Monday, December 28, 2009

A Banking Insider Reveals How the Fed Manipulates the Mortgage Game

Occasional EPJ commenter Michael J. Dunton, aka Mike in Alaska, is a community banker.

Bob Murphy asked him to put together a report from his insider perspective on what is going on in the mortgage industry. Here is his report:

Let me explain to the average reader what excess reserves mean in a context of a small community bank. Each day a young lady from my staff would come into my office and show me where we were at, in cash (paper and electronic), from the day’s course of business. I always had to know what time it was in the morning so as to be ready for her visit between 11:30 and Noon—I sometimes could be in a meeting in the building, or could be somewhere about town. If we needed cash, I would call up the Federal Home Loan Bank that we belonged to and borrow overnight funds—or I could borrow for 30, 60, 90, 12, 180, or 360 days if the rate was too good to pass up. We could even borrow on a term facility for up to 30 years, but going out that long on the yield curve, whether borrow or lending, is a bit dramatic for me. The same goes if we had excess cash: I could lend it out overnight, or buy a CD of varying maturities and rates.

That was then.

Fast forward to now and we get the situation where we haven’t had to borrow for daily liquidity for so long that I have forgotten the Federal Home Loan Bank’s phone number and our bank’s account number (don’t worry, I have it written down). We are swimming in excess cash. We see this as a result of several events: first, mortgage-backed securities we hold have been paying off at a faster speed due to the Federal Reserve’s purchase of MBS in the market; second, our loan demand is down—our loan balances are about 5% lower than normal; third, other bonds' yields are being dragged down and issuers are calling the higher yielding securities and reissuing new bonds at lower yields; lastly, our customers are holding higher cash balances. I now needn’t worry if I have to borrow for my daily liquidity on any given day for the foreseeable future—I just need to worry how to stay in business with $15 million stuck earning 0.25% and flat to decreasing loan demand for the next year.

Let’s explore why the Fed has been affecting excess reserves by way of buying up mortgage-backed securities. The Fed is trying to stimulate the economy, help homeowners, and buoy the banks by re-inflating the housing asset bubble. Most mortgages are rolled up into securities (MBS) and sold to investors. We’ve written, through November, $126 million in mortgages versus $58 million last year. We’ve only kept on our books about $28 million in mortgages. Most of our mortgages are sold to Fannie, who then rolls them into large pools of MBS. Regular banks (the big boys), in the past, have done the same thing as Fannie and Freddie and rolled their mortgages into private-label MBS. As I will discuss later, Fannie and Freddie pretty much control the mortgage landscape right now and other players are living off the crumbs.

Read the rest here.

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