The Great Fed Unwind: It’s All About Treasury Note/Bond Sales, Not Agency MBS

The Federal Reserve was supposed to start shrinking their $4.4 TRILLION balance sheet back in October, but have only recently begun actually selling the assets on their balance sheet.

As you can see, the US Treasury 10-year Note yield was just above 4% when The Fed’s asset-buying began and after now resides at around 2.4%. And you can barely see the unwinding of the balance sheet since The Fed is moving at glacial speeds to unwind.

But we have only seen a slight uptick in the 10-year Treasury Note yield with the recent unwinding of the balance sheet (pink box).

Since The Fed’s asset purchases are primarily Treasury Notes/Bonds and agency Mortgage-backed Securities (Agency MBS), we can see that it is the T-Notes/Bonds that are being sold-off, not the Agency MBS. The Fed’s strategy is to let the Agency MBS run-off (gradually mature as mortgages prepay).

But as The Fed’s Balance unwinds and Treasury/Mortgage rates rise, mortgage prepayments are likely to slow, making The Fed’s plans less effective. This is called “extension risk.”

Let’s see what The Fed of New York does tomorrow!


America’s Disappearing Mortgage Tax Break Finds Few Defenders (Beware of Tax Carveouts And Shrinking Middle Class Incentives!)

Federal income taxation should be simple. Here is my FIT (Federal Income Tax) pecking order:

  • No Federal Income taxation. A consumption tax (or national sales tax) could be used to raise revenues.
  • Flat tax or fair tax. A simple tax rate for everyone (say, 12%) would greatly simplify matters. Or if you feel that households making less than, say, $20,000 should be exempted, so be it. Under either tax, we wouldn’t need to itemize tax deductions; hence, the mortgage interest deduction would be eradicated.
  • OR we can have our current system where special interest groups lobby for and get tax carveouts (essentially exempting them from or reducing their tax bill). For the carveout approach, see the Senate’s 479 page tax revision.
  • After all the special interest and corporate carveouts got their piece of the tax pie, the one group that is losing their carveout is American households with the dimishing mortgage interest rate deduction.

Which brings me to this nice piece by  Bloomberg reporters Joe Light and Prashant Gopal.

(Bloomberg) -By Joe Light and Prashant Gopal- One of America’s most popular tax breaks is about to be rendered nearly useless. And there are few economists rushing to defend it.

The $64 billion mortgage-interest deduction has long been touted as fuel for U.S. homeownership. Yet as the real estate industry fights the Republican tax plan that’s set to diminish its use, finding economic supporters of the perk is tough, even among affordable-housing advocates. John Weicher, a 79-year-old former official with the Department of Housing and Urban Development, says he’s one of the few who believes in the break.

“We’re about as common in the economics profession as Republicans are in the District of Columbia,” said Weicher, now director of the right-leaning Hudson Institute’s housing center in Washington, a city where only about 4 percent of voters chose President Donald Trump in last year’s election.

While Republican lawmakers aren’t directly killing the mortgage benefit, their tax plan would make it worthless for most homeowners by doubling the federal standard deduction, making it less likely that a typical person would itemize write-offs of any kind. Almost 38 million American households who would otherwise itemize would opt for the standard deduction under the new tax plan, according to Moody’s Analytics Inc.

The bill’s passage would be one of the greatest defeats for the National Association of Realtors, Washington’s second-most powerful lobbying group, which had for decades successfully fended off criticism of the benefit. Detractors argue that the tax perk inflates home prices for first-time buyers and favors families with bigger incomes and bigger mortgages (including for discretionary vacation-home purchases).

It’s “not an effective way to support homeownership,” Mark Zandi, chief economist for Moody’s Analytics, said of the mortgage-interest deduction, or MID. “I think my views on the MID are in the consensus.”

Opposition to the deduction has created strange bedfellows.

In February, Diane Yentel, chief executive officer of the National Low Income Housing Coalition, and Mark Calabria, then working at the libertarian Cato Institute, co-wrote a column in The Hill calling for Congress to kill or reform the deduction.

“No longer a political ‘third rail,’ experts from across the ideological spectrum are increasingly calling it what it really is: a wasteful use of federal resources,” they wrote.

