What happens when the FED stops buying mortgages?

April 1st the FED stops buying (MBS) Mortgage Backed Securities. It has been buying them up relentlessly since January ’09. So far $1.25 Trillion’s worth.

What happens when they stop?

The way it used to work was banks gave out a mortgage. The banks then needed/wanted to sell-on those mortgages, in order to get more cash for more lending. It was Fannie May and Freddie Mac, the quasi governmental organisations, whose job was to ‘support’ the housing market, especially the ‘lower’ end, by being a virtual guarantee that the banks would find a buyer for their mortgages. Fannie and Freddie’s job was to buy the mortgages, or securities based on them them and sell debt/bonds based on them turn.

Fannie and Freddie sold their debt/bonds for cash. The mortgages, stayed at F&F the bonds/debt was sold, and cash come back in its place. Fannie and Freddie then used that cash to buy more mortgages allowing the banks to offer more mortgages to more people. It was China’s job to stand at the end of the debt chain to buy the debt from Fannie and Freddie. The cash dollars the Chinese used were earned from exports which China needed to repatriate. So everyone was happy.

OK that’s the money chain on the way out. Now for the chain coming back the other way.

That chain of buyers and seller not only provided the cash for mortgages but also set the mortgage rate. How?

Remember those securities are essentially a debt/bond. Fannie and freddie are selling a piece of paper based on someone paying their mortgage. So like all bonds/debt the key to selling is the interest rate you are offering your buyers. Part of Fannie and Freddie’s job was to take mortgages good and not-so-good from anybank and everybank, bundle them together and sell them at a better i.e. lower rate than the loan originators might have been able to secure. And they did.

How? Was it sheer volume? Yes. Brilliant financial acumen? Er no. Was it because buyers saw Fannie and Freddie as being sort-of governmental and therefore having the backing of the US Treasury? Sadly yes. And this is where the debt problem with China started.

It has to be noted it says quite clearly on the actual physical piece of paper that the bond does NOT have the full faith and credit of the US government. However, because F and F did seem awfully like they were governmental, they did manage to sell securities at a good rate.

And this rate, that F&F pay on their debt, is what largely determines the rate commercial banks get charged for the money they borrow and that determines in turn what they charge people for their mortgages.

So you can imagine if F&F stopped buying up and selling-on, the rates commercial banks had to pay for their borrowing, and what they therefore charged on the mortgages they offered to customers, would all go UP.

So now we come to the crunch – credit crunch that is. The Chinese, holders of near on $800B of the F&F paper, suddenly think, `if the value of the mortgages underlying all this paper we have bought from F&F is rotting away ( or worse was never really there in the first place because someone in the chain LIED) then we are STUFFED!´ So they let it be known that Fannie and Freddie paper HAD BETTER HAVE the backing of the US government or there would be a shit storm.

Rumblings of this were heard in public and phone calls to Poulson are rumoured to have contained the full unedited version.

The result was PRESTO, the FED buys all F&F paper, the Treasury funds the FED, and the paper the Chinese had bought now appears to have almost full faith and credit backing. At the US taxpayer gargantuan expense.

That goes on for a year. And here we are.

What happens when on April 1st when the FED stops buying?

Fannie and Freddie are not guaranteed. They also have no money – only debts Beelzebub would flinch at. Without the Fed buying, who are banks going to sell on their mortgage securities to? And more importantly – crucially, in fact, AT WHAT RATE?

The rate on MBS paper has already gone up. Mortgage rates have gone up alongside. Without the FED buying, mortgage rates will inevitably start to creep up and if it goes up too far, that will cripple any idea of a housing recovery. How far is too far, I don´t know.

Any serious chance of getting to that point and the Fed has to start buying again. To do that the US either has to borrow more or print more (QE as we like to say). Either one, will add to sovereign debt and ratings woes.

All in all should be an interesting show.