By the Numbers
How the Fed might sell MBS
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The minutes from the Fed’s March meeting shed some light on the Fed’s plans to shrink its MBS portfolio. The Fed expects to begin runoff soon, and an announcement at the May meeting seems likely. The minutes indicate runoff could be capped at $35 billion a month, although some members favored a higher cap or no cap at all. And the Fed expects to step up to the full cap over only a few months. Runoff should be well below the cap since mortgage rates are approaching 5%. The Fed also indicated that outright MBS sales are possible once runoff is well underway. That probably means outright sales would not begin until 2023 at the earliest but will be necessary if the Fed wants to sell most of its MBS holdings this decade.
The slow pace of paydowns
Interest rates and mortgages rates have moved much higher this year. MBS prepayment speeds, including the pools owned by the Fed, are going to slow. This means the Fed’s MBS holdings are going to shrink slowly if it relies only on scheduled payments and prepayments (Exhibit 1). The data in the table assumes that the Fed begins runoff immediately and does not cap runoff. However, in the base case runoff averages only $21.5 billion in the first year and will likely not exceed $25 billion in any month. After five years the portfolio will have returned $1.1 trillion, and the Fed will still own $1.6 trillion MBS. That is a larger amount than it owned in early 2020, before starting QE4.
Exhibit 1. Fed MBS portfolio runoff will be low
Source: Federal Reserve, Yield Book, Amherst Pierpont Securities
The Fed would likely prefer to unwind the MBS portfolio faster than this. Even if interest rates fall 150 bp the Fed would own over $1.2 trillion MBS in five years. Outright MBS sales will be necessary to shrink the balance faster.
The meeting minutes did not provide any details regarding how the Fed would handle MBS sales. It is probably that the amount of MBS sold would be set each month to eliminate the shortfall between MBS paydowns and the runoff cap. For example, if the Fed receives $15 billion in paydowns one month, then it is likely it would sell $20 billion of MBS. If the Fed begins to sell MBS in mid-2023 to ensure the portfolio shrinks $35 billion each month then the portfolio should be fully divested sometime in 2029.
Another question is what MBS the Fed will sell. The portfolio is currently split 79% conventional and 21% Ginnie Mae. The holdings in both sectors are concentrated in lower coupons, but the coupon distribution is a little different in conventional and Ginnie Mae MBS since there were few Ginnie Mae 1.5%s issued during the pandemic.
Markets would probably find it least disruptive if the Fed were to sell MBS across various coupons each month, instead of concentrating the sales in specific coupons. The Fed could sell pro-rata based on the balance of each coupon and agency in its portfolio. Or the Fed could sell pro-rata to match the distribution of paydowns received in the prior month, so that sales effectively boosted the natural runoff in the portfolio. But whatever choice the Fed makes most of the sales will come from lower coupons since they make up the bulk of the holdings.
The effect of selling on spreads
Mortgage spreads could widen when the Fed starts runoff and again when it starts to sell MBS. Prior Fed research indicates that mortgage yields tighten as the Fed owns a larger share of outstanding MBS, and therefore will widen as the Fed’s holdings shrink. The Fed found that each 1% of the MBS market owned by the Fed tightened MBS spreads by 2.3 bp, all else equal. If that relationship holds, the basis could widen as much as 74 bp from its tightest levels since the Fed owns almost 32% of all MBS. Spreads have widened 45 bp since the start of the year so some of that potential widening may already be priced by the market. But it suggests there is still room to widen even more.
Brian Landy, CFA
1 (646) 776-7795
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