Fed MBS Program Update: 98.1% of Funding Used. Looming Exit Yet to Hurt Rates

By: • Fri, Mar 12 2010, 9:46 AM

The Federal Reserve reported on their weekly purchases of agency mortgage-backed securities (MBS).

In the week ending March 10, 2010, the Federal Reserve purchased a gross total of $29.4 billion agency MBS. In that week the Fed sold $19.4 billion mortgage-backeds (supported the roll), for a net total of $10.0 billion agency MBS purchases. While this amount is unchanged from the previous week, the broader trend of a decline in weekly purchases continues.

The goal of the Federal Reserve's agency MBS program is to provide support to mortgage and housing markets and to foster improved conditions in financial markets more generally. Only fixed-rate agency MBS securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae are eligible assets for the program. The program includes, but is not limited to, 30-year, 20-year and 15-year securities of these issuers. (N.Y. Fed MBS FAQs)

Since the inception of the program in January 2009, the Fed has spent $1.23 trillion in the agency MBS market, or 98.1 percent of the allocated $1.25 trillion, which is scheduled to run out at the end of this month. With three weeks left in the program, there is now only $24.1 billion in funds remaining.

Of the net $10.0 billion purchases made in the week ending March 10, 2010:

$600 million was used to buy 30 year 4.0 MBS coupons. 6 percent of total weekly purchases ($500 million more than last week)
$6.3 billion was used to buy 30 year 4.5 MBS coupons. 63 percent of total weekly purchases ($300 million less than last week)
$1.4 billion was used to buy 30 year 5.0 MBS coupons. 14 percent of total weekly purchases ($900 million less than last week
$1.5 billion was used to buy 15 year 4.0 MBS coupons. 15 percent of total weekly purchases($500 million more than last week)
$200 million was used to buy 15 year 4.5 MBS coupons. 2 percent of total weekly purchases($200 million more than last week)

56 percent of the mortgage-backs purchased were Fannie Mae MBS, 44 percent were Freddie Mac coupons. No Ginnie Mae coupons were bought. 83 percent of purchases were 30 year MBS coupons (90% last week)

The Fed's daily purchase average during the trading week was $2.0 billion per day, unchanged from last week and still enough to offset daily originator loan supply. If the Fed were to evenly disperse the remaining $24.1 billion over the next 3 weeks, they would average $1.6 billion purchases per day or $8.03 per week (compare previous $8.52 billion per week)

Below is a chart illustrating the evolution of the Federal Reserve's Agency MBS Purchase Program. Notice over the past few months the Fed has reduced their purchases and used remaining funds to offset new loan production supply, 4.50 (RED) and 5.00 (GREEN) MBS coupons specifically, which has helped keep mortgage rates low relative to benchmark Treasury yields.

So far the gradual reduction in the Fed's weekly purchases has been counterbalanced by the slowdown in new loan production and an increase in non-Federal Reserve funded "down in coupon" demand (banks, hedge funds, insurance companies, loan servicers, money managers) (thanks to Fannie/Freddie delinquency buyouts). However, funds are running low and soon there will not be enough $$$ to offset average new loan production supply from originators (currently running between $1.5 billion and $2 billion per day).

While we do not expect an abrupt "cheapening" in mortgage-backed security valuations (wider yield spreads), we do anticipate mortgage rates will begin to gradually rise relative to Treasury yields toward the end of March into April. This does not include the general directional guidance offered by benchmark Treasuries...more simply, if Treasury yields rise, mortgage rates will follow. READ MORE ABOUT THE MORTGAGE RATES EQUATION

Currently, the secondary market current coupon (essentially the MBS yield lenders use to derive par mortgage rates after servicing and guarantee fees) is 4.381%. The 10 year Treasury note yield is 3.769%.

Yield Spread Calculation: 4.381% - 3.769% = 61.2 basis points.

When the Federal Reserve does exit the agency MBS market, we estimate the secondary market current coupon yield spread will widen out as far as 100 basis points over 10 year Treasury note yields (gradually, not all at once) This would put the MBS yield lenders use to derive par mortgage rates at 4.769%.

If the 10 year Treasury note touches 4.00% and the current coupon yield spread widens to 100 basis points, the MBS yield lenders would use to derive the par mortgage rate would be 5.00%. This is the base yield used to set mortgage rates. If 10 year Treasury yields do touch 4.00% in the months ahead, we expect the average par 30 year fixed mortgage rate to approach 5.50%. We do not expect 10s to break 4.00% in the first half of 2010 though.