Some Thoughts On Surcharges, Caps and Liquidiy

February 29th, 2008 9:42 am | by John Jansen |

 The MBS market is still a shambles and illiquidity reigns. For many years prior to the onset of this crisis last year bid to offer spreads on pass through paper had tightened significantly and it was easy for large institutional players to shift around billion dollar blocks of TBA paper without paying much freight in the way of dealer spread. That is not the case and many who had grown accustomed to paying 1/32 for liquidity are now perplexed and troubled by the 3/32 or 4/32 which dealers tack on now for block transactions.

I had a long conversation with a friend and former customer who commented on the lifting of the portfolio caps as well as the demise of the capital surcharge which OFHEO had imposed. Regarding the portfolio caps this portfolio manger thought that the immediate impact would be mitigated by the credit conditions in the housing market which presage further losses.So the best guess is that the agencies would be selective buyers until they get some sense that there is indeed light at the end of the tunnel. ( I think Genral Westmoreland uttered that phrase regarding the Vietnam War sometime in 1967 or 1968. It did not turn out as he expected.) The more important aspect of the removal of the portfolio caps is that it allows the agencies to function in a sense as a lender of last resort. If there is an institution stuck in some dire margin call liquidity vise,the agencies now have the capacity to buy paper on the cheap if they deem such purchases economically purposeful.

The removal of the capital surcharge performs a similar function as it allows the agencies to gurantee loans. As I understand the mechanics of this the gurantee obligation is a liability and as spreads widen the value of the liability jumps. Lacking capital the agencies would be reluctant to place their imprimatur on too much paper as a significant spread widening would whack their sccarce capital. The action to remove the surcharge allows them to continue to  gurantee paper which will serve to keep the pipeline from unduly clogging. It will allow the securitization of paper and will help banks to keep this stuff off their balance sheet and place it in the hands of end user investors.

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