The most important point is that these fools in the Federal Reserve are trying to manage the economy to achieve certain outcomes. It cannot be done. It should not be attempted. They are harming us all and endangering our future.
I will post below an excerpt from a Paul Volcker speech given just this week. Volcker is very much a mainstream economist, of course. A guy who spent much of his career in central banking. Volcker is very polite, but it's also clear that in his opinion our contemporary central bankers don't know what the fcuk they are doing. IMHO, he is understating the case by a very significant margin.
Tom
Via Doug Noland’s Credit Bubble Bulletin:
From “Central Banking at a Crossroad,” Paul Volcker, The Economic Club of New York, May 29, 2013
“In no doubt, the challenge of orderly withdrawal from today’s (vs. 1950s) broader regime of quantitative easing is far more complicated. The still growing size and composition of the Fed’s balance sheet implies the need for, at the least, an extended period of disengagement. Moreover, the extraordinary commitment of Federal Reserve resources alongside other instruments of government intervention is now totally dominating the largest sector of our capital markets – that for residential mortgages. Indeed, I do not believe it an exaggeration to note that the Federal Reserve with assets of $3.5 Trillion and still growing is, in effect, acting as the world’s largest financial intermediator, by acquiring long-term obligations and financing short-terms, of course aided and abetted by the unique privilege to create its own liabilities.
Beneficial effects of the actual and potential monetization of public and private debt – the essence of the various QE programs – appear limited and diminishing over time. The old “pushing on a string” analogy is relevant. And the risks of encouraging speculative distortions and the inflationary potential of the current approach plainly deserve attention. All of this has given rise, obviously, to debate within the Federal Reserve Board itself. In that debate, I trust sight is not lost of the merits - economically and politically - of an ultimate return to more orthodox central banking approaches.
I do not doubt the ability and the understanding of chairman Bernanke and his colleagues. They have a very considerable range of tools and instruments available to them to manage the transition. They include the novel approach of paying interest on excess reserves, potentially sterilizing their monetary impact. What is at issue – what is always at issue – are matters of good judgment, leadership and institutional backbone. The willingness to act with conviction in the face of predictable political opposition and substantive debate is, as always, a requisite part of a central bank’s DNA.
Those are not qualities that can be learned from textbooks. Abstract economic modeling and the endless regressions of econometricians will be of little help. The new approach of “behavioral” economics itself is recognition of the limitations of mathematical approaches, but that new “science” is in its infancy.
I think a reading of history may be more relevant. Here and elsewhere the temptation has been strong to wait and see before acting to remove stimulus and then moving toward restraint. Too often the result is to be too late, to fail to appreciate growing imbalances and inflationary pressures before they are well ingrained.
There is something else beyond the necessary mechanics and the timely action that is at stake: the credibility of the Federal Reserve, its commitment to maintain price stability and its ability to stand up against pressing and partisan political pressures is critical. Independence cannot be just a slogan. Nor does the language of the Federal Reserve Act itself assure protection, as was demonstrated in a period after World War II. Then, as now, the law and its protections seem clear, but then it was the Treasury for a long time that called the tune.
In the last analysis, independence rests on perceptions of high competence, of unquestioned integrity and the will to act. Clear lines of accountability to the Congress and to the public need to be honored. Moreover, maintenance of independence in a democratic society ultimately depends on something beyond those internal institutional qualities. The Federal Reserve – any central bank – should not be asked to do too much – to undertake responsibilities that it cannot responsibly meet with its appropriately limited powers.
I know it’s fashionable to talk about a dual mandate – that policy should somehow be directed to two objectives of price stability and full employment. Fashionable or not, I find that mandate both operationally confusing and ultimately illusionary. Operationally confusing and in breeding incessant debate in the Fed and the markets about which way policy should lead – month to month, quarter to quarter – with close inspection of every passing statistic. More important, illusionary implies a tradeoff between economic growth and price stability – a concept that I thought had been long refuted not just by Nobel prize winners but by experience.
The Federal Reserve, after all, has only one basic instrument so far as economic management is concerned – managing the supply of money and liquidity. Asked to do too much - for instance to accommodate misguided fiscal policies, to deal with structural imbalances, or to square continuously the hypothetical circles of stability, growth and full employment - then it will inevitably fall short. If in the process of trying it loses sight of its basic responsibility for price stability, a matter that is within the range of its influence, then those other goals will be beyond its reach.