“People were shocked,” Mickelson said. [Side note: people were shocked when they discovered that Regulatory Capture (pitting one group against another when the public is not best served) is alive and well?]

When the column ran, Sarah Mickelson, director of public policy for the NLIHC, said she got surprised emails from colleagues that her organization could find something to agree on with Calabria, who’s now the chief economist for Vice President Mike Pence.

The agreement only goes so far. While Mickelson’s group wants to reinvest the savings from limiting the mortgage-interest deduction into help for low-income renters, neither bill in Congress does that.

Standard Deduction
Both the Senate and House bills increase the standard deduction to $24,000 from $12,700 for a married couple filing jointly. The House plan also caps the home-loan write-off to mortgages up to $500,000 instead of the current $1 million limit. The plans have other elements that stand to disrupt the housing market, from shifts in capital-gains levies on home sales to limiting deductions on state, local and property taxes.

Taxed in Scarsdale: GOP Plan Daunts Metro New York Real Estate
While housing lobbyists’ furious opposition to the tax overhaul didn’t emerge until the last few months, the industry’s tax breaks have been vulnerable for much longer, said Isaac Boltansky, a policy analyst with Compass Point Research & Trading.

“The die was largely cast the minute the GOP swept the 2016 election,” said Boltansky, who said getting rid of or lessening the value of itemized deductions was always going to be a target of a tax bill in order to save money for broader cuts.

Denmark Study
Jon Gruber, an economics professor at the Massachusetts Institute of Technology, said he opposes the GOP tax plan because it adds to the deficit at the benefit of the wealthy, but that the mortgage-interest deduction isn’t something that should be saved. The perk would cost the government almost $80 billion by 2019, according to Congress’s nonpartisan Joint Committee on Taxation. The government could spend much less, for example, on a permanent tax credit for first-time buyers, Gruber said.

“If the goal is middle-class homeownership, you could just as well be throwing $100 billion in the ocean,” Gruber said. “At least then you’d have a landfill and you could build a house there.”

Gruber co-wrote a July working paper, “Do People Respond to the Mortgage Interest Deduction?,” using Denmark’s sharp cut in its mortgage deduction for top-rate earners in the late 1980s to make the case.

“The mortgage deduction has a precisely estimated zero effect on homeownership,” the paper concludes. “The largest effect of the mortgage deduction is on household financial decisions, inducing them to increase indebtedness.”

‘Simple Logic’
Lawrence Yun, chief economist of the National Association of Realtors, said he’s skeptical of studies that use very different mortgage systems in other countries to make conclusions about the U.S. Without the deduction, the homeownership rate would drop by one or two percentage points, he said.

It’s “simple logic” that the deduction is one of many factors that encourages purchases, Yun said. A study that his group commissioned said home prices in the short run could decline 10 percent with the elimination of the deduction, as potential buyers stop factoring it in to how much they can pay.

Weicher, the benefit’s backer, said economists who oppose the mortgage-interest deduction tend not to have studied it themselves and merely take that view because it’s what other economists they know believe.

The last time the deduction was under assault, a few years ago, he was popular with newspaper opinion pages. He said he wrote op-eds that appeared in a handful of publications as they got interested in having columns, both pro and con, running side by side.

“Nobody else has an MID op-ed that takes the pro side,” Weicher said.

This article points to a mostly negative view on the mortgage-interest deduction for homeownership.  I agree with Lawrence Yun simply comparing the US with other housing finance (and tax) systems can be misleading. But more than that, the 479 page tax bill coming from the US Senate points to the actual problem: the tax code is all about special interest/corporate carveouts and not about middle-class Americans.

To let middle-class Americans compete with special interest groups on the tax front, the mortgage interest deduction should be preserved, not erradicated or deleted.

So why are American home prices so high and affordability so low? You can thank 1) land use restrictions (either natural or man-made) that reduce the available construction of housing units, 2) The Federal Reserve and their zero interest rate policies.


The hysteria from Pelosi and even Larry Summers ring hollow considering that the Federal Tax Code has been filled with carveouts for decades they never complained until now. The 479 page tax bill is just a reshuffling of the deck chairs on the Titanic (or Tax-anic).

