What the Future Holds After Fed MBS Purchases End

Other than how to deal with the AIG backlash, the largest conundrum facing the Fed is how and when to pull back on its massively expansive monetary stimulus. Certainly Bernanke maintains that he will know what to do and when to do it. You know, just like he saw the housing bubble from a mile away and prevented the whole thing from happening. Right. Moving along, the Fed made it relatively clear in its announcement on interest rate policy yesterday, that it would be ending its massive Agency and MBS purchases as originally scheduled. So that's been settled. Hope everybody's ready.

Most folks are anticipating an increase in mortgage interest rates when the Fed's purchase program is over. With the Fed purchasing roughly 80% of all GSE issuance from last year, it seems the most logical conclusion. However, the WSJ did manage to find that the ranks of "mortgage bulls" are growing. These folks argue that investors who are "reaching for yield" in this great new bull market of ours will step in to purchase MBS because it is a lower risk investment than other corporates that are not explicitly backed by the US government. We saw how well that "reaching for yield" argument worked in early 2007 too, when bubble investors were trying to convince themselves to continue to purchase all sorts of crap at ridiculous prices.

So who are these fools that are about to dive into the market when the largest and currently only buyer is about to step out? Sadly, it might be your pension fund. A very interesting, yet widely ignored, article in the WSJ yesterday mentioned that pension funds were considering leveraged fixed income investments as a way to make up for all the money they have lost in the credit crisis. The pension managers were really unhappy about the fact that they had piled into stocks in the late 90's, only to get smoked. Then they followed that shrewd move by piling into private equity and hedge funds in the '00's, then got smoked. So now they are going to make up for all of it by using that low-risk strategy of purchasing high- rated fixed income products and levering up to juice returns. Because leveraged fixed income investing never blows up in your face, particularly when you dive in when rates are at historical lows and the Fed is considering pulling back on its easy monetary policy. I mean look at how well Orange County did with this strategy in 1994, and Long Term Capital in 1998. It's bound to be a big winner.

Naturally, this idea is the brainchild of pension consultants who are just looking for more and better ways to blow-out pensions so they continue to lose money so they need to hire more consultants. Because frankly, I can't think of a single reason why anyone would advise this strategy right now. Furthermore, if you wanted to give a pension fund some good advice on how to meet its 8% a year earnings target, you could've told them to pile into fixed income, without any leverage, in 2008-2009 when high quality corporates were yielding double digits. But most consultants were probably too busy cowering in the corner while their customers were yelling at them because they couldn't get their money out of that hedge fund the consultant had recommended. Not to mention the private equity fund. Or the money market fund. Oh yeah, and why the hell were their stocks all trading back at 1997 levels?