Back in the 1950s, after the Federal Reserve finally regained its operational independence, it decided to confine its open market operations almost entirely to the short-term money markets – the so-called “bills only doctrine.” We can’t go back to that – we can’t go home again to the simpler days of the 1950s and 1960s. Markets and institutions are much larger, far more complex. They have also proved to be more fragile, potentially subject to large, destabilizing swings in behavior. The rise of shadow banking, the relative decline of regulated commercial banks, the rapid innovation of new instruments have all challenged both central banks and other regulatory authorities.
But one simple logic remains. It is, I think, reinforced by these developments. The basic responsibility of a central bank is to maintain reasonable price stability - and by extension that means it must take account of the stability of financial markets generally. In my judgment, those functions are complimentary and they should be doable.
With or without a numerical target, the broad responsibility for price stability over time does not in any way imply an inability to conduct ordinary counter-cyclical policies. Indeed, in my judgment confidence in the ability and commitment of the Federal Reserve or any central bank to maintain price stability over time is precisely what makes it possible to act aggressively in supplying liquidity in recession or when the economy is in a prolonged period of growth well below potential.
Credibility is an enormous asset. Once earned, it must not be frittered away by yielding to the notion that a “little inflation right now” is a good thing to release animal spirits and to pep up investment. The implicit assumption behind the siren call must be that the inflation rate can be manipulated to reach economic objectives – up today, maybe a little more tomorrow, and then pulled back on command. But all experience amply demonstrates that inflation, when fairly and deliberately started, is hard to control and reverse. Credibility is lost.
I have long argued that central bank concern for stability must range beyond prices for goods and services to the stability and strength of financial markets and institutions generally. I am afraid we collectively lost sight of the importance of banks and markets robustly able to maintain efficient and orderly functioning in time of stress. Nor has market discipline alone restrained episodes of unsustainable exuberance before the point of crisis. Too often, we were victims of theorizing that markets and institutions could and would take care of themselves.
My concerns in that respect and their relevance to central banking and the organization of regulatory authority, were more fully expressed in a speech to this Club several years ago. Congress was then beginning to consider reform legislation. It was recognized that regulatory agencies, perhaps most specifically the Federal Reserve, had exhibited a certain laxity and ineffectiveness in the period leading up to the financial breakdown, particularly with respect to the mortgage market…
The erosion of confidence and trust in the financial world, in the financial authorities that oversee it, and in government generally is palpable. That can’t be healthy for markets or for the regulatory community. It surely can’t be healthy for the world’s greatest democracy, now challenged in its role of political and economic leadership…
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I share all of these concerns about the Feds ability to exit QE in a timely fashion. So what should an investor do when confronted with this risk? That is arguably a more important question than whether the fed should be reformed.
Suggestions?
Scott Grannis
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Tom,
Obviously, the Fed has far exceeded its mandate in Mortgage Lending. The CFPB, which was established under control of the Fed by Dodd Frank, is setting the new mortgage lending regulations, and risk as well. Coupled with the MBS purchases, the Fed is taking over mortgage lending.
I am going to post a primer on MBS so that all can get a better understanding of how it works. Then, when one realizes that the Fed is buying 93% of all new origination MBS, it really goes to show how the Fed has manipulated rates.
Pat
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This comes from Mortgage News Daily, an industry website that covers events as they happen. One thing that they do is to follow MBS pricing daily, throughout the day, showing changes, etc, so that lenders and brokers can react to what is occurring.
The data provided here gives a good primer to the understanding of MBS, price changes, etc. When what is here is applied to Feb operations, it gives better insight to understanding. But, even then, it is only a primer. And as Scott will attest to, this is simplified greatly.
http://www.mortgagenewsdaily.com/mortgage_rates/mbs-basics.aspxWhat is MBS?
Any time you see us write MBS in this blog, or anywhere else for that matter, we're always going to be referring to Mortgage Backed Securities. These are the securities comprised of groups of similar mortgages, also known as "pools." MBS function similarly to other bonds in that have a purchase PRICE and pay the investor back in installments based on the YIELD. The PRICE always refers to the cost of buying $100 of that particular bond. For instance, if the price of a bond is 101.00, then an investor would pay $101.00, and in exchange, would then own only $100.00 worth of that bond. So why pay more or less?
