Federal Reserve building (Photo: iStock) (Photo: iStock)

The Federal Reserve’s wind down of its balance sheet has been handled without too much trouble by the mortgage sector to date — but now comes the deluge.

As the Fed terminates the mortgage-backed security purchase program started a decade ago, the end to its buying should cause MBS supply from the central bank’s wind down to jump about 50% in the second half of this year compared to the first six months.

Private investors will need to take down about $90 billion from July through December, according to Walter Schmidt, the head of FTN Financial’s MBS strategist team.

(Related: Lincoln Adds Indexed Variable Annuity)

The Fed has so far reduced its vast MBS holdings to $1.709 trillion, the lowest since 2014. It’s widely forecast that by October the central bank will no longer reinvest any proceeds back into mortgages, and that should widen spreads.

“We have seen year-to-date widening of 15 to 20 basis points on production coupon Treasury spreads and expect another 5 to 10 basis points by year-end,” according to Ankur Mehta, the head of MBS research at Citigroup Inc.

The coming end to the Fed’s MBS purchases, used in the recent past to keep its holdings steady, will release about $150 billion into the market for this year in total. That is a material amount considering forecasts put aggregate net supply this year from normal sources, such as borrowers taking out home mortgages, at around $300 billion.

When the Fed’s balance sheet wind down is combined with that organic supply, the second half of the year may see as much as $270 billion compared with the net total of $170 billion in the first two quarters of 2018, Mehta said.

Helped in part by very low volatility, mortgage spreads haven’t widened too much despite the coming end of the Fed program, but next year may see as much as $195 billion flood the market.

“It’s a pretty large amount of supply for the private sector to have to absorb,” said Matt Jozoff, head of JPMorgan’s securitized products, rates and municipal research. The spread widening year-to-date puts mortgages at a historically attractive levels, he said.

Still, some investors may wish to position their portfolios defensively for yet more weakness.

“To the extent that there is widening pressure on the basis that argues for being in shorter spread duration product, and we also like going up-in-coupon for the hedged-adjusted carry,” he said.

The wind down has been well-telegraphed by the central bank, helping to dampen spread widening and hence any negative effect on mortgage rates for borrowers, despite the massive size of its holdings.

“The Fed built its portfolio during a time of crisis, they essentially were making it up as they went along. The unwind of the balance sheet, they hope, will be as exciting as watching paint dry,” Schmidt said.

Editor’s Note: Why This Matters to Agents

Life policies and annuities are, in effect, burrito wrappers for life insurance companies’ investments.

U.S. life insurers had about 11% of their own, “general account” assets invested in mortgage-backed securities in 2016, according to data from the American Council of Life Insurers’ ACLI 2017 Life Insurers Fact Book.

Life insurers invest about 48% of their assets in corporate bonds. The share of their assets invested in mortgage-backed securities is roughly comparable to the share of their assets invested in government bonds and in mortgage loans made directly to the borrowers.

Holders of variable annuities, variable life policies and other arrangements backed by separate accounts had invested about 4.3% of the separate account assets in mortgage-backed securities.

For separate account holders, mortgage-backed securities rank third in terms of share of assets, behind stocks, with a 77% share, and corporate bonds, with a 15% share.

— Read What Could Slug Life and Annuity Investment Managers Next: KKR Analystson ThinkAdvisor.

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