On a side note, House Minority Leader Nancy Pelosi and Senator Elizabeth Warren are whining the Republicans did not give them time to read the 479 pages. They seem to conveniently forget that the Democrats did the exact same thing with the disastrous Obamacare legislation. Remember Pelosi’s infamous “We Have to Pass the Bill So That You Can Find Out What Is In It.”?


So, unless Congress wants to move to a more simple tax code, they should leave the MID in place (except for vacation homes). Since The Fed mostly benefitted wealthier Americans, the middle class does demand some tax relief.

Particularly given that income inequality keeps getting worse and worse.


Heartache Tonight! Bank C&I Lending Falls To 1.2% YoY (Auto Loans Fall To 2.1% YoY, Real Estate Loans Fall To 5.1% YoY)

We’ve got a heartache tonight … in terms of bank lending. Particularly commercial and industrial lending (C&I) and auto loans. Particularly since bank lending is the primary transmission vehicle for Federal Reserve policies.

C&I lending growth fell to 1.2% YoY, which has historically meant that a recession is close at hand.


Auto loans also fell to 2.1% YoY.


The good news? Real estate lending fell too, but to 5.1% YoY.


Have the stimulative effects of The Fed’s ZIRP and QE policies run out?


Yes, its a heartche tonight for bank lending and Fed monetary policies.

Fed Chair Janet Yellen Testifies At Senate Hearing On Semiannual Monetary Policy Report To Congress

The Venture Capital Bubble Is Imploding! (The Beginning Of The Great Bubble Deflation?)

Following The Great Recession and The Fed’s extraordinary response, there was a lot of money available that we seeking risky assets, such as equities, housing and apartments.

Venture capital, the darling of business schools (that rarely look at the data, but focus on the snake oil-aspect of VC), has been in decline since 2014 after a meteoric rise after 2007.



Most of the decline has been in early stage Venture Capital.


As The Fed begins it perilous journey to return to normalized interest rates, the VC bubble will disappear.


Will other risky assets bubbles begin exploding as well?

Whalen: Banks and the Fed’s Duration Trap (The Perils Of Fed QE and Low Rate Policies For Ten Years)

As we approach final exams at George Mason University School of Business, I thought this summary of how The Fed is impacting both Treasury and Agency MBS risk (duration) would be appropriate. A great summary of the topics we have discussed in class are provided by my friend Chris Whalen.

Chris Whalen (Institutional Risk Analyst): Is a conundrum worse than a dilemma? 

One of the more important and least discussed factors affecting the financial markets is how the policies of the Federal Open Market Committee have affected the dynamic between interest rates and asset prices.  The Yellen Put, as we discussed in our last post for The Institutional Risk Analyst, has distorted asset prices in many different markets, but it has also changed how markets are behaving even as the FOMC attempts to normalize policy.

One of the largest asset classes impacted by “quantitative easing” is the world of housing finance.  Both the $10 trillion of residential mortgages and the “too be announced” or TBA market for hedging future interest rate risk rank among the largest asset classes in the world after US Treasury debt. Normally, when interest rates start to rise, investors and lenders hedge their rate exposure to mortgages and mortgage-backed securities (MBS) by selling Treasury paper and fixed rate swaps, thereby pushing bond yields higher.

An essay on this very subject was published by Malz, Schaumburg et al in a blog post for the Federal Reserve Bank of New York in March 2014 (“Convexity Event Risks in a Rising Interest Rate Environment”).  Since then, the size of the Fed’s portfolio has grown a bit, and volatility has dropped steadily. The key characteristic to note is that the Fed owns most of the recent vintage, lower coupon MBS that would normally be hedged by private investors and banks. For those of you who follow our work, this argument tracks that of our colleague Alan Boyce, who has long warned about the hidden duration risk in the bond market since the start of QE.  The FRBNY post summarizes the situation nicely:

“When interest rates increase, the price of an MBS tends to fall at an increasing rate and much faster than a comparable Treasury security due to duration extension, a feature known as the negative convexity of MBS. Managing the interest rate risk exposure of MBS relative to Treasury securities requires dynamic hedging to maintain a desired exposure of the position to movements in yields, as the duration of the MBS changes with changes in the yield curve. This practice is known as duration hedging. The amount and required frequency of hedging depends on the degree of convexity of the MBS, the volatility of rates, and investors’ objectives and risk tolerances.”    

