Federal Reserve, mortgage-backed securities, MBS, mortgage rate, quantitative easing. We employ empirical pricing models for mortgage-backed security MBS yields and for mortgage rates to measure deviations from normal market functioning in order to assess how the Federal Reserve MBS purchase program--a 16 month program announced on November 25, and completed on March 31, affected risk premiums that were embedded in mortgage and swap markets. Our pricing models suggest that the announcement of the program, which signaled strong and credible government backing for mortgage markets in particular and for the financial system more generally, reduced mortgage rates by about 85 basis points between November 25 and December 31, , even though no MBS had yet been purchased by the Federal Reserve. Once the Federal Reserve s MBS program started purchasing MBS, we estimate that the abnormal risk premiums embedded mortgage rates decreased roughly 50 basis points. However, observed mortgage rates declined only slightly because of generally rising interest rates. After May 27, fairly normal pricing conditions existed in U.
Did the Federal Reserve s MBS Purchase Program Lower Mortgage Rates?
Federal Reserve, mortgage-backed securities, MBS, mortgage rate, quantitative easing. We employ empirical pricing models for mortgage-backed security MBS yields and for mortgage rates to measure deviations from normal market functioning in order to assess how the Federal Reserve MBS purchase program--a 16 month program announced on November 25, and completed on March 31, affected risk premiums that were embedded in mortgage and swap markets.
Our pricing models suggest that the announcement of the program, which signaled strong and credible government backing for mortgage markets in particular and for the financial system more generally, reduced mortgage rates by about 85 basis points between November 25 and December 31, , even though no MBS had yet been purchased by the Federal Reserve. Once the Federal Reserve s MBS program started purchasing MBS, we estimate that the abnormal risk premiums embedded mortgage rates decreased roughly 50 basis points.
However, observed mortgage rates declined only slightly because of generally rising interest rates. After May 27, fairly normal pricing conditions existed in U. After the end of the Federal Reserve s MBS purchase program on March 31, , mortgage rates and interest rates more generally were significantly less than they had been at the beginning.
In sum, we estimate that the Federal Reserve s MBS purchase program removed substantial risk premiums embedded in mortgage rates because of the financial crisis. The Federal Reserve also re-established a robust secondary mortgage market, which meant that the marginal mortgage borrower was funded by the capital markets and not directly by the banks during the financial crisis-had bank funding been the only source of funds, primary mortgage rates would have been much higher.
Lastly, many observers have attributed part of the Federal Reserve s effect from purchasing MBS to portfolio rebalancing. We find that if portfolio rebalancing had a substantial effect, it may have had its greatest importance only after the Federal Reserve s purchases ended, but while the Federal Reserve held a substantial portion of the stock of outstanding MBS.
There is, of course, a disparity between rates in mortgage secondary markets i. This paper is focused on the question: We use empirical pricing models for MBS yields in the secondary mortgage market and for mortgage rates paid by homeowners in the primary mortgage market to measure how distorted mortgage markets were prior to the Federal Reserve s intervention, and the course of market risk premiums during the restoration to normal market functioning.
We also use this measure to assess if either MBS yields or mortgage rates were significantly lower than would be expected; this measure may indicate if investors faced a shortage of longer-term non-Treasury financial assets. We argue that this return to normal pricing occurred because the Federal Reserve s announcement signaled a strong and credible government backing for mortgage markets in particular and for the financial system more generally. Moreover, the Federal Reserve s purchases were expected to have a "portfolio rebalance effect" derived from the withdrawal of relatively safe fixed-rate assets from investors portfolios and a reduction in the demand for interest rate swaps used to hedge interest rate risks on MBS portfolios.
However, the steep decline in mortgage rates after the end of the MBS purchase program may have been enhanced by the "stock effect" of the Federal Reserve s purchases. More specifically, we estimate that the Federal Reserve s MBS purchase program over the course of 16 months reestablished normal market pricing in the MBS market and resulted in lower mortgage rates of roughly to basis points for purchasing houses.
After this point, both mortgage rates and risk premiums remained relatively stable until the end of the Federal Reserve MBS purchase program. However, there was a substantial decline in interest rates during the months following the end of the purchase program, part of which might be attributed to the "stock effect" of the Federal Reserve s holdings.
The remainder of this paper is structured as follows: Section 2 provides a brief description of mortgage markets during the autumn of , when the Federal Reserve s MBS program was announced, through early , when the program was wound down. Section 3 provides a brief historical account of the intervention period that contains three distinct intervals-one associated with the announcement, another associated with uncertainty about the intent of government actions, and one that brought the return to normal market pricing conditions.