In a word: YIELD. Yield is the rate of return paid on that bond over time. There are multiple different types of bonds, and each bond has a certain yield that it pays. You will sometimes hear us refer to yield as "coupon" or "issue." As you might guess, the higher the yield, the more the buyer will make over time, so the more the buyer is willing to pay. For instance, if an MBS with a 3.0% yield costs $104.50, the investor pays $104.50 for the ability to collect 3.0% interest on $100.00. Conversely, yields that are low enough may have prices under Par (100.00), meaning that investors could buy $100.00 worth of MBS at a discount. Bottom line, the higher the coupon of MBS, the higher the price will generally be.
For this same reason, when considering only one coupon (you might find it easier to think of it as "if the coupon stays the same") and the price is going higher, then the yield for the investor goes lower (because they're paying a higher price for the same coupon yield). This is what we mean when we say "as price goes up, yields go down," which is a different concept that "higher yielding coupons fetch higher prices." This can be a bit of paradox for some, but if it doesn't make sense at first, try to separate the two different approaches mentioned above:
1. In this case, we're looking at and/or considering the price/yield relationship of numerous MBS coupons, at one moment in time, and noticing that the higher the coupon, the higher the price.
2. In this case, we're looking at one specific MBS coupon. The coupon doesn't change, but the price does. As the price moves higher and lower over time we're noticing that investors are paying more or less for the same coupon yield. Thus if prices for a particular coupon are moving higher, yields are moving lower.
Keep in mind that the COUPON YIELD of a particular MBS only determines the rate of return of whatever principal amount remains in the MBS pool purchased by the investor. Because the duration of a mortgage can vary (borrowers can sell, refinance, foreclose, etc..) the ACTUAL yield that an investor receives will depend on how quickly the loans in their MBS pools are retired. Suppose you paid $104.00 for the right to collect interest on a $100.00 loan. If the borrower pays you back before their first interest payment, now you've earned $100.00 for your $104.00 investment!!! Not profitable! You're realizing a MUCH lower yield than another investor whose borrowers keep their loan for several years.
This is the "Prepayment Risk" that investors seek to avoid and it's the reason for the various "early pay-off" penalties charged to originators if loans are retired or refinanced within a certain time frame.
So MBS's are bonds! Where do they come from?
Grossly oversimplified and leaving out numerous items that are not germane to rate analysis, MBS are the bonds that mortgage loans are turned into when they are bought or sold. That's a tough one to grasp your first time around. I know it was for me.
Basically, Big Bank will write a check for your mortgage, say it's $100,000. Big Bank A then has a promissory note saying that you will pay them a certain interest rate over time (sound familiar?). But Big Bank A needs some more money to lend other people... Where to get it? I know! They can sell your mortgage note to someone else in the form of a bond! Hopefully, that investor is willing to pay something like $102,000 for the right to collect interest on your $100,000 loan. Big Bank A just made $2000, and the investor has something that will hopefully pay them interest over time. Remember price vs. yield? The higher your interest rate, the more the investor would be willing to pay Big Bank A. That's YSP Baby! And if the investor is only going to pay $97,000 for the loan, that means Big Bank has to pay them a discount to buy it, which was probably passed on to you on line 802 of the GFE! Now YSP starts to become clear I hope!
But there's a big problem! The investor doesn't want all of their risk riding on one loan, so we have to find a way to spread out the risk. Because even if you only have a 3% chance of defaulting, in the event that you do, the investor would lose his hat. So to spread out the risk, Big Bank A combines your loan with 10's to hundreds of other similar loans with similar rates and similar credit quality.
Then either by selling them directly to Fannie Mae and Freddie Mac or by utilizing Fannie and Freddies Protocols and doing it themselves, Big Bank A accomplished what is known as SECURITIZATION. Now the "pool" (collective of all the bundled loans which will now be in the millions of dollars) can be broken up into bond-sized chunks. Now instead of buying one loan for $100,000 dollars (give or take), and investor can buy a portion of 10's to hundred's of loans for the same amount of money, with the same rate of return, with the same risk of default. BUT NOW, if you apply the 3% rate of default, the investor only loses 3%! Brilliant! And it's a concept that has allowed a significantly larger amount of money to be available for home loans than ever before.
We just said that investors are paying 102% of the face value of a bond in certain cases right? So what happens if they are not interested at that price any more? No more liquidity for the mortgage market. So how do you combat this? In a nutshell, the market forces of supply and demand take care of it. If demand for a bond is low when the price is 102.00, then the sellers of the bonds may lower the price to 101.50 to ENTICE investors to start buying again. And what did we already say would happen to the YIELD when the price got lower for a particular issue? It goes UP because the same money the investor was going to spend, now buys more shares. So their rate of return per dollar spent (yield) goes up.
