Mortgage-Bond Carnage Shows What the Future Holds Without Fed Help

(Bloomberg) -- The bloodbath last month in the mortgage-bond market points to what the future may be like without Federal Reserve hand holding. Investors are now wondering if anyone will step in to stop the bleeding.

Returns on mortgage-backed securities in October lagged Treasuries by 37 basis points, the most since November 2016, when rates surged in the aftermath of President Donald Trump's surprise election. Last month's weakness coincided with the Fed ending its mortgage purchases as it winds down the $1.7 trillion MBS portfolio it amassed since the financial crisis to support the market.

“When the Fed announced they were going to buy mortgages, we tightened a lot and rolls performed really well -- now the reverse is happening,” said Kevin Jackson, a managing director on Wells Fargo's mortgage trading desk. “One should expect widening.”

In a situation rarely seen over the last four decades, there isn't going to be a government entity -- which before the financial crisis included Fannie Mae and Freddie Mac -- at hand to provide liquidity for mortgage-backed securities. This, combined with the Fed increasing rates, is likely to continue to push spreads wider and rates for home buyers higher.

Some investors hope that banks or money managers will fill that role, but both face challenges that may prevent them from taking on that task, according to Ankur Mehta, the head of MBS research at Citigroup Inc.

“It is not obvious to us where that incremental demand for mortgages comes from,” Mehta said, noting domestic banks already earn an attractive return on reserves, while “money managers are facing headwinds due to outflows and their existing MBS overweights.”

The carnage in October also came about due to the fact “mortgages were still looking rich” compared to pre-crisis spreads when the Fed didn't own any MBS, according to Mehta.

A popular method of valuing the mortgage market, the Fannie Mae 30-year current coupon spread over a blend of 5-year and 10-year Treasuries, ended October at its widest since June 2017.

While it's uncertain where spreads, and therefore mortgage rates, will find their footing, it's certain that someone will need to fill the demand gap.

To contact the reporter on this story: Christopher Maloney in New York at cmaloney16@bloomberg.net

To contact the editors responsible for this story: Christopher DeReza at cdereza1@bloomberg.net, Randall Jensen, Brendan Walsh

©2018 Bloomberg L.P.