Now that the U.S. Federal Reserve has nearly finished its massive mortgage bond buying spree, its huge portfolio could be used to tighten credit if and when the economy begins to show real signs of recovery.

After plowing billions per week into the $5 trillion market for mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae since early 2009, the Fed ceases its $1.25 trillion agency MBS purchase program at the end of March.

As overseer of the largest mortgage bond portfolio in the world, the central bank itself has indicated it wants to steer clear of selling agency MBS outright, at least for now.

Selling agency MBS could be a useful tool, but it would also be outright reckless, said Christopher Sebald, chief investment officer at Advantus Capital Management in St. Paul, Minnesota.

Unloading its holdings would pressure the sector considerably and de-value the rest of its agency MBS holdings. By sending yields higher, it would negate the purpose of the purchase program, which was to bring down mortgage rates and to stimulate the battered housing sector and the overall economy.

Analysts say the Fed will likely initiate passive and active strategies to maneuver its balance sheet and may not sell MBS holdings until 2011, at the earliest.

The Fed is seen holding onto its agency MBS portfolio, letting the bonds mature and pay down over time. The bonds, meanwhile, could be exchanged with big U.S. banks for an interim period as a way to pull cash out of the economy.

REPOS AND ROLLS

Most experts believe the Fed will begin to drain liquidity from the financial system in the second half of the year.

Mukul Chhabra, vice president in the mortgage strategy group at Credit Suisse in New York, said the Fed could initially drain reserves through reverse repos.

In this transaction, the Fed would take cash from the dealer community in exchange for its agency MBS holdings. The Fed later buys back the bonds at a specified time, typically one month later.

Dealer balance sheet constraints, however, may limit the total size of such a program to about $100 billion, which is small compared to what it has in reserves, Chhabra said.

The Fed could also initiate a similar transaction in dollar rolls. The Fed would deliver securities to a dealer and agree to repurchase similar securities on a future date at a predetermined price, but unlike a reverse repo, the dealer is not obligated to return the identical securities to the Fed.

Dollar rolls have a direct impact on agency MBS valuations. When rolls trade poorly, agency MBS tend to cheapen. In fact, one reason agency MBS have performed so well over the past year has been due to the strength in dollar rolls.

Chhabra said the Fed could sell dollar rolls to banks with the dealers as intermediaries. This would not use dealer balance sheets, and banks buying dollar rolls should not face significant accounting/regulatory constraints with respect to their own balance sheets.

The dealers could distribute the Fed dollar roll sales of $200 to $300 billion based on an estimated $1 trillion market size currently, he said.

The dollar roll market is also not new to the Fed. In fact, the Fed has been involved in the dollar roll market throughout much of 2009 and 2010, not for monetary policy reasons, but more likely as an attempt to support the market.

To be sure, the dollar roll market is huge and would be a good tool for the Fed, Matthew Jozoff, managing director and head of mortgage strategy at JPMorgan in New York, said in the firm's 2010 outlook.

The Fed has ample room in the dollar roll market to maneuver given the size of that market, he said.

FED RETURN UNLIKELY

The lowest mortgage rates in decades and high affordability helped the hard-hit housing market find some footing last year after a three-year slump, but the sector remains highly vulnerable to setbacks and heavily reliant on government intervention.

Recent data on new and existing home sales point to a sector that is still struggling. If mortgage rates jump significantly after the agency MBS purchase program ends, the Fed could re-enter the market, but its imminent exit is probably permanent.

While there are extreme cases in which the Fed could grow the program again, we find that scenario unlikely, Jozoff said.

Some Fed officials have said they want an eventual return to holding U.S. Treasuries as the primary asset.

Prior to 2009, the Federal Reserve had never purchased agency MBS, so its presence in this market has been significant. Commercial banks own about 21 percent of the market. Money managers, insurance companies and indexed pension funds own around 18 percent, while government-sponsored enterprises own about 15 percent.

Brett Rose, head of agency MBS strategy at Citigroup in New York, said the Fed could reinvest paydowns back into the agency MBS market, but does not believe that will happen.

When it comes down to it, the agency MBS market does not need another trillion dollar buyer, he said.

While the Fed has been a substantial market player, it has cut weekly purchases down substantially in recent months. Other investors, particularly banks, will probably step in to fill the demand for mortgages.

Credit Suisse's Chhabra said the Fed will probably eventually seek to sell some of its holdings down the road.

That is a possibility, but definitely not this year, perhaps next year, at the earliest, he said.

(Editing by Andrew Hay)

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