Monday, November 23, 2009

Mortgage valuation: how much is due to Fed purchases?

This chart from Bloomberg shows the option-adjusted spread (OAS) on current coupon Ginnie Mae MBS, as calculated by Merrill Lynch. Spreads peaked about a year ago, just after the Fed began its quantitative easing program which ended up more than doubling the monetary base. In the context of the widespread belief that Fed purchases of MBS have pulled mortgage rates down to artificially low levels, I would note that the Fed didn't start buying MBS in earnest until mid-March. As this chart shows, mortgage OAS had already declined from a high of 166 bps last November to about 35 bps before the Fed began buying the stuff. Since then, and for the most part, spreads haven't come down all that much further, and have been fairly steady for the past six months. With a negative OAS, mortgages sure aren't cheap, but they've been amazingly stable vis a vis Treasuries for quite some time.

I can't say definitively that the Fed is not keeping mortgage rates at artificially low levels, but that may be a moot point in any event. If rates are going to rise in the future (and I think they will), it will not be because the Fed stops buying MBS, it will be when the Fed and the market realize that policymakers and market participants have mistakenly assumed that inflation risk is extremely low because of the economy's excess capacity (aka slack).


W.E. Heasley said...

Very much agree with your analysis.

The inflation item, in particular the “slack”: Friedman proved Cost Push was short term while Demand Pull was the real engine of inflation.

The “slack” is more of a Keynesian or Neo-Keynesian argument. About the time they figure out that “slack” was an error , suddenly comes Cost Push, then they will get blind-sided by Demand Pull.

Public Library said...

I agree it is not direct purchases by the Fed keeping rates so low on MBS.

However, keeping the Fed funds rate at zero and guaranteeing essentially all agency MBS has the same effect.

AS I noted on your other post, it is the other side of the same coin. Without the Fed, the market prices current risk much, