For all the good the Federal Reserve’s $1.25 trillion of mortgage-bond purchases have done, they’ve also left part of the market broken.
By acquiring about a quarter of home-loan bonds with government-backed guarantees to bolster housing prices and the U.S. economy, the Fed helped make some securities so hard to find that Wall Street has been unable to complete an unprecedented amount of trades. Failures to deliver or receive mortgage debt totaled $1.34 trillion in the week ended July 21, compared with a weekly average of $150 billion in the five years through 2009, according to Fed data.
The difficulty of executing transactions may eventually drive investors away from the $5.2 trillion mortgage-bond market, which has historically been the most liquid behind U.S. Treasuries, potentially causing yields to rise, according to Thomas Wipf, who chairs an industry group that is trying to address the problem. The unsettled trades also stand to exacerbate the damage caused by the collapse of a bank or fund.
“You’re adding systemic risk into the market,” said Wipf, chairman of the Treasury Market Practices Group and the New York-based head of institutional-securities group financing at Morgan Stanley. “Investors are taking on counterparty risk in trades they didn’t intend to take on.”
An incomplete agreement can lead to a “daisy chain” of unsettled trades because a broker-dealer acting as a buyer in one transaction may fail to deliver those bonds as a seller in another, according to Alexander Yavorsky, a senior analyst at Moody’s Investors Service in New York. Investment banks are required to hold capital against both sides of the trades, which also makes the agency mortgage-backed market less attractive to make markets in, according to Wipf.
“From a broker-dealer perspective, this uses your credit resources, this uses your balance-sheet resources and it uses your capital resources,” he said. “It’s a drag on the business.”
The Fed was willing to accept some trading disruptions as a byproduct of its mortgage-bond purchases because its primary aim was to bolster the housing market by reducing financing costs and help the economy emerge from the deepest recession since the Great Depression, according to Yavorsky. If reduced liquidity in the mortgage-market persists and causes investors to seek other assets, that would run counter to the Fed’s goal of buoying demand for the securities. The program began in January 2009 and officially ended in March.
“The program was a major success and kept home prices from really collapsing,” Scott Simon, head of mortgage-backed securities at Newport Beach, California-based Pacific Investment Management Co., said the day it ended. At the same time, it’s left mortgage-bond prices too rich for Pimco, which reduced the world’s biggest bond fund’s holdings of the securities to 16 percent in June, down from 83 percent in January 2009, according to its disclosures.
The central bank and private investors helped send yields on Fannie Mae’s 4.5 percent mortgage securities down to 2.86 percent on July 30 from 5.95 percent on Nov. 24, 2008, the day before the plan was announced, data compiled by Bloomberg show.
Propping up the home-buying market “is probably a more-compelling consideration for them than fails” in the mortgage-backed securities market, Yavorsky said. “The risk and reward, if you will, are not entirely comparable in magnitude and social implications.”
The Fed’s purchases “were undertaken to broadly support mortgage and housing markets and were conducted with an eye towards limiting adverse effects on liquidity, given the importance of healthy, functioning markets,” said Federal Reserve Bank of New York spokesman Jeffrey Smith. “We are supportive of the TMPG’s efforts to identify best practices in these markets, including practices that limit fails.”
The group Wipf chairs, which the New York Fed helped form in 2007, includes banks such as New York-based Goldman Sachs Group Inc. and money managers like BlackRock Inc. It advises on transactions in U.S. securities and expanded its role in March to include Fannie Mae, Freddie Mac and Ginnie Mae mortgage-backed debt.
The group proposed guidelines on July 15 to reduce the number of uncompleted agreements across the Treasury, agency and government-backed mortgage-bond markets after failed home-loan debt trades reached a record $1.99 trillion on May 19, according to Fed data based on the 18 broker-dealers who transact directly with the central bank.
The measures include a recommendation that market participants manage large positions with “heightened vigilance” and avoid strategies intended to profit from settlement failures, the TMPG said. The group asked for comment on the “best-practices” document through July 29.
