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  • October 1, 2012

    Andy McCormick Andy McCormick, T. Rowe Price's Head of Active Taxable Fixed Income and Portfolio Manager of the T. Rowe Price GNMA Fund.

    Liquidity and other issues mean the Federal Reserve is likely to adjust QE3.

    Executive Summary:

    • The Fed's latest asset purchase program targets agency mortgage-backed securities (MBS) and was significantly larger than expected. It is linked to the labor market outlook and has no designated expiration date.
    • While QE3 could keep mortgage borrowing costs low and accelerate housing price appreciation and construction, mortgage lenders' capacity issues may actually constrain the benefits to consumers.
    • QE3 represents a growing subsidy into government-supported segments of U.S. housing and may discourage more private sector involvement in the mortgage market.
    • The Fed's purchases could exacerbate shortages or cause trading disruptions in the MBS market, forcing investors to seek liquidity and income elsewhere and the central bank to adjust the program in the months ahead.

    This commentary reflects the views of Andy McCormick, T. Rowe Price's head of Active Taxable Fixed Income and portfolio manager of the T. Rowe Price GNMA Fund, as of September 25, 2012.

    QE3's size and MBS focus surprised investors

    On September 13, the Federal Open Market Committee (FOMC) announced a third round of asset purchases, dubbed QE3 by the market. Under the new open-ended program, the Fed will purchase an additional $40 billion per month in agency MBS.

    We expect that the new purchases will run through at least year-end, although the Fed has stated that the program is linked to the labor market outlook and not to the calendar. In addition to the new asset purchase program, the FOMC extended its exceptionally low policy rate guidance through at least mid-2015.

    As part of its existing quantitative easing programs, the Fed has already been purchasing approximately one-third of monthly agency MBS new issuance. Given the additional purchase requirements of QE3, many expect that the Fed's monthly purchases could at times reach as high as 85% of total gross agency MBS issuance, which has averaged slightly more than $110 billion per month in 2012.

    Prior to the September FOMC meeting, investors were pricing in a fairly high probability of some form of QE3. However, the substantial post-announcement move in MBS spreads indicated that market participants were surprised by the exclusive focus on MBS and the significant increase in monthly purchase volume. In the two-day period ended Friday, September 14, the option-adjusted spread (OAS) on agency MBS, which adjusts for the embedded prepayment risk premium, on 30-year Fannie Mae 3.5% MBS tightened 30 basis points versus Treasuries as the Fed initiated its new program.

    QE3 benefits may not reach mortgage borrowers and could crowd out the private sector

    While recent data suggest that the U.S. housing market may be recovering modestly, the sector's current contribution to growth is still well below the level experienced in previous economic recoveries. By specifically targeting agency MBS in its latest round of asset purchases, the Fed is, in part, attempting to accelerate price appreciation and construction activity by keeping borrowing costs artificially low and reinforcing housing affordability.

    However, many mortgage lenders are now facing capacity constraints as they attempt to process increased refinancing activity generated by other government programs. Such operational bottlenecks lead us to question whether lower yields on agency MBS will flow through to lower mortgage rates for prospective borrowers.

    In the near term, we do not expect increased Fed purchases to lead to a significant decrease in the primary mortgage rate. Rather, the margin that banking institutions earn through the loan origination and securitization process—known as the primary/secondary spread—should remain elevated (see Figure 1). This means that banks will earn a larger profit on each loan originated or refinanced. At some point, it is expected that banks will lend or invest these profits, thereby stimulating economic activity.

    Figure 1

    Mortgage Market - Primary vs. Secondary Rates

    Longer term, QE3 and Fed purchases of agency MBS will effectively drive a growing subsidy into the government-supported segments of the U.S. housing market—Fannie Mae, Freddie Mac, and Ginnie Mae. This appears to run counter to the housing policy outlined in a white paper released by the Treasury and the Department of Housing and Urban Development in February 2011. In that document, entitled "Reforming America's Housing Finance Market," the Obama administration laid out a framework designed to attract private capital by increasing the fees associated with government-sponsored mortgage securitization. Certainly, QE3 reduces the incentives for more private sector involvement by driving up the price of government-supported execution, thereby making private execution less competitive.

    It is unclear whether recent measures represent a shift in policy or just differing priorities at the Fed and the Treasury, but QE3 has effectively increased the subsidy associated with government-backed pricing. Fee increases are proceeding as scheduled, but the development of a private mortgage market appears to be on hold for now. Presumably, policymakers now have additional time to enact meaningful housing reform, knowing that consumers have access to mortgage credit through government-supported programs for the time being.

    Shortages or trading disruptions in the MBS market may push investors away

    The sharp price moves following the Fed's announcement have pushed the OAS on lower coupon agency MBS through the current yield levels on Treasury securities (see Figure 2). At current prices, traditional MBS holders, such as banks and money managers, may begin to reallocate capital into Treasury securities or higher-risk assets in an attempt to improve their total return potential. Moreover, investors that have relied on the liquidity of the agency MBS market may be concerned that the new Fed program will cause trading disruptions due to its dominant size.

    Figure 2

    Fannie Mae 30y Current Coupon Option Adjusted Spread

    Financing markets in MBS were beginning to expose shortages in available inventory before the announcement of QE3 and will likely experience more stress as the purchase program progresses. The MBS financing market provides valuable transparency into imbalances in supply and demand and can be a leading indicator of fading liquidity and inflated valuations.

    Traditional MBS investors are now left to recalibrate the liquidity and return potential of their holdings. With the Fed as the dominant force in the market, we expect investors to seek both liquidity and yield in other markets.

    Liquidity issues mean QE3 adjustments are likely

    The Fed intends to purchase a large volume of agency MBS at a fairly rapid pace through its new QE3 program. While the mortgage market was pricing in a high probability of further balance sheet expansion, QE3 is significantly larger than anticipated. Investors were already dealing with diminished MBS supply prior to the announcement, and now expectations are that the Fed could buy well over half of monthly gross issuance.

    Our securitized credit analysts believe that the intended consumer benefits of QE3 may be constrained by mortgage lender capacity issues and that the pace of Fed purchases may overwhelm the forecast supply. As a result of the decreased liquidity in the mortgage market, we expect that the Fed may have to adjust the program.

    Notably, the Fed gave itself flexibility to purchase other assets—assumed to be Treasuries—and to adjust the actual monthly purchase volume in the announcement of the program. It appears that the goal of buying an additional $40 billion of agency MBS per month will be a difficult task in the current market environment and may require the Fed to shift into Treasuries or lower its MBS purchase volume within the next six months.

    All charts are shown for illustrative purposes only and are not intended to represent the performance of any specific security. Past performance cannot guarantee future results.

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