Section 4 presents our secondary market and primary market mortgage pricing models and our time-series estimates of the effects of the Federal Reserve s mortgage-backed securities program on mortgage rates. Section 5 provides the conclusion. When a homeowner finances a home with a year fixed-rate conforming mortgage, he she has the option to prepay his her mortgage.
This option is implicitly paid for by the homeowner with an upward adjustment in the mortgage rate. However, the provider of the mortgage has to estimate how much to increase the mortgage rate to cover the costs associated with this prepay option, and thereby has to estimate when the homeowner is likely to prepay the mortgage.
Suppose a mortgage is incorporated into an agency MBS. In the event that the homeowner prepays the mortgage, the cash payment is sent to the holders of the agency MBS on a pro-rata basis. Although the holders of the MBS are uncertain about when such a pre-payment will be received, the pre-payment is more likely when mortgage rates are lower. Investors adjust the stated yields on MBS for the homeowner s prepayment option when comparing yields across fixed-rate securities.
This "option-adjusted spread," or OAS, is the additional return from holding an MBS relative to a benchmark, such as a swap rate or a Treasury yield. OAS is usually derived from computer simulations that attempt to model the propensity of homeowners to prepay their mortgage when current mortgage rates are low compared with previous mortgage rates. Homeowners are more likely to refinance their mortgage in low rate environments, with the result that the investor receives cash at exactly the wrong time-just when reinvestment possibilities all provide low returns.
During , such OAS calculations became difficult and unreliable. With declining home values and fears about how high unemployment would affect both mortgage delinquencies and default, homeowners propensity to prepay became very difficult to model and predict. Without the ability to reliably estimate prepayment speeds, the duration of MBS holdings became difficult to predict. More specifically, duration is the change in the market value of MBS as interest rates change.
When interest rates become higher, the value of MBS declines because other bonds pay higher rates and because the effective maturity of the security extends in a relatively high rate environment because homeowners are less likely to prepay their mortgage. When interest rates become lower, the likelihood of prepayments by homeowners with fixed-rate mortgages rises, and the value of MBS will reflect refinancing and home sale decisions. During , the lack of homeowner refinancings of mortgages in response to low interest rates primarily due to rising refinancing costs, homeowners declining home equity, and homeowners deteriorating financial conditions repeatedly surprised MBS market participants and lengthened that is, raised their estimates of duration.
All things equal, during relatively high coupon MBS increased in value because of these rising estimates of duration, and newer and lower yielding MBS became viewed as much longer-lived assets and consequently more volatile financial instruments. The additional volatility in the market value of the new and lower yielding coupon MBS meant that hedging such instruments became more expensive and also less reliable. But during the autumn of , a period of severe financial market turmoil and a deep recession, private sector buyers of MBS were on the sidelines.
Moreover, the Federal Reserve s MBS purchases far outpaced net MBS issuance throughout the period of its purchase program because the refinancing of mortgages and new home sales remained relatively weak in spite of the low level of mortgage rates. In short order, the Federal Reserve became the dominant player in the secondary mortgage market. Up until the autumn of , the major players in the MBS market were the two housing-related GSEs Fannie Mae and Freddie Mac , depository institutions, foreign buyers including central banks and sovereign wealth funds , and money managers.
Among these players, the GSEs had typically operated with the lowest funding costs. Fannie Mae and Freddie Mac. At the same time, Treasury took three additional steps to complement FHFA s decision to place both enterprises in conservatorship. First, Treasury and FHFA established Preferred Stock Purchase Agreements-contractual agreements between the Treasury and the conserved entities-to ensure that each company would maintain a positive net worth.
Second, Treasury established a new secured lending credit facility that would be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, thereby implementing the temporary liquidity backstop authority that had been granted by Congress in the previous July. This backstop would be available until those authorities expired in December While the GSEs are expected to moderately increase the size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage affordability.
Depository Institutions. Banks and other depository institutions have tended to compare MBS yields to their own loan yields. During a recession, GSE MBS had traditionally been a "parking spot" for banks excess funding while they waited for clearer signals concerning loan demand. More specifically, when MBS yields rose relative to loan yields, and loan demand remained subdued, then banks stepped-up their MBS purchases.
But the recession that began in December was atypical. By autumn , some banks were facing capital constraints that limited their ability to increase their MBS purchases. Moreover, to enhance their capitalization, such banks had an incentive to sell their MBS holdings when OAS spreads were falling, in order to book capital gains and build their capital. Indeed, with bank capital in short supply, some banks found it appealing to purchase Ginnie Mae securities with a zero risk-weight in regulatory capital calculations , rather than Fannie Mae or Freddie Mac securities with a 20 percent risk-weight in regulatory capital calculations.