The guidelines coincide with the most sweeping set of financial rules since the Great Depression as Congress tries to prevent another credit crisis. The Dodd-Frank bill, signed into law last month by President Barack Obama, gives the government new authority to unwind failing financial firms that may threaten the entire system.
Slower U.S. growth and Europe’s sovereign debt crisis have led investors to become more concerned about banks’ credit risk. The extra yield that investors demand over benchmark rates to hold financial companies’ bonds has climbed to 2.39 percentage points from 1.86 percentage point in April, according to Bank of America Merrill Lynch index data. That’s still down from the record 8.81 percentage points in March 2009.
‘Wrench in Things’
When it comes to the trade fails, “I’m concerned about maybe a Lehman or Bear Stearns,” said William Chepolis, who oversees about $9 billion of bonds as a fixed-income fund manager in New York at DWS Investment, a Deutsche Bank AG unit. “Something like that could put a wrench in things.”
The Fed facilitated JPMorgan Chase & Co.’s purchase of Bear Stearns Cos. in March 2008 to prevent the securities firm’s failure. Investment bank Lehman Brothers Holdings Inc. filed for bankruptcy in September of that year.
The recommendations from Wipf’s group may not be enough to change practices or address mortgage-bond trading failures, based on an announcement this month by the Securities Industry and Financial Markets Association of New York and Washington that certain dealers have been violating some of the association’s guidelines for home-loan debt “over a number of years.”
Failures also persisted in the Treasury market even after the TMPG released guidelines in 2008, prompting the industry’s imposition in May 2009 of a 3 percentage-point penalty on uncompleted trades. The penalty caused unsettled transactions to plunge. The problems arose after Lehman’s failure led to a surge in demand for government securities as a refuge from market turmoil.
Broker-dealers have let trades go uncompleted in part because record-low interest rates have reduced the economic costs of failing to make good on those agreements. When traders don’t deliver bonds to their counterparties, they don’t receive cash they could be earning interest on. With the federal funds target rate in a range of zero to 0.25 percent since December 2008, the amount of foregone earnings is almost nothing.
Failed mortgage-bond trades last approached current levels in 2003, when the Fed’s benchmark rate was at 1 percent, showing how the central bank’s decision to keep rates at record lows helps fuel instability in the market.
The Fed’s difficulty completing its own purchases led the central bank to say in June it would replace its outstanding contracts to buy $9.2 billion of some debt with agreements to acquire different securities, called a coupon swap. It has also been entering trades to buy and sell the same amount of similar securities, so-called dollar-roll transactions, to help wrap up the program.
“What they’re doing is after-the-fact saying, ‘We bought more than existed, so we’re going to try to alleviate those problems,’” said Scott Buchta, head of investment strategy at New York-based Braver Stern Securities LLC.
The Fed’s coupon-swap and dollar-roll transactions do little to fix the mess in the overall market, according to Barclays Capital analysts led by Ajay Rajadhyaksha.
“Although the current move is aimed at resolving the Fed’s settlement issues, it does little to alleviate the widespread lack of available float or the fail situation,” the New York analysts said in a July 2 report.
The scarcity of some securities has allowed traders essentially to be paid to borrow to buy mortgage debt and adopt trading strategies designed to profit from the market dysfunction. The difference between dealers’ failures to deliver securities and to receive them “is a pretty good measure of intentional fails,” said Yavorsky of Moody’s. That figure was $44 billion in the week ended July 21, after climbing as high as $155 billion earlier this year.
As of July 30, an investor could agree to sell Fannie Mae’s 5.5 percent securities in August for 0.28 cents on the dollar more than it would cost to strike an agreement to buy similar securities in September. That translates into an implied borrowing cost of negative 0.28 percent based on dealer prepayment forecasts and short-term interest rates, according to data compiled by Bloomberg.
The scarcity of mortgage bonds has helped send prices on some securities to record highs, which means they may have farther to fall when the central bank eventually starts raising interest rates from record lows.
“It’s a game of hot potato in my mind, and you don’t want to be the last guy holding the roll,” said Paul Norris, a senior money manager at Dwight Asset Management Co., who oversees about $15 billion at the Burlington, Vermont-based firm he joined last year from Fannie Mae.