Bloomberg recently reported that a number of dealers expect the Fed to initiate a new round of MBS purchases, with the goal of pushing mortgage rates lower and giving a boost to the still-sickly housing market. The idea of more MBS purchases raises a host of critical issues, particularly with respect to an exit strategy. (An investor who holds more than $1 trillion of an asset class effectively becomes the market.) Nonetheless, I believe that a well-conceived program can positively impact mortgage rates and housing.
Recent policy initiatives by both the Fed and the Obama administration have been intended to lower mortgage rates and stimulate home purchases and refinancing activity. The Fed's recent Operation Twist was intended to put downward pressure on mortgage rates, while the revised HARP was created to help underwater homeowners take advantage of current low mortgage rates, allowing them to refinance their higher-rate loans and improve their monthly cash flows.
However, these initiatives have bumped up against market realities. The current structure of the MBS market has limited the Fed's ability to further influence primary mortgage rates. Since there is no natural buyer of 30-year 3s, the lowest liquid 30-year passthrough coupon is 3.5%. Given the current rules that require the holding of a 25-basis-point servicing strip, the lowest conventional mortgage rate that can be issued and securitized is 3.75%. Along with the operational inefficiencies currently plaguing the mortgage industry, the lack of a functioning market for 30-year 3s has effectively put a floor under mortgage rates.
HARP 2 also faces market-related issues that will reduce its effectiveness. New loans with LTVs greater than 125% must be pooled into separate programs. (Thirty-year Fannie pools will be issued with an FNCR designation.) These pools will not be deliverable into TBAs; moreover, they probably cannot be used as collateral for REMICs because their LTVs make them ineligible as REMIC collateral. As a result, FNCR pools will probably trade well behind TBAs. Combined with other pricing adjustments, the price concession will be passed on to borrowers in the form of higher rates, diluting the ultimate effectiveness of the program.(Fannie Mae announced that it will initially purchase >125% LTV whole loans at the same price as other loan products. However, the extent of their purchases is unclear, and cash window pricing is generally inferior to other loan sale options.)
While it may be effective as monetary stimulus, a program to simply buy massive quantities of MBS will have little to no impact on the housing markets. The benefits will not flow through to borrowers, and it will serve only to distort passthrough market pricing while further expanding the Fed's balance sheet and interest rate exposure.
A more effective approach would be a targeted program to buy MBS, such as 30-year 3s and FNCR pools, for which the markets are poorly defined and illiquid. For example, the Fed could commit to buying new-issue FNCR pools at TBA levels, allowing borrowers eligible for the new HARP program to avail themselves of rates only slightly higher than generic mortgage rates. The Fed could also have a standing bid for 30-year 3s. An interesting idea might be for the Fed to back into its pricing from best-execution analysis, i.e., calculating where the coupon needs to trade in order to generate a given rate level.
This type of program does carry risks for the Fed, as it would increase its portfolio duration while impairing its liquidity. Nonetheless, an effective initiative that will lower mortgage rates and support housing must be structured in a sophisticated manner that takes the subtleties of mortgage pricing and MBS trading into account.
Bill Berliner is Executive Vice President of Manhattan Capital Markets. He is the co-author, with Frank Fabozzi and Anand Bhattacharya, of the recently-released second edition of Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques. His email address is email@example.com.