Since the Fed and other sovereign holders of MBS do not hedge their positions against duration risk, the selling pressure that would normally push up yields on mortgage paper and longer-dated Treasury bonds has been muted.  Thus the Treasury yield curve is flattening as the FOMC pushes short-term rates higher because longer-dated Treasury paper, interest rate swaps or TBA contracts are not being sold, either in terms of cash sales by the FOMC or hedging activity.  Chart 1 shows 2s to 10s in the Treasury bond market from FRED.

Source: FRED 

More, the volatility normally associated with a rising interest rate environment has also been constrained because the Fed’s $4 trillion plus portfolio of Treasuries and MBS is entirely passive.  As the FOMC ends purchases of Treasuries and MBS, and indeed begin to sell down the portfolio, presumably the need to hedge by private investors and financial institutions will push long-term rates up and with it volatility.  As Malz notes, “the biggest change [between 2005 and 2013] is the increase in Federal Reserve holdings, partly offset by a large reduction in the actively hedged GSE portfolio.”  Yet since the modest selloff in 2013, volatility in the Treasury market has continued to fall.

While it is clear that some smart people at the FRBNY understand the duration dilemma, it is not clear that the Fed staff in Washington and particularly the members of the Board of Governors get the joke.  Unless you believe that the FOMC is intentionally pursuing a flat yield curve as a matter of policy, it seems reasonable to assume that the folks in Washington do not understand that reducing the size of the System portfolio is a necessary condition for normalizing the price of credit.

George Selgin at Cato Institute wrote an important post this week talking about Chair Janet Yellen’s defense of paying interest on excess reserves (IOER) held by banks at the Fed (“Yellen’s Defense of Interest on Reserves”). Selgin’s analysis raises a couple of important issues.

The fact that Yellen and the FOMC will not manage IOER at or below the market rate for Fed Funds is quite telling, particularly since doing so would address many of the key criticisms of the policy. This suggests two things, first that there really is no “free” trading in Fed Funds anyway and the Fed is the market. Second that the FOMC somehow thinks that it must push higher the bottom of the band — this despite the huge net short duration position of the street and the $4 trillion passive Fed portfolio.

The more urgent question is Yellen’s view of a trade off between QE/open market operations and IOER that Selgin illustrates very nicely. The FOMC seems to think that merely not growing the portfolio or slowly selling is an option while they raise benchmark rates like IOER and Fed Funds. In fact, reducing the portfolio always was the first task, before changing benchmark rates. Especially if one is cognizant of current market conditions.

Unless the FOMC changes its approach to managing its $4 trillion securities portfolio, either through outright sales or active hedging, it seems likely that the Treasury yield curve will invert by Q1 ’18.  The Fed could sell the entire system portfolio and the street would probably still be short duration due to low rates and continued QE purchases by ECB, BOJ, etc. And to repeat once again, the agency mortgage securities market is down 30% on issuance YOY. Again, the FOMC does not seem to appreciate that the yield curve must invert, unless the bond trading desk at the FRBNY is actively selling and/or hedging all of the MBS and even longer dated Treasury paper.   

Some analysts such as Ed Hyman (Barron’s, “A Smooth Exit Seen for Mortgage Securities,” 11/20/17) believe that banks will increase purchases of agency paper as the Fed unwinds QE. We beg to differ.  Bank holdings of MBS as a percentage of total assets has barely moved in years.  But more to the point, one has to wonder if Yellen and other members of the FOMC appreciate the trap that has been created for holders of late vintage MBS.

 The Fed has suppressed both interest rates and volatility via QE, as shown in Chart 2 below:

Source: Bloomberg

As and when the balance between buyers and sellers in the MBS market slips into net supply, volatility will explode on the upside and the considerable duration extension risk hidden inside current coupon Fannie, Freddie and Ginnie Mae MBS could prove problematic for the banking industry. 

