With much anticipation and fanfare, the Federal Reserve is finally on track to reduce its MBS holdings. Guidance from the September FOMC meeting reveals that the Fed will allow its MBS holdings to “run off,” reducing its position via prepayments as opposed to selling it off. What does this mean for the market? In the long-term, it means a large increase in net supply of Agency MBS and with it an increase in overall implied and realized volatility.
MBS: The Largest Net Source of Options in the Fixed-Income Market
First, some background on the U.S. MBS market. U.S. homeowners, by and large, finance home purchases using fixed-rate, 30-year mortgages. These fixed-rate mortgages amortize over time, allowing homeowners to pay principal and interest in even, monthly payments. Homeowners have the option to pay off their mortgages early for any reason, which they tend to do either when they move and sell the property (“turnover”) or when prevailing mortgage rates drop to the point where they are incentivized to refinance. Historically, between 6% and 10% of mortgages prepay each year due to turnover, with economic conditions and the state of the housing market accounting for the variance. In contrast, refinancing rates, which are mainly a function of the difference between the borrower’s existing mortgage rate and prevailing market rates, can reach 40% per annum under current lending conditions and crossed 60% per annum in the early 2000s for certain cohorts.
Put another way, homeowners are long the option to refinance, and MBS holders are short that same option. As rates drop and borrowers’ refinance options move into the money, refinancing activity on fixed-rate MBS picks up, which leads to higher prepayments overall and shorter average lives and durations. The opposite effect occurs in a rising rate environment. The homeowner’s option to refinance puts MBS holders in a negatively convex position, i.e., one whose value underperforms comparable rate products as rates fluctuate. Consequently, MBS holders benefit from low volatility—they are “short vega.”
Some MBS holders hedge volatility risk explicitly by buying shorter- and longer-dated options—instruments that are long vega. Others, such as long-only funds with a duration target, hedge dynamically by buying or selling assets as the rates market gyrates. One way or another, the short-volatility risk from MBS will be transmitted into the larger fixed-income market, thus making the broader rates market short vega on net.
While not all investors hedge their short-volatility position, the aggregate market tends to hedge a similar amount of the short-options position over time. This changed when the Fed entered the market and promptly became the largest buyer of MBS. Beginning in 2009, the Fed purchased progressively more MBS, and by the end of 2014 it owned just under 30% of the entire Agency MBS market, shrinking the effective size of the non-Fed-owned MBS market. Because the Fed doesn’t hedge its position in either rates or convexity, the effective size of the market’s short volatility position dropped by a similar proportion. 1
The Fed’s Balance Sheet
As of late September 2017, the Federal Reserve owned $1.77 trillion in Agency MBS, or just under 30% of the outstanding Agency MBS market. The Fed publishes its holdings weekly on the New York Fed’s website. The chart below summarizes the Fed’s 30yr MBS holdings, which make up roughly 90% of the Fed’s MBS holdings.2
Runoff from the Fed
Following its September meeting, the Fed announced it will reduce its balance sheet by not reinvesting runoff from its Treasury and MBS portfolio. If the Fed sticks to its plan, monthly runoff from MBS will reach $20B by 2018 Q1.
All else equal, this runoff from the Fed will now need to be absorbed by the private, non-Fed market, which has traditionally hedged the convexity of MBS through a combination of delta hedging and option strategies.
Given the expected runoff rate of the Fed’s portfolio, we can now estimate the vega exposure of new mortgages entering the wider (non-Fed-held) market. When fully implemented, we estimate that $20B in new MBS represents roughly $34 million in vega hitting the market each month. To put it in perspective, that is roughly the vega equivalent of $23 billion notional 3yr->5yr at-the-money swaption straddles hitting the market each and every month.
While the Fed isn’t selling its MBS holdings, portfolio runoff will have a significant impact on rates volatility. Runoff implies significant net issuance outside the Fed. It’s reasonable to expect increased demand for options hedging, as well as increased delta hedging activity, which should drive both implied and realized vol higher over time. This change will manifest itself slowly as monthly prepayments gradually shrink the Fed’s position. But the reintroduction of negative vega into the wider market represents a change in paradigm which may lead to a more volatile rates market over time.
 This is not entirely accurate. The short-vol position in a mortgage passthrough is also a function of its note rate (GWAC) with respect to the prevailing market rate, and the mortgage market has a distribution of note rates. But the statement is broadly true.
 The remaining Fed holdings are primarily 15yr MBS passthroughs.