To QE3 or to Not QE3: That is the Question

By David Schawel, CFA of Economicmusings


To QE or not to QE dominates economic headlines of late.  Lost in this debate is a readily available but under the radar tool that the Fed has at its disposal. Slowing global growth, and subsequently lower interest rates, has given credit worthy borrowers an opportunity to continue a now annual tradition of refinancing their mortgage.

To QE3 or to Not QE3: That is the Question

While many are content, mortgage market participants know that the primary/secondary mortgage spread shows that rates should be even lower!.  More specifically, this spread is above 50-70bps higher than the longer term average. Big banks have failed to ramp up capacity, and consequently the rate between what MBS holders earn buying a bond and the rate the borrower pays has expanded.

What does this have to do with the Fed?  An astute Credit Suisse analyst pointed out this week that the Fed could perform a “MBS Twist” operation in which they sell up in coupon premium MBS pools and buy lower coupon MBS which could have the affect of lowering mortgage rates to borrowers.  In their own words:

“…this policy will specifically target the near par secondary MBS rate, the key driver of the primary rate that is offered to the consumer.  Consumers spend “permanent income”, not temporary tax rebates…Operation MBS twist will reduce mortgage payments and redirect consumer cash to increase M-velocity and bump up inflation.”

To put this in perspective, the Fed owns ~$530bil of Fannie 4.5-5.5% pools (purchased during QE1) in which they have an unrealized gain of ~$32bil.  30yr 3.5’s (borrower rates of 4%) still comprise the lions share of origination volume, but 30yr 3.0’s are in production now as well.  Pushing down on 3’s and 3.5’s by buying almost all new production could, as CS points out, help compress the primary-secondary spread.

This idea has not just been floated by CS. In a note today, Jefferies told of a recent call in which the Fed mentioned that their systems are now in place for selling mortgages.  Like the team at Credit Suisse, the analyst at Jefferies believes this could be a precursor to an event where the Fed sells higher coupon bonds and buys 3’s and 3.5’s.  While certainly not the glamor of a multi-hundred billion dollar balance sheet expanding QE program, this could be very effective and something we see Bernanke unveil in September.