MarketWatch
Deborah Levine, MarketWatch
As the Federal Reserve ends its purchases of more than a trillion dollars in mortgage-related debt this month, bond investors say the market is now stable enough to prevent a big jump in mortgage rates once its biggest buyer exits.
NEW YORK (MarketWatch) -- As the Federal Reserve ends its purchases of more than a trillion dollars in mortgage-related debt this month, bond investors say the market is now stable enough to prevent a big jump in mortgage rates once its biggest buyer exits.
Investors and analysts at RBS Securities, National Penn Investors Trust, DWS Investments and others expect rates will rise only between 0.1% and 0.25% over the next several months, because of less supply of new securitization of mortgage debt and more interest from fund managers as soon as the U.S. central bank bows out.
Analysts say they also believed Fed Chairman Ben Bernanke when he said the Fed won't turn around and sell holdings any time soon, though other Fed officials have suggested just those sales to reduce the central bank's balance sheets.
The small increase in mortgage rates now forecast is far less than Fed officials themselves estimated at the beginning of the year, demonstrating the continued improvement in financial markets and the low amount of yield that mortgage-backed securities carry above U.S. Treasurys.
"I don't think there is going to be a huge change in the yield spread," said Roger Bayston, senior vice president of Franklin Templeton's fixed-income group. "It would take a sizable increase in mortgage spreads to increase mortgage rates to the point that it would have a meaningful impact on housing activity."
The key metric that bond-market participants look at is that gap between yields, to gauge how attractive the mortgage debt is to investors.
The gap has collapsed since the Fed started its program, falling from historic highs at the time when markets froze up and housing giants Fannie Mae (FNM, US) and Freddie Mac (FRE, US) appeared to be doomed.
That gap has narrowed to nearly nothing from 1.92 percentage points in December 2008, according to an index of mortgage-backed securities compiled by Bank of America Merrill Lynch.
Mortgage rates have also dropped sharply. In late 2008, the average 30-year fixed mortgage rate topped 6.30%, according to Bankrate.com. Now, it's 5.02%.
Over that time, the Fed has been the biggest buyer of mortgage-backed securities backed by U.S. government agencies.
The Fed has purchased an estimated $1.235 trillion in mortgage-backed securities, in a program it announced in late 2008 near the height of the credit crisis. It has said it will buy $1.25 trillion.
It's also bought $171 billion in agency debt, out of a target of $175 billion. The Fed has said it expects to finish its purchases of mortgage-related debt at the end of this month. See Fed's site for latest purchases. http://www.newyorkfed.org/markets/pomo_landing.html
Now bond buyers are trying to determine how much that spread will widen -- and how far mortgage rates will rise -- after the Fed is done.
"We'll see somewhat higher mortgage rates and higher spreads after the Fed exits," said Dan Adler, a senior portfolio manager at Smith Breeden Associates. "It seems like something on the order of a quarter-percentage point higher seems rational, given where spreads are and where we'd expect to see other buyers come into the market."
Many other investors in mortgage bonds, including mutual funds, pension funds, foreign official institutions and private investors, have been crowded out of this segment of the bond market by the Fed, pushing MBS yields so low that the securities, which are bundles of many individual mortgage loans, became unattractive.
Supply and demand
As the housing market slowed to a crawl during the recession, the amount of loans given dropped, reducing the amount of securitization. The Fed then effectively bought up more than the amount of new supply coming into the market. And last year, supply was unusually high because of refinancings.
Once the Fed bows out, the spreads will need to increase modestly to lure buyers back, investors said. But supply is likely to stay low, limiting that widening.
Net issuance of mortgage-backed securities -- accounting for maturing and repaid debt -- could drop 40% in 2010, said Ira Jersey, head of U.S. interest rate strategy at RBC Capital Markets.
"There will probably be plenty of demand not too far from where we are today" in terms of spreads, Jersey said. "So many people are underweight."
Mortgage-backed bonds, depending on the exact security, were once considered second only to Treasurys as a safe asset class. In general, people pay their mortgages, and there's a certain amount of default, prepayment and other factors built into every securitization.
This perception of safety shattered when the subprime sector of the market fell apart in 2008. That market -- both for subprime loans and securitization of them -- has effectively disappeared, however.
Everything the Fed has bought over the last year was debt held by Fannie Mae, Freddie Mac and the Federal Home Loan Banks -- all of which require higher credit quality.
Analysts say their forecasts for MBS spreads include a certain percentage of homeowners defaulting.
Franklin Templeton's Bayston also notes that homes have become more affordable, mostly as a function of falling home prices over the last couple years. Existing-home prices, the bulk of the market, have fallen 1.8% in the last year, the National Association of Realtors said Tuesday.
Of course, not helping the housing market is high unemployment, stagnant incomes and stricter lending requirements. Existing-home sales fell to the slowest rate in eight months in February, NAR said. (RELATED ARTICLE: U.S. existing-home sales down third month in a row) Read about existing home sales.
Some members of the Fed have a gloomier view on rates.
In January, Eric Rosengren, head of the Boston Fed, said he expects mortgage rates to rise by as much as three-quarters of a percentage point in the coming months as a result of the Fed's ending the program.
After last week's Federal Open Market Committee meeting, officials said in a statement they "will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability." See Fed's statement. http://www.federalreserve.gov/newsevents/press/monetary/20100316a.htm
The Fed is also likely to pay close attention to what mortgage rates do, and take further action if spreads widen significantly, say 0.75% to 1.5%, said Smith Breeden's Adler.
"They would at least talk about coming back into the market," Adler said.
Also, an interest in keeping housing affordable so the economy can heal will prevent the Fed from selling off some of its massive holdings, as some officials and analysts have said would be prudent.
"The recovery is too fragile for them to be considering that at this juncture," Adler said.
