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What QE2 Could Mean for the Bond Market

Kathryn Young

Kathryn Young: Hi. I'm Kathryn Young, a mutual fund analyst with Morningstar. I'm joined by Steve Walsh. Steve is the Chief Investment Officer of Western Asset and part of the team that won Morningstar's Fixed Income Manager of the Year in 2004.

Steve, thanks so much for being here.

Steve Walsh: You're welcome. Good to be here.

Young: So let's start with a couple of big ticket news items. We've heard a lot of speculation recently about a possible second round of quantitative easing. Can you tell us what you are expecting from the Fed's upcoming meeting?

Walsh: Sure. The Fed's been pretty consistent in trying to telegraph the idea that they're going to come with a quantitative easing program. So it certainly seems from our perspective that they will initiate with their November meeting some sort of quantitative easing program designed to try to stimulate the economy.

The big questions that seem to surround this issue are how large it will be and how it'll be implemented. Initially about a month ago, there was a lot of conversation that they might take a shock and awe  approach to announce something on the range of $1 trillion or $1.5 trillion worth of purchases of Treasury securities over the course of the next year. We believe that is a lot less likely and that they will have a more modest program that will kind of be a buy as you go sort of program, where they'll announce some measure of either $100 billion a month or $500 billion the next X months allowing them the flexibility, depending upon how economic statistics come in. So we believe a program of purchases of Treasury securities will be forthcoming in the November meeting. It will be more modest than people had initially estimated in that it will kind of be a program that will evolve as the economy evolves and gives the Fed the flexibility to adapt the program to changing circumstances.

Young: Do you think there will be a big impact on the bond market or is a lot already priced in?

Walsh: Well, that's a big question that weighs over investors today. Our sense, given a more modest program that we would expect, is that it's largely priced into the marketplace today. Again, you could have a 10 or 20 basis points swing in 10-year notes, but a more modest program we would believe is pretty much priced into the marketplace.

Young: Okay. I think another issue near and dear to you is the issue of foreclosures. We've seen a lot about that in the news recently. Many states are halting foreclosures for the near term and also we've seen some issues about Bank of America in their servicing. Can you tell us a little bit about what's behind all of those issues and what do you think the impact might be on non-agency mortgages?

Walsh: Sure. There is kind of two separate issues. One is the more recent one that's come out about robo-signings, is the fact that many foreclosures were notarized and signed en mass rather than maybe the due diligence in specific detail of going through each file. We actually believe that's a more procedural issue and will not be that big of a deal over long periods of time. It will slow up the foreclosure process, but it already is very, very slow. So it's not a meaningful issue as far as we are concerned. Got a lot of headlines in this political season, but in terms of foreclosure and the robo-signing issue that's been brought up. We think that's a less of an issue.

The more important issue I think for banks, certainly, is the ability for investors to put back to the banking institutions faulty mortgages or the poor servicing. We've certainly joined a bondholder group that is trying to encourage Bank of America to do a better job with regards to their servicing and asking the trustee to do their due diligence and making sure the servicer does efficiently and effectively process on mortgages.

That has the potential to be a bigger deal, because ultimately you could actually put back mortgages that were faulty in their paperwork to the institution causing the banks to buy these securities at par. But, again, I have to be honest, we're a little surprised that how meaningful the market has treated that over the last couple of days. It's been an issue that's been in the equity markets, and investors have thought about a lot over the course of last four or five quarters, and most banks have addressed that issue at each of their quarterly earnings. So we're a little surprised at how significant that appears to be over the course of the last few days.

It's going to be a long, drawn-out issue. It doesn't really impact agency mortgage securities whatsoever. It really has to do with non-agency mortgages and, again, our initial thought today is that it probably is a little bit overblown by the marketplace.