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Shorting Mortgage Backed Securities the Credit Default Swap Trade of 2010

According to Henry Kaufman, in “The Real Threat to Fed Independence” in the November 10, 2009 edition of the Wall Street Journal, the Fed’s balance sheet includes $1 trillion of mortgage related securities. This was up from $0 during the same period in 2008. Which means the Fed purchased $1 trillion in mortgage securities over the past 12 months. Before I continue, I decided to check these statistics myself so I checked the Fed’s balance sheet. Not that I did not believe the esteemed Henry Kaufman but I wanted to see what was going on with the Fed’s balance sheet myself and this exercise made a good excuse. So here is what I found from the Fed’s web site:



Millions of dollars
Reserve Bank credit, related items, and                            Averages of daily figures
reserve balances of depository institutions at            Week ended   Change from week ended     Wednesday
Federal Reserve Banks                                    Nov 11, 2009 Nov 4, 2009 Nov 12, 2008 Nov 11, 2009
Reserve Bank credit                                       2,115,704   -   33,209   -   82,498    2,116,959
 Securities held outright (1)                            1,699,466   +    1,822   +1,209,865    1,701,766      
    U.S. Treasury securities                                776,517   +      285   + 300,071      776,520
      Bills (2)                                              18,423            0            0       18,423
      Notes and bonds, nominal (2)                         707,649   +      277   + 297,158      707,649
      Notes and bonds, inflation-indexed (2)                 44,643            0   +    3,572       44,643
      Inflation compensation (3)                              5,803   +        9   -      657        5,806
    Federal agency debt securities (2)                      148,122   +    1,163   + 134,967      149,673
    Mortgage-backed securities (4)                          774,827   +      373   + 774,827      775,573



The boxed part is the most important. I think there might be a few other areas in the latter part of the balance sheet that shows the Fed’s other assets that may bring that amount up to and over the $1 trillion Henry Kaufman was talking about. I will therfor use the $1 trillion.
 
The $1 trillion comes out to about 1/3 of the Fed’s entire balance sheet. The legendary Meredith Whitney mentioned this today on CNBC. By the way, both of these market commentators were at the Economic Club of New York today to listen to Fed Chairman Ben Bernanke give a speech and take some questions. 

Ok, now that I have established the $1 trillion in mortgages that the Fed owns, what is the problem here? And, second, what is the opportunity? First, the problem as pointed out in the Henry Kaufman article in the Journal on November 10th and then reiterated today by Ms. Whitney in a CNBC interview is how does the Fed remove itself from this mortgage market? $1 trillion in mortgage purchases is a lot and that comes out to about $4 billion per day in purchases or $20 billion per week. Even if the Fed were to stop purchasing mortgages in the mortgage market and hold its mortgage security in inventory, the mortgage market will likely be affected to some extent and mortgage securities would likely decrease in value and interest rates would increase in value. Plus, these mortgage securities have been 'watered down' over the past year as the Federal agencies have made it easier for home owners who would not normally qualify for mortgages get mortgages. 

Now let’s bring this one step further. Imagine that the Fed were to not only stop its purchases but actually sell its inventory? What would happen to the price of MBSs? Well, mortgage security prices would most likely go down and mortgage rates would likely go up. I say most likely because one thing I know and that is the markets don’t always do what you think they will do. Also, Ben Bernanke and the other hard workers at the Fed I am sure have already thought about this and are working on a solution to prevent a melt up in interest rates.

Those things said, it almost seems like a slam dunk that mortgage securities are going to drop significantly in price when the Fed starts selling its inventory of mortgage securities. A savvy trader could capitalize on this by taking a short position ahead of the Fed’s decision to extricate itself from the mortgage market. Now, thinking out loud about this trade it almost seems to be anti-American to make a bet like this. But if you think deeply about it, I mentioned the flaw in the trade above, just because I think this is going to work as a trade does not mean that it will. Maybe Ben Bernanke and the Fed want to lure smart-alleck traders into a scheme where traders bet mortgage securities will fall in value and have some way to offset it, then again, maybe not. So you see, there is nothing anti-American about this trade. That is because there is no guarantee that the trade will work.

To recap, the Fed is the 800 pound gorilla in the mortgage market at the moment. It faces two tasks. First, to remove itself as a buyer of mortgage securities and second to unload its inventory of mortgage securities. Its ultimate goal would be to accomplish these feats without creating a selloff in the mortgage market as the last thing the Fed would want to do is see mortgage rates sky rocket as a wobbly housing market tries to get its legs. The astute trader could move ahead of the Fed and take a short position ahead of the Fed’s move to extricate itself from the mortgage market. Hedge fund star John Paulson capitalized on the past crisis with moves in the Credit Default Swap (CDS) Market ahead of the market turmoil in 2008, could shorting the Mortgage Back Securities Market be the Credit Default Swap trade of 2010?  


Article by Tom Henderson, Strategist at JBH Capital.


Disclosure: I have no position in any mortgage security nor does the firm I work for.