What Will The Fed Do With $1 Trillon Worth Of Bad Assets?

While the Fed and Washington are boasting of the economic recovery underway, some analysts point out that the recovery is the result of an unprecedented level of government intervention that ultimately has resulted in the Fed acquiring more than $1 trillion worth of bad mortgage securities. With its bloated balance sheet, the Fed is in a difficult position to try and figure out a realistic strategy for unloading these toxic assets without undermining the delicate economic recovery. See the following post from Expected Returns.

While talks of an economic recovery reach a deafening crescendo, questions still abound about the sustainability of a recovery driven by unheard of government intervention. The Fed has become the buyer of last resort for toxic waste that had no place on the balance sheet of private institutions. To think that the market can absorb these toxic securities is dubious at best. From the WSJ, Fed to Discuss Mortgage-Bond Sales:

The Federal Reserve has acquired more than $1 trillion worth of mortgage-backed securities in the past 15 months. At their policy meeting in the coming week, Fed officials will try to decide how and when to get rid of them without jarring financial markets and the nascent economic recovery.

The Fed's thinking on interest rates is straightforward. The recovery has gained traction but hasn't been vigorous or long lasting enough to warrant raising them soon; after its Tuesday and Wednesday meeting it is likely to repeat its signal that rates will stay low for an "extended period."

The more challenging issue will be agreeing on a long-term plan to shrink a balance sheet bloated to $2.38 trillion—more than double precrisis levels—according to Fed insiders.

Sales of mortgage-backed securities aren't likely soon. It is also possible that the Fed won't signal its intentions on the matter in its post-meeting statement Wednesday. But markets are on edge because its mortgage bonds holdings are so large. At $1.1 trillion in holdings of mortgage debt guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae, the Fed owns roughly a fifth of all these outstanding instruments.

Based on the preceding chart, it's obvious the Fed's focus has been on housing. While sales have perked up leading into homebuyer tax-credit expiration, keep in mind that we are making comparisons based on historically low levels. Celebrating a tax-credit induced rise in housing sales is like a student celebrating going from an F to a D, but only after cheating from his buddy. You cannot analyze complex markets statically without taking into account the variables that generate data points.

The Fed's Dilemna

"If they sell the assets, it is clearly going to have a pretty big impact on the long end of the bond market, depending on how they do it, when they do it, and the speed at which they do it," said David Zervos, bond market strategist with Jefferies & Co.

Even if they reach a consensus, many officials want to stay flexible to avoid locking themselves into a course they might need to change later. "It seems to me neither necessary nor advisable to decide upon a single game plan that will be announced in advance and rigidly implemented," said Daniel Tarullo, a Fed governor, earlier this month.

Fed staff in the coming week will present models to forecast how different approaches to reducing the portfolio might play in markets. But some officials worry that they have little experience selling assets and can't rely exclusively on models to predict how markets will react. That—and a worry about disturbing the vulnerable housing market—has top officials inclined to proceed gradually and cautiously, at a predictable pace.

I can tell you right now that the Fed's models will end up being way too optimistic. Remember the models that took skewed historical housing data (because of Mr. Greenspan and negative real interest rates) and predicted never-ending rising home prices? If your inputs are out of wack, your outputs won't come out clean.

The most realistic scenario is for housing to stagnate as mortgage originations dry up. While this won't result in an utter collapse in housing, it does suggest further declines lie ahead. Investors should tread cautiously; markets are currently trading based on a strangely familiar speculative fever.

This post has been republished from Moses Kim's blog, Expected Returns.