Foreign Buyers. Foreign buyers, including central banks and sovereign wealth funds, greatly curtailed or ceased their purchases of GSE MBS in the months leading up to the establishment of the GSE conservatorships in September Afterwards, in the face of persistent dollar accumulations, they occasionally entered the MBS market, but persistent uncertainty about the future of Fannie Mae and Freddie Mac put these foreign institutions "on-hold," and they generally limited any increases in their U.
Treasury securities. Money Managers. The money managers who participate in bond markets on behalf of themselves and others usually compare the relative return on holding GSE MBS to holding other forms of fixed-income securities. Because of the sheer magnitude of its MBS purchase program, there is no doubt that the Federal Reserve became the predominant purchaser of MBS during its purchase program.
When a bank or other type of entity originates a mortgage that is eligible for GSE securitization, it must decide whether to 1 bear the credit risk of the mortgage itself i. In essence, the bank compares its own marginal cost of funds to that of the marginal cost of funds for the marginal secondary market purchaser of GSE MBS. Consequently, to actually influence the primary conforming mortgage rate, a GSE MBS purchaser must change the economic calculations associated with the mortgage originator s two decisions described above.
Department of the Treasury were passive, that is, the MBS were purchased at prevailing market prices. Such purchases removed supply from the secondary market, with the hope of causing banks and other private market purchasers of MBS to bid more aggressively for the remaining MBS in the marketplace. Thus, Federal Reserve MBS purchases in the secondary market would influence primary mortgage rates only to the extent that 1 the secondary market itself was providing the marginal funding of primary mortgages and 2 the lower yields on current coupon MBS were effectively determining the primary mortgage rate.
With regard to the first condition, the secondary market was indeed the likely source of marginal funding during the recent financial crisis. During that period, the spread between the mortgage rate and Treasury rate increased substantially, in part because large bank originators were exercising increased caution. Originators were facing greater uncertainty with regard to holding the mortgages they originated.
The interest rate risks associated with the mortgages was very uncertain in this unusual environment, with very low prepayments expected if mortgage rates increased and very high prepayments expected if mortgage rates fell. Finally, the cost of capital was very high for mortgage originators. For all these reasons, capital-starved mortgage originators likely had very high marginal costs if they decided to hold their newly originated mortgages in their own portfolios.
Against this backdrop, failure had become epidemic among mortgage originators. During for example, more than mortgage companies failed. And during , three of the top eight mortgage lenders-Countrywide, Washington Mutual, and Wachovia-were acquired by their rivals. To sum up, capital was fleeing the traditional bank business of originating and holding mortgages, so a functioning government-backed secondary mortgage market was instrumental for financing mortgages during the financial crisis that began in With regard to the second condition, the Federal Reserve s strategy of creating a shortage of "current coupon MBS" and thereby promoting housing market activity by lowering mortgage rates was expected to be difficult to achieve for at least three reasons: Such borrowers would continue to find it difficult to refinance their mortgages and thus they might not benefit from lower mortgage rates.
Second, as mortgage rates decline, mortgage refinancings by households usually increase. But such a refinancing wave could result in many "high coupon" agency MBS being prepaid and refinanced into "current coupon" MBS. Analogously, mortgage originations would likely increase with lower mortgage rates, and thereby create additional MBS supply. Such an origination cycle might have created a need for the Federal Reserve to purchase an ever larger quantity of MBS just to hold MBS spreads constant.
In practice, neither the refinancing wave nor the origination cycle became a significant source of mortgage supply during the recent financial crisis because of rising unemployment and falling house prices. Ex ante , the elasticity of this potential substitution across different coupons was unknown. For all these reasons, the Federal Reserve s MBS purchases would likely need to be very big relative to the size of the secondary market in order to measurably lower the primary mortgage rate.
Moreover, it might be difficult using the tools that were available to the Federal Reserve to influence the banking system s marginal cost of lending to conforming mortgage borrowers. The large-scale GSE MBS purchase program was an integral component of the "credit easing" by the Federal Reserve, which focused on using the asset side of the central bank s balance sheet to eliminate illiquidity and abnormally high credit spreads in financial markets.
Ginnie Mae securities, with explicit full faith and credit government guarantees, were generally not the focus of Federal Reserve MBS purchases.
Did the Federal Reserve s MBS Purchase Program Lower Mortgage Rates?
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