“The duration extension risk goes turbo if we see rates up, volatility up and a curve steepening,” notes Boyce.  Or as Malz noted succinctly in 2014:

“When interest rates increase, the price of an MBS tends to fall at an increasing rate and much faster than a comparable Treasury security due to duration extension, a feature known as the negative convexity of MBS. Managing the interest rate risk exposure of MBS relative to Treasury securities requires dynamic hedging to maintain a desired exposure of the position to movements in yields, as the duration of the MBS changes with changes in the yield curve. This practice is known as duration hedging. The amount and required frequency of hedging depends on the degree of convexity of the MBS, the volatility of rates, and investors’ objectives and risk tolerances.”

Let me add color to Whalen’s interesting article.

First, here is a chart of Fannie Mae 3.0% 30 year TBA OAS duration compared to the 10-year Treasury yield and Freddie’s 30-year mortgage survey rate. You get the general idea of what will happen to Agency MBS duration when rates really begin rising.


Second, The Fed has suppressed Treasury volatility with its massive QE program along with the 10-year low Fed Funds policy.


Third, The Fed’s super low interest rate policy has left investors in the perilous left-hand side of the bond/MBS price-to-yield curve.


Fourth, The Fed finally began their long-anticipated balance sheet unwind this week, although it was barely noticeable (only 0.27). 


Here is a video of The Fed trying to unwinds its $4.4 TRILLION balance sheet.

Let’s see what happens when The Fed starts unwinding for real instead of just raising the target rate.


Good luck GMU finance students on your final exam! Just play Ten Years After “I’m Going Home” to calm your jangled nerves. 

Coincidentally, Fed Chair Janet Yellen is going home as soon as Powell is sworn in as Federal Reserve Chair.

Janet Yellen

Freddie Mac 30Y Mortgage Rate Falls To 3.90% (150 Basis Points Above 10Y Treasury Note Yield)

While all eyes are on The Federal Reserve and their upcoming rate announcement (and eventual unwinding of their balance sheet), the Freddie Mac 30Y mortgage survey rate actually fells to 3.90%.


That represents a 150 basis point spread over the benchmark 10-year Treasury Note yield. The pink box below corresponds to the separation of the 10-year Treasury Note  yield and the 30-year mortgage rate.


All eyes (at least MY eyes) will be on the Fed of New York’s announcement on Thursday on whether they actually start undwinding their balance sheet (which could cause the 10-year Treasury Note yield to rise).


To quote Judge Smails from Caddyshack, “Well, we’re waiting!”


Maybe I misunderstood Yellen when she said the balance sheet underwind would begin in October (it is now almost December).


For Fannie-Freddie Regulator (FHFA), Battle Heats Up With White House (Buffer Drops To Zero In 2018!)

The fight continues over Fannie Mae and Freddie Mac, the mortgage giants in conservatorship with their regulator, FHFA, as the buffer for F&F goes to zero in 2018.

(Bloomberg) -By Joe Light- While the Consumer Financial Protection Bureau grabs headlines, another independent U.S. regulator is quietly locked in its own showdown with the Trump administration. (CFPB Director Richard Cordray stepped down and tried to appoint his own successor Leandra English. The Trump Administration wanted to appoint Mick Mulvaney, who serves as head of the Office of Management and Budget. A court ruled that Trump has the authority and Cordray did not.)

The Federal Housing Finance Agency is in deep discussions with the White House over what to do with more than $7 billion owed to the government at year-end by Fannie Mae and Freddie Mac.

FHFA officials in negotiations have said they want Fannie and Freddie to keep $2 billion to $3 billion each as a buffer against losses, according to people familiar with the matter. Administration officials in exchange want to limit the mortgage giants’ market footprint by steps such as tightening restrictions on the size of loans they back, according to the people, who requested anonymity because the talks are private.

The ongoing negotiations could face a de-facto deadline at the end of December, when Fannie and Freddie are scheduled to pay $7.7 billion to the U.S. Treasury. If FHFA Director Mel Watt chooses to withhold some of that money without the administration’s sign-off, it could set off another firestorm between President Donald Trump and an independent agency led by an appointee of his predecessor Barack Obama.
Spokeswomen for the FHFA and the Treasury Department declined to comment.

Bailout Agreements
Fannie and Freddie don’t make mortgages. They buy them from lenders, wrap them into securities and give guarantees to make mortgage-bond investors whole if borrowers default.

