Fed Attempts To Quantify Why Mortgage Rates Lag MBS Improvements

The Federal Reserve Bank of New York held a workshop today on The Spread between Primary and Secondary Mortgage Rates:  Recent Trends and Prospects.  William Dudley, the Bank's president told participants the bank had organized the workshop because the topic of the primary-secondary mortgage rate spread is important for current efforts by the Federal Open Market Committee (FOMC) to foster faster economic growth.

Because unemployment remains high, the FOMC took action at its September meeting to provide additional monetary accommodation including a new program to purchase an additional $40 billion a month of agency mortgage-backed securities (MBS) and in October it announced it will continue its purchases of agency MBS, undertake additional asset purchases, and employ its other tools as appropriate until there is a substantial improvement in the outlook for the labor market in a context of price stability.

Dudley explained that the impact of monetary policy on economic activity depends on the extent it is effectively transmitted to key sectors of the economy and MBS purchases affect the economy most effectively through the housing and mortgage markets, lowering the secondary market rate at which mortgage-backed securities trade and putting downward pressure on the primary mortgage interest rate.  This in turn enables borrowers to refinance at lower rates and increases demand for home purchases, thus supporting house prices and household wealth, which in turn may increase access to credit.  

This has indeed happened since the September FOMC meeting, Dudley said.  Yields on new agency MBS are down about 45 basis points and the Freddie Mac survey 30-year primary rate has declined 23 basis points to 3.32 percent.  The declines are even larger if dated from the August FOMC meeting when expectations of easing increased.

But this easing has been impeded by two factors.  Dudley called the credit standards for mortgages since the housing bust "overcorrected" and said, coupled with the number of underwater mortgages it is impossible for some people to take advantage of the low interest rates.   

But the purpose of the workshop, he said, is to focus on the second impediment; the significant widening of the spread between yields on MBS in the secondary market and primary mortgage rates.  In order for actions taken by FOMC to have their full impact on the economy, they need to pass through from the secondary to the primary rate.   "To the extent that the primary-secondary rate spread widens, the reduction in pass-through limits the full impact of the policy actions."

The spread through the late 1990s and early 2000s was in the range of 30 to 50 basis points but more recently and especially in the past 18 months the spread has increased substantially and after the September FOMC meeting it rose above 150 basis points.  This spike was not surprising, Dudley said, because the primary market may be slower to react and it has now retracted to its pre-meeting level of about 120 basis points which is still high by historic standards.

The spread is influenced by a number of elements such as the value attached to servicing rights and the annual GSE guarantee fee which has increased in what Dudley called a necessary and overdue re-pricing of the credit guarantee provided to investors.  While they differ by mortgage and by seller, the average effective guarantee fee has increased from 20 to 25 basis points to nearly 50 basis points today but that still leaves a significant part of the spread to be otherwise explained.

Dudley referenced the new study on the subject, The Rising Gap between Primary and Secondary Mortgage Rates written by several Fed staff among others and available here, and summarized it for his audience.  The study, he said, comes up with a measure of originator profits and unmeasured costs or OPUCs and evaluates a number of factors that could explain the historically elevated levels of the latter. The study concludes:

"The rise in OPUCs is mainly driven by higher MBS prices, which are not offset by corresponding increases in measurable costs. Conversely, a decline in the value of mortgage servicing rights may have reduced OPUCs to some extent, and thus contributed to the widening primary-secondary spread. Among harder-to-measure costs, we find that putback risk and pipeline hedging likely cannot explain the full rise in OPUCs. Absent other cost increases that we cannot measure well, such as operating costs, the rise in OPUCs reflects to some extent an increase in originator profits. While market concentration alone does not seem to explain the rise in these profits, capacity constraints do appear to play a significant role. Additionally, we provide evidence suggesting that originators have enjoyed pricing power on some of their borrowers looking to refinance over the past year."

The financial crisis and the housing bust created headwinds to the recovery in part through adverse impacts on the mechanisms of monetary policy transmission.  It is important, he concluded, that the forces that have been acting on the primary-secondary spread be correctly identified and, to the extent possible, quantified.  He urged the workshop participants to bring their broad range of informed perspectives to the table and be as open, frank and precise in their discussions in order to draw some conclusions about the factors influencing the spread. .