Those pricing adjustments from 102.00 to 101.50 should look familiar. They move in exactly the same proportion to YSP. Although Big Bank A has to pull profit off that for themselves, THE PRICES OF MBS ALWAYS MOVE IN DIRECT PROPORTION TO THE PRICES (YSP IF POSITIVE, DISCOUNT IF NEGATIVE) OF THE MORTGAGES FROM WHICH THEY ARE DERIVED.
That is why we want to follow MBS instead of any other treasury or index in order to gauge the direction of the market. If investors are wanting to buy more MBS, then the prices are going to go up (Price vs. Demand function). Higher prices mean that Big Bank A makes more on a given coupon, which means they can originate a loan for your clients with either a slightly lower interest rate or a slightly higher YSP. Your choice!
So that is the theme of any mortgage market analysis. We want to assess the movements of MBS prices (which change by the second), in conjunction with the macroeconomic climate, in order to determine which way they might be headed and what future events can have an impact.
For instance, inflation data being negative hurts bonds because bonds return a fixed income. So if inflation has devalued the dollar over time, the bond is not really worth as much as when it first was purchased. So high inflation makes investors seek higher yields in order to get on that boat. Another popular correlation is that a booming economy draws money out of bonds and into more rapidly appreciating stocks. This causes bond owners to lower the price to entice buyers which raises mortgage rates. That is why, if you look at a historical chart of recessions and interest rates, you will almost always see recessions coincide with low rates.
Beyond that, there's only a little more you need to know when reading my analysis.
First of all, there are several coupon rates ranging from 4.5%-7.5%. Right now, we primarily track the 5.5% coupon and the 6.0% coupon as most of the trades are taking place in that range, giving us a higher sample size and thus more reliable data. We will always report on the bond coupons that are closest to PAR for this reason (par meaning a cost of 100.00).
Bonds move in 32nds. So 101-32 would actually be 102-00. And 101-16 would actually be 101.50 in decimal form. So when you see prices improve by 16/32nds, that means that at some point in the future, lenders have the ability to improve the YSP on rate sheets by .500. NOW, in this day and age, lenders are not quick to pass on a price improvement to its full effect. They want to see the market hold its gains for a bit. However, if the market worsens, they will hedge their positions by taking even more away from you than they have lost on price. This is just smart business, and it's a balancing act between lenders to see who reprices and by how much. I will often times refer to 32nds as TICKS. So if I say "we're down 6 ticks on the 5.5," that would mean that the 5.5% coupon MBS has declined in price by 6/32nds from yesterday's close. Lot less typing my way!
Tight or Wide. Bond investors have a choice between MBS and other types of bonds. The benchmark competitor is the US 10 year treasury. MBS price relative to treasury price is important because even if mortgage prices go up on the day, if treasury prices go up a whole lot more, the MBS will still be the better investment all other things being equal. Because there is a significantly higher amount of risk in MBS than in treasuries, the MBS prices will ALWAYS be lower than treasury prices for a similar coupon amount. So when prices rise on MBS and "close the gap" on treasuries, we say "MBS are trading tighter." You might also hear "tighter to the curve," meaning the yield curve. Wide is simply the opposite.
Graphs. Hopefully the graphs I've been posting make much more sense now. They are simply tracking the curve of the price of a particular coupon throughout the day. As the curve gets higher, rates have the potential to go lower and vice versa. There is a school of thought known as "technical analysis," which some think is crazy voodoo, while others think it is gospel. Basically, technical analysis throws all economical analysis out the window and simply focuses on the numbers, what they have done in the past, their propensity to "obey" certain trends, their resistance to certain price floors or ceilings, etc... I am a fence-sitter when it comes to Technicals. I will comment on them, but always keep in mind that technical analysis must be considered in conjunction with the rapidly changing economic climate.
So for instance, if I say "there is a price floor today that has been established at 99-16," that means that bond prices have resisted going below the horizontal line on the graph at the 99-16 mark. If bonds then were to break through that floor and go lower, it could indicate a potential increase in pressure to sell, which would hurt rates. Hope that makes sense.
