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Federal Reserve Slowly Killing Mortgage Market


Bernanke and Co. have come into the market, overpaid, gobbled up supply, left it less liquid, and have driven participants out.

Ben Bernanke Cast in Godfather Remake

No, he's not going to have a starring role, but a bit part. I hear he's trying out for a part as one of Michael Corleone's bodyguards. Specifically, he's trying out to be the one who tried to snuff out Hyman Roth with a pillow in Havana.

Okay, maybe he isn't. But after reading this article from Bloomberg, I wonder. The way the article starts out immediately brought that image from The Godfather II to mind (emphasis, mine):

For all the good the Federal Reserve's $1.25 trillion of mortgage-bond purchases have done, they've also left part of the market broken.

By acquiring about a quarter of home-loan bonds with government-backed guarantees to bolster housing prices and the US economy, the Fed helped make some securities so hard to find that Wall Street has been unable to complete an unprecedented amount of trades. Failures to deliver or receive mortgage debt totaled $1.34 trillion in the week ended July 21, compared with a weekly average of $150 billion in the five years through 2009, according to Fed data.

A near tenfold increase in failures to deliver. But what exactly is a failure to deliver? Here's the definition from Investopedia:

An outcome in a transaction where one of the counterparties in the transaction fails to meet their respective obligations. When failure to deliver occurs, either the party with the long position does not have enough money to pay for the transaction, or the party in the short position does not own the underlying assets that are to be delivered.

Welcome to the world of counterparty risk. In the broker-dealer/banking communities, counterparty risk either makes or breaks the system. When you enter into trades or exit out of them, you expect your counterparty to perform the other end of the trade. If they fail to deliver on their end frequently enough, you'll start to view them as being riskier to do trades with and you have to assess a counterparty risk premium. It's just a cost of doing business.

What's going on in the mortgage markets is a bit more than just counterparty risk. Again, from the Bloomberg piece (again, emphasis is mine):

The difficulty of executing transactions may eventually drive investors away from the $5.2 trillion mortgage-bond market, which has historically been the most liquid behind US Treasuries, potentially causing yields to rise, according to Thomas Wipf, who chairs an industry group that is trying to address the problem. The unsettled trades also stand to exacerbate the damage caused by the collapse of a bank or fund.

"You're adding systemic risk into the market," said Wipf, chairman of the Treasury Market Practices Group and the New York-based head of institutional-securities group financing at Morgan Stanley (MS). "Investors are taking on counterparty risk in trades they didn't intend to take on."

In my view, Wipf is right and wrong at the same time. He's right about the added risk being taken on, but I'd argue that counterparty risk has to end somewhere and systemic/liquidity risk has to begin. To me, counterparty risk is idiosyncratic: It's different for everyone and it only pertains to one firm. Liquidity risk is about the liquidity of the entire asset class; the ability to enter/exit positions with ease. With the levels of failures to deliver we're seeing, would you say we're still dealing with idiosyncratic risk?
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