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Cornering the Mortgage Market

By: Mark Tranckino

Financially speaking, the expression to “corner the market” is to get sufficient control of a particular stock, commodity or other asset to allow the price to be manipulated. Another definition is “to have the greatest market share in a particular industry without having a monopoly.”

One of the most famous attempts to corner a market in our lifetime was the attempt by the Hunt brothers, Nelson and William Herbert, to corner the world’s silver market in the late 1970s and early 1980s. At one point, they held the rights to more than half of the world’s deliverable silver. During the Hunts’ accumulation of the precious metal, silver prices rose from $11 an ounce in September 1979 to nearly $50 an ounce in January 1980 — just four months! Silver prices ultimately collapsed to below $11 an ounce just two months later as a result of changes made to exchange rules regarding the use of margin.

Although there have been many attempts to corner markets by making massive purchases in everything from tin to cattle, to date few of these attempts have ever succeeded. Those attempting to corner a commodity can become vulnerable due to the size of their positions, especially if the attempt becomes widely known.

Some market pundits are fearful that the Federal Reserve has inadvertently fashioned its own cornering of the mortgage-backed securities market, having purchased more than a half-trillion dollars in mortgages in 2013 alone.

On Sept. 13, 2012, the Fed announced a third round of quantitative easing. This new round provided for an open-ended commitment to purchase $40 billion of agency mortgage-backed securities per month, until the labor market improved “substantially.”

The Federal Open Market Committee voted to expand its quantitative easing program further on Dec. 12, 2012. This round continued to authorize up to $40 billion worth of agency mortgage-backed securities per month and added $45 billion worth of longer-term securities. The outright Treasury purchases as part of the augmented program continued at a pace comparable to that under “Operation Twist;” however, the Federal Reserve could no longer sell short-dated Treasury securities to buy longer-dated ones because they had insufficient holdings of short-dated Treasuries.

Here is an interesting side note: Operation Twist is not a novel concept attempted by the Fed. The FOMC made a similar attempt to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The year was 1961, and the activity was named after the twist dance craze that was sweeping the country at that time.

The total of $85 billion in monthly purchases, ($40 billion in mortgage-backed and $45 billion in Treasuries) remained in play during all of 2013. Since the beginning of this year, however, it has been the Fed’s intent to taper its monthly purchases by $10 billion at each FOMC meeting. Indeed, in May, it was scheduled to purchase just $45 billion total, ($25 billion in Treasuries and $20 billion in mortgage-backed).

Simple supply-and-demand economics would suggest that as the Fed purchases less mortgage paper, yields and spreads should increase. The problem is that the Fed’s “portion of the pie” is not shrinking as fast as the pie itself.

Let’s look at the math. In December 2012 the Fed was purchasing $40 billion in mortgages, but the market generated $136 billion in qualifying mortgages that month. As rates rose in 2013, the Fed’s purchases were a much higher percentage of origination. Pool issuance was more than $150 billion monthly in 2013 until August, when it dropped to $137 billion. It soon dropped below $100 billion in October and has averaged just $66 billion so far in the first four months of 2014.

It is this drop in mortgage supply that has muted the market’s reaction to the taper. One would expect mortgage prices to be cheaper after the Fed is finished buying, but as long as the volume of mortgage originations stays low, so will the spreads on mortgage-backed products.

What does all of this mean to the portfolio manager? First of all, spreads are tight across all sectors of fixed income securities. For example, we are finding tax-free yields as a much smaller percentage of Treasuries than they have been over the past few years. Tight spreads are also the case with corporates and agencies.

Many managers are using this strong price environment to liquidate pools that are performing poorly, or are of questionable quality, as well as “clean up” pools that are approaching “odd lot” status.

In conclusion, continue to purchase mortgages you have been comfortable with, 10- and 15-year pass-throughs along with 5/1 or seasoned 7/1 agency ARMs. Don’t be lured into marginal credits or creative and untested mortgage-backed products. 

 

Mark Tranckino is senior vice president in the Capital Markets Group at Country Club Bank in Kansas City. His email address is mtranckino(at)countryclubbank.com.


Copyright 2014. BankNews Media. June 2014.


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