The Fed's Balance Sheet Could Just Vanish

 | Sep 27, 2013 | 9:00 AM EDT
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I've written extensively over the past few years about the issues facing the banks, especially the money centers -- JPMorgan Chase (JPM), CitiBank (C ), Bank of America (BAC), and Wells Fargo (WFC) -- the housing industry and its related components, and the economy overall, concerning the problem of non-performing residential mortgages.

Since home values and sales have been rising over the past year, allowing banks to begin to reduce the size of the problem, we can begin to project, if housing prices and sales remain stable, how long the process of resolving the non-performing issues will take.

The total value of non-performing residential mortgages that are carried by banks in the United States has declined from about $176 billion a year ago to about $149 billion at the end of the second quarter of this year and is currently running at about $13 billion quarterly. 

If that trend continues the carried value of non-performing mortgages by all banks will be reduced to a normal rolling carry of about 1% of bank carried mortgages, about $17 billion, over the next 10 quarters, about 2.5 years. That is a far more aggressive rate than I was expecting even just a year ago.

This is also the rate of resolution being evidenced currently by the money centers. 

And this does not account for the potential of this process to be accelerated by the FHFA's streamlined refinance initiative for defaulted mortgages I referenced in the column mentioned earlier. As this program is just beginning we won't have a good feel for how much of an impact it will have until probably the first quarter of next year.

More interestingly though is the potential impact of the FHFA's push to modify existing agency backed mortgages I discussed yesterday on the value of such mortgages that are being carried by the Federal Reserve

In the past year the Fed has acquired about $500 billion worth of agency mortgage backed securities as a part of their Large Scale Asset Purchase program announced in September 2012 and better known as quantitative easing 3 (QE3).

The total value of the agency mortgages being targeted by the FHFA for loan modifications is equal to the value of the agency backed mortgages the Federal Reserve has purchased in the past year, at about $500 billion. 

The FHFA's push to modify about two million agency (Fannie Mae/Freddie Mac) backed mortgages will have an impact on the Fed's holdings of mortgages and provide the opportunity for a stealthy reduction in the size of the Fed's balance sheet without the Fed having to announce any tapering of their mortgage purchases whatsoever.

The vast majority of these mortgages will have to be refinanced into a brand new loan as part of the FHFA's loan modification process as the companies currently servicing them do not offer loan modifications.

That also means that the agency mortgages currently being carried by the Federal Reserve will be prepaid when the mortgagors refinance and modify. The result of such action is that the value of the mortgages being carried by the Fed will run off, potentially reducing the size of the Fed's balance sheet and stealthily exiting quantitative easing without the Fed having to take any action whatsoever.

It is logical to assume that a large percentage of the Fed-held mortgages qualify for the FHFA program because these were the most illiquid agency mortgages remaining in the market when the Fed implemented QE3, and thus most probably are over-represented of the mortgages the banks sold to the Fed. 

Although the Fed agreed to purchase $40 billion of mortgages monthly as part of QE3 there was no mention of maintaining the value of those mortgages on their books. If the mortgagors refinance and the loans are called away from the Fed and prepaid in the process, so be it.  

The financial media has assumed that the Fed would either have to sell the mortgages at some point in order to exit QE or that the mortgages would be held to maturity, which would mean the Fed's balance sheet would remain inflated for a decade and probably longer.

It is possible that at some point within the next several months, if the FHFA is successful in their drive to get these loans modified, that the value of mortgages held by the Fed that are being called away, and reducing the size of the Fed's balance sheet as they are paid off through the refinance modification process, will exceed the value of the mortgages coming in to the Fed by way of QE3.

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