that MIGHT lead mortgage rates lower. I wish it had gotten as much attention as the WSJ story though, at least we addressed the fact that housing by itself doesn't need lower rates, the housing market needs more qualified borrowers (income and collateral qualified).

A "flight to safety" has led Treasury yields and mortgage rates back to historic lows. Demand for government debt and agency MBS is high, flows have been heavily one-way (all buyers) for the past month. The only thing the TBA MBS market has really needed is more loan production supply. 

From an investing perspective, if the Fed were to begin buying 3.50 MBS, mortgage rates would fall below 4.25% and many of the borrowers who've recently refinanced  would see their refi option go back "into the money" and look for a lower mortgage rate. If these borrowers were able to execute another refinance, it would drastically erode the value of the Fed's MBS portfolio. If anything, the Fed should be exploring the idea of  coupon swaps to ensure the entire stack doesn't become one big paper trade (4.0s roll special every month?)

Right now...further MBS/TSY QE doesn't seem prudent from any perspective.  How about we find a way to stimulate the labor market? Let's reinvest some money back into HUMAN CAPITAL

ugh. who wants to trade that much duration. what do you hedge against? the long bond?