Following the financial crisis of 2008/2009, the Federal Reserve orchestrated an ambitious stimulus program of buying enormous amounts of U.S. government debt and mortgage securities. Over the past eight years, these efforts ballooned the balance sheet of the Federal Reserve to over $4.5 trillion, compiled of both Treasuries and MBS (Mortgage Backed Securities). Essentially, the idea was to take large amounts of debt out of market circulation in order to drive bond prices higher and yields lower. The outcome of this strategy led to historically low bond rates and mortgage rates, while subsidizing the housing market simultaneously.

This past month, several Fed officials raised the topic of alleviating the large amounts of mortgage debt on the Fed’s balance sheet. The accumulation of debt by the Fed has basically provided a temporary fix to the financial crisis. Now the Fed has reached the point to start unwinding its gigantic portfolio of both Treasuries and mortgage bonds.

The challenge for the Fed will be how it will gingerly extract the billions of dollars of MBS bonds from its balance sheet. Currently, the Fed constitutes the single biggest source of demand for U.S. government backed mortgage debt, while also owning roughly a third of the entire mortgage bond market. The Fed’s accumulation of MBS bonds did enable the housing market to maintain stability even during an eight-year period of almost zero wage growth.

Unwinding the Fed’s mortgage bond holdings will be difficult because the Fed will need to find buyers for its $1.75 trillion of MBS bonds. Without any new buyers, selling bonds could drive yields up fast. The Fed’s encroachment into the MBS market reduced volume by more than 40 percent since 2008, creating possible liquidity issues as well.

Many bond traders expect that as MBS bonds start to flow off the Fed’s balance sheet, it will allow private buyers such as mutual funds and pension funds to essentially take over the buying from the Fed. The hope is that in conjunction with alleviation of certain Dodd-Frank rules that limit trading by banks and financial institutions in government securities, these two dynamics may encourage new market participants to become buyers of what the Fed is selling.


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