We just said that investors are paying 102% of the face value of a bond in certain cases right? So what happens if they are not interested at that price any more? No more liquidity for the mortgage market. So how do you combat this? In a nutshell, the market forces of supply and demand take care of it. If demand for a bond is low when the price is 102.00, then the sellers of the bonds may lower the price to 101.50 to ENTICE investors to start buying again. And what did we already say would happen to the YIELD when the price got lower for a particular issue? It goes UP because the same money the investor was going to spend, now buys more shares. So their rate of return per dollar spent (yield) goes up.
Those pricing adjustments from 102.00 to 101.50 should look familiar. They move in exactly the same proportion to YSP. Although Big Bank A has to pull profit off that for themselves, THE PRICES OF MBS ALWAYS MOVE IN DIRECT PROPORTION TO THE PRICES (YSP IF POSITIVE, DISCOUNT IF NEGATIVE) OF THE MORTGAGES FROM WHICH THEY ARE DERIVED.
That is why we want to follow MBS instead of any other treasury or index in order to gauge the direction of the market. If investors are wanting to buy more MBS, then the prices are going to go up (Price vs. Demand function). Higher prices mean that Big Bank A makes more on a given coupon, which means they can originate a loan for your clients with either a slightly lower interest rate or a slightly higher YSP. Your choice!
So that is the theme of any mortgage market analysis. We want to assess the movements of MBS prices (which change by the second), in conjunction with the macroeconomic climate, in order to determine which way they might be headed and what future events can have an impact.
For instance, inflation data being negative hurts bonds because bonds return a fixed income. So if inflation has devalued the dollar over time, the bond is not really worth as much as when it first was purchased. So high inflation makes investors seek higher yields in order to get on that boat. Another popular correlation is that a booming economy draws money out of bonds and into more rapidly appreciating stocks. This causes bond owners to lower the price to entice buyers which raises mortgage rates. That is why, if you look at a historical chart of recessions and interest rates, you will almost always see recessions coincide with low rates.
Beyond that, there's only a little more you need to know when reading my analysis.
First of all, there are several coupon rates ranging from 4.5%-7.5%. Right now, we primarily track the 5.5% coupon and the 6.0% coupon as most of the trades are taking place in that range, giving us a higher sample size and thus more reliable data. We will always report on the bond coupons that are closest to PAR for this reason (par meaning a cost of 100.00).
Bonds move in 32nds. So 101-32 would actually be 102-00. And 101-16 would actually be 101.50 in decimal form. So when you see prices improve by 16/32nds, that means that at some point in the future, lenders have the ability to improve the YSP on rate sheets by .500. NOW, in this day and age, lenders are not quick to pass on a price improvement to its full effect. They want to see the market hold its gains for a bit. However, if the market worsens, they will hedge their positions by taking even more away from you than they have lost on price. This is just smart business, and it's a balancing act between lenders to see who reprices and by how much. I will often times refer to 32nds as TICKS. So if I say "we're down 6 ticks on the 5.5," that would mean that the 5.5% coupon MBS has declined in price by 6/32nds from yesterday's close. Lot less typing my way!
Tight or Wide. Bond investors have a choice between MBS and other types of bonds. The benchmark competitor is the US 10 year treasury. MBS price relative to treasury price is important because even if mortgage prices go up on the day, if treasury prices go up a whole lot more, the MBS will still be the better investment all other things being equal. Because there is a significantly higher amount of risk in MBS than in treasuries, the MBS prices will ALWAYS be lower than treasury prices for a similar coupon amount. So when prices rise on MBS and "close the gap" on treasuries, we say "MBS are trading tighter." You might also hear "tighter to the curve," meaning the yield curve. Wide is simply the opposite.
Graphs. Hopefully the graphs I've been posting make much more sense now. They are simply tracking the curve of the price of a particular coupon throughout the day. As the curve gets higher, rates have the potential to go lower and vice versa. There is a school of thought known as "technical analysis," which some think is crazy voodoo, while others think it is gospel. Basically, technical analysis throws all economical analysis out the window and simply focuses on the numbers, what they have done in the past, their propensity to "obey" certain trends, their resistance to certain price floors or ceilings, etc... I am a fence-sitter when it comes to Technicals. I will comment on them, but always keep in mind that technical analysis must be considered in conjunction with the rapidly changing economic climate.
So for instance, if I say "there is a price floor today that has been established at 99-16," that means that bond prices have resisted going below the horizontal line on the graph at the 99-16 mark. If bonds then were to break through that floor and go lower, it could indicate a potential increase in pressure to sell, which would hurt rates. Hope that makes sense.
