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What exactly is quantitative easing? Part 5

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Nov. 20 2020, Updated 1:12 p.m. ET

Back to part 4

Mark-to-market issues

The Fed does actually have a profit and loss statement and it is a line item on the Federal Budget. Since quantitative easing began, the Fed has profited from this activity as it has pushed up prices through its own buying. As it stops purchasing MBS and Treasuries, it should experience the same sort of losses that the mortgage REITs have experienced. There is still a large contingent of U.S. voters that are mad about the banking bailouts and might have even less patience with the Fed if it starts losing money.

Implications for the mortgage REITs

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Mortage REITs have benefited from quantitative easing as the Fed has pushed up the value of their assets. Now that people are speculating the Fed is beginning to withdraw is excessive accommodation, mortgage backed securities have sold off, which is causing mark-to-market losses for the mortgage REITs. The most vulnerable REITs are REITs like Annaly (NLY) and American Capital (AGNC) who have large portfolios of 30 year fixed rate mortgage backed securities. Mortgage REITs that invest primarily in adjustable-rate securities (ARMs) like MFA Financial (MFA) and Hatteras (HTS) are less sensitive to the Fed’s moves.

As the Fed withdraws quantitative easing, the yield curve will steepen as the short end of the curve is still being held down by the Fed. The Fed has given a target for when it will start increasing rates (6.5% unemployment and 2.5% inflation). This means that once long-term rates find their level, the profit margin for REITs will increase. Borrowing rates will still remain low, and if mortgage backed securities yield an extra 50 basis points or so, then their net interest margins will increase and their dividends should increase. However, until long-term rates find their level, mark-to-market pain will define life for the mortgage REITs

Implications for the homebuilders

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The Fed’s quantitative easing program has helped homebuilders like Lennar (LEN) and KB Homes (KBH) by keeping mortgage rates low, which influences affordability. As rates rise, homes become less affordable and renting becomes more attractive, although the rent-vs buy decision is still heavily skewed towards buying. Quantitative easing helps people with assets the most, which means the luxury end of the homebuilding sector benefits the most. A builder like Toll Brothers (TOL) which focuses exclusively on the luxury end of the market will benefit more than someone who focuses primarily on the first-time homebuyer.

Finally, quantitative easing has helped the homebuilders by providing them with extremely low rates to issue debt. This gives them a source of long-term capital at very attractive rates. For example, last fall Toll Brothers (TOL) issued a 20 year convertible bond with a coupon of 50 basis points, with the right to convert into stock at a 50% premium to the then-current stock price. In any other interest rate environment, such terms would be unheard-of.

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