Stealth QE3 Is Upon Us, How Ben Did It, And What It Means

Like most market observers and participants, the buildup to this afternoon’s Fed announcement was palpable.  With the release void of an explicit “QE3” or new bond buying program, the Street was left to deal with ramifications of holding Fed Funds rates down until mid-2013.

While, a new bond buying program was not explicitly announced, the implications will be in the form of a “stealth QE3”.  What do I mean?  This promise has caused (will cause) longer term rates to rally (prices up, yields down) and flatten versus the short end.  With the Fed holding billions of MBS securities from prior QE’s, we can expect these same mortgages to refinance.

The most common type of MBS purchased by the Fed was 30yr 5’s and 30yr 5.5’s.  A 30yr 5 is made up of loans with an average mortgage rate of 5.5%.  (~25bps goes to GSE guarantee fee and the other 25bps to servicing.)  So in terms of mortgage rates, we can say the average rate is somewhere around 5.75%.  Current 30yr conventional rates are roughly around 4.25% and will likely be lower given today’s rally.  Hence, these particular homeowners are at least 150bps in the money.  For a person with a $300k mortgage, their payment would drop from $1,750 per month to about $1,475. This is more than enough incentive to prepay and refinance.

To the naysayers who think people cannot refinance:  The Fed bought new issue MBS (via TBA) in 2009 and 2010.  These were all people who met the more stringent underwriting guidelines.

A surge of refinancing will reduce the size of the Fed’s MBS holdings and allow them to re-invest the proceeds further out the curve.   A note by TD today indicates that there is ~$130bil of UST’s maturing between now and the end of 2012.  Coupled with a potential buoyant refinancing wave, the amount of UST’s reinvested at the long end of the curve could be substantial.  Not the explicit “Operation Twist” that many expected, but essentially the same thing – just in stealth mode!