Yesterday, government mortgage agencies Fannie Mae and Freddie Mac announced that they would purchase $200 billion in delinquent mortgages that they had guaranteed. The agencies think this will ultimately be a better for accounting treatment. But the move will hardly be done in a vacuum. By buying up these home loans, the mortgage-backed securities that they're packed up in will provide investors with early principal payments. What will they do with all that cash?
First, for those who don't understand what I'm talking about, let me explain. Certain mortgages qualify for a guarantee from Fannie and Freddie. They're then packaged into "agency" mortgage-backed securities, and investors buy the bonds that result. So when the homeowners pay principal and interest, the investors get that money. But if the bonds incur losses, then the agencies cover them so investors don't lose money on principal.
Ever since the government made its backing of Fannie and Freddie explicit, the market has been even more comfortable with agency bonds. In fact, it was reported today that the spread between the yields of agency mortgage-bonds and Treasury bonds is the lowest it's been in 17 years, now approaching zero. And why not: if the U.S. government will stand behind agency debt, then investors shouldn't demand a much greater return than they would from other U.S. debt.
But back to the $200 billion. Since these bonds are taken to be so safe, they're often traded at a premium. In other words, a bond worth $100 in principal might be trading for $106, since the bondholder will also get interest payments in addition to that guaranteed principal. So the first problem is that these bonds will be redeemed at par -- meaning that anything trading at a premium will cause a loss to investors. In the example above, the investor would only get $100 for a bond worth $106, a loss of $6. As you might imagine, those investors won't be thrilled.
There's also another interesting consequence: despite these losses, investors will be flush with cash. Many of these bonds weren't set to mature for decades. And until then the principal would have slowly rolled in each month, as homeowners made their mortgage payments. But when the agencies buy these mortgages up, that principal will all come at once like a tidal wave. What does this mean for the market?
It could actually be good, depending on investors' view of the world. If they believe that the economy is, indeed, on the way back up, then they'll be eager to invest it. What they will buy with it, however, is unclear. If they think stocks are the safest bet right now, then they may put it there. Another option is unsecured corporate bonds. But if they think the housing market is relatively safe, then they could take over the role the Fed had been providing for the past year and begin purchasing mortgage-backed securities again.
I had been pessimistic about the MBS market picking back up after the Fed's exit, but this development with Fannie and Freddie could actually change that. If investors want to keep their diversity profile intact, then they'll still want that money to go towards real estate exposure. And $200 billion is an awful lot of money to get soaked up by just the secondary market. As a result, you could see some new activity in MBS stemming from this development after all. This could keep mortgage rates from exploding after the Fed ends its buying.
Of course, that's all assuming that investors are comfortable taking risks on the economy. If they aren't, then they may just hold this cash or used it to buy Treasuries for the time being, until they're convinced that the recovery has taken hold.