Permanent Open Market Operations. POMO.
That’s government-speak for the Fed buying gobs of Treasuries and Agency Mortgage-Backed Securities (MBS).
I’ve used this tiny podium in a handful of older posts to present my opinion of the grand experiment known as POMO. Repeat readers will recall that my pet peeves generally fall into two main categories of fully-intended (but oft-denied) consequences: 1) Financial Repression – punish savers until they move into risk assets, and 2) Market Distortion – levitate the stock market to create a wealth effect and consumer confidence. As to point #1, it’s self-explanatory and not worthy of much deeper analysis. As for #2, I’ll let the following graph do the talking. The orange line is the S&P 500 while the white line is POMO. (Click on chart to enlarge)
Today, however, I’m adding #3. Witness the mREIT. An mREIT is a mortgage-based Real Estate Investment Trust. In simple terms, they borrow money at low rates (usually via repo) and invest the borrowings in higher yielding long-term mortgage securities and profiting from the spread. mREITS come in two flavors: Agency mREITS and non-Agency mREITS.
The distinction is huge. We’ll circle back to it in a minute.
Monetary policy is holding down the cost of short-term borrowing at nearly zero – an advantage in the borrowing costs for both Agency and non-Agency mREITS. With such cheap borrowing, mREITS have bloated the amount of mortgage assets on their books. The bloat allows huge dividend payments to mREIT investors – a cool drink of water in an otherwise yield-parched world. And the short-term kicker for Agency mREIT’s specifically was the amount of Agency MBS the Fed would be purchasing as part of POMO. To provide some perspective, they will be buying $26 billion this month. These purchases increase the value of MBS which, in turn, resulted in increases in the stock price of Agency mREIT’s.
What more could a yield seeking investor want? Big dividends, rising share price, and an implicit government guarantee on the underlying investment.
Then came the AGNC earnings report. AGNC is a large Agency mREIT. During the first quarter, AGNC had a huge earnings miss driven by two factors; both of which are related to Fed activity and POMO. First, the high-priced MBS on AGNC’s books (higher due to POMO buying) tumbled by $837 million ($2.21 per share) as the market began to anticipate an end to QE and POMO due to stronger economic reports. Second, spreads fell from 1.63% in 4Q2012 to 1.52% this quarter. Despite the market pricing down MBS, the constant buying by the Fed via POMO continued to compress the spreads. Viewed YOY, spreads declined from 2.31% in 1Q 2012 to 1.52% as mentioned above.
The impact of these dynamics was further expansion of financial repression. Investors needing yield who moved into Agency mREITS were delivered these returns for the day:
AGNC -7.3% (it was down 9% at its day low)
And this on a day when the S&P 500 closed up 1.05%
To paraphrase the most interesting man in the world, “I don’t always seek yield, but when I do it’s always hedged. Stay cautious my friends.” – LL