Where Has All the MBS Debt Gone?

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Includes: DIA, SPY
by: The Hedonic Calculus

The Fed's holdings of Agency and MBS debt topped $1T on its way to $1.25T by the end of 1Q10. The Fed purchases represent roughly 12% of the market. This begs the question: who did they buy all of these securities from? The answer can be found in the flow of funds data released yesterday and posted below.

The main seller of Agency and MBS debt has surprisingly been the household sector, which has trimmed its holdings of MBS from $840B in 3Q08 to $68B in 3Q09, a 92% liquidation. The household liquidation almost exactly matches the amount of securities that the Fed purchased. The other seller of the period were "Rest of World" holders, who sold almost $300B worth of MBS since 1Q08. Foreigner's sales were picked up mostly by US Financial institutions. Commercial banks increased their holdings of MBS by almost $200B over the same period.

The selling by foreign holders and accumulation by commercial banks makes a lot of sense. Foreign holders basically went on strike buying Agency MBS when the US government refused to explicitly guarantee them in the late summer of 2008. You may recall that spreads blew out to all time wides before Fannie (FNM) and Freddie (FRE) were finally put into conservatorship. Commercial banks on the other hand have had huge deposit inflows over the past year thanks to the Fed's money printing and general risk aversion. With loan demand virtually non existent, they've needed to park the funds somewhere and have chosen MBS as the vehicle of choice (because they're "risk free" so capital doesn't need to be held against them).

Households selling should be a huge surprise though. It makes sense that people should want to sell Agencies to the Federal reserve at peak prices, but it is totally unexpected that households would be the ones to do it. Households are notoriously poor investors, usually buying at the peak and selling at the trough, so why with respect to MBS have households gotten this so right as banks continued to load up on the assets at the peak (only beginning to be net sellers in 3Q09 after buying all year)? I honestly have no idea. My gut tells me there may be some kind of anomaly in the data at work, but if households are actually the sellers, then bravo.

MBS represent a significant risk to the financial system once the Fed stops buying them. US households were right to liquidate their holdings. Once the Fed is gone from the market, there will be no incremental buyer and prices could collapse. Foreigners used to be the incremental buyer, but now have shown a lack of appetite. Banks certainly will not step up and be a natural buyer of these securities when the Fed doesn't stand behind them. The question of 2010 may therefore be--who will? If no one steps up, then things could get ugly. Remember these are securities not loans, and securities are marked to market.

Disclosure: None