The FHFA negotiations stem from the bailout agreements struck when the government took control of the companies in 2008. Fannie and Freddie eventually received $187.5 billion to weather the financial crisis, and in exchange taxpayers received a new class of senior preferred stock that paid a 10 percent dividend, along with warrants to acquire nearly 80 percent of their common stock.

In 2012, the Treasury and FHFA, which controls Fannie and Freddie, amended the agreements. Instead of a 10 percent dividend, taxpayers each quarter receive a dividend equal to all of the companies’ net worth above a specified capital buffer. (This is the infamous “profit sweep” that helped fund the dying Obamacare healthcare law).

Zero Buffer
That buffer is $600 million each this year, but drops to zero in 2018. At that point, Fannie and Freddie would need another bailout from Treasury to cover even small quarterly losses. The companies have $258 billion to draw on from the U.S. Treasury if needed, but that amount can’t be replenished with future profits. If the companies make their fourth-quarter payment as scheduled, they will have paid taxpayers a combined $283.6 billion.

At the center of the conflict is Watt, a former Democratic congressman picked by Obama to lead the agency in 2013. After fierce opposition from Senate Republicans who tried to block his confirmation, Democrats changed the rules to eliminate the use of the filibuster for some presidential nominees, enabling Watt to get through.

After becoming director, Watt exhibited an independent streak, making moves that irked Democrats and Republicans alike. The behavior won him the respect of many Republican lawmakers. They’ve limited their criticism of Watt even as they lambasted former CFPB Director Richard Cordray, who set off a public battle over the agency’s leadership last week by trying to put his chief of staff in charge as he walked out the door.

Investor Confidence

Watt has said that his concern is with how mortgage-bond investors might react if Fannie and Freddie begin to draw funds from the remaining Treasury commitment. For now, many investors treat the companies’ mortgage-backed securities as if they have no risk of losses from borrower defaults. Watt has said that perception could change if the $258 billion line of credit is being tapped to cover losses.

“We reasonably foresee that this could erode investor confidence,” Watt said at a House Financial Services Committee hearing in October. “This could stifle liquidity in the mortgage-backed securities market and could increase the cost of mortgage credit.”

The possibility of losses is more than theoretical. Freddie Mac in 2015 and 2016 posted small quarterly losses as a result of a quirk in how the company accounted for interest-rate hedges. The capital buffer kept the company from needing bailout money.

One-Time Loss
Fannie and Freddie could also face one-time losses if Congress passes a bill that reduces the corporate tax rate. That’s because the change would reduce the value of Fannie and Freddie assets that can offset taxes.

The $2 billion to $3 billion requested by FHFA officials could withstand a small loss but likely wouldn’t be enough to protect against a cut in the corporate tax rate.

Treasury Secretary Steven Mnuchin has publicly said he expects the companies to pay their dividends as scheduled.

In the private talks, administration officials have suggested that FHFA agree not to raise the size of a mortgage that Fannie and Freddie can buy. That so-called conforming loan limit currently stands at $424,100 for most of the U.S. and at $636,150 for areas with the priciest homes.

On Tuesday, FHFA raised the limit for most areas of the U.S. to $453,100 for 2018. The agency raises the limit based on changes to its own home-price index, pursuant to the law governing the agency. It’s unclear what discretion the FHFA would have in taking steps to limit the increase.

Private Capital
Trump administration officials have said they want to increase private capital’s role in the mortgage market, a goal that could be furthered by freezing the loan limit.

FHFA officials have resisted the administration’s request to stop a loan-limit increase, the people said. Complicating matters, Watt has publicly said that he believes the companies’ bailout agreements allow him to withhold some or all of the dividend without White House approval.

Some lawmakers have urged Watt to let the companies keep capital, while others have said the move could be interpreted as an early step toward fully recapitalizing the companies and releasing them from government control. Watt has been adamant that he won’t recapitalize and release the companies without congressional approval.

Retaining a combined $4 billion to $6 billion from a quarter where the companies owe $7.7 billion would allow the companies to make partial payments rather than stopping the dividends completely.

Of course, if the bond and housing markets are in a bubble and they burst/shrink, Fannie Mae and Freddie Mac are likely to suffer negative earnings again and will require a bailout. Then again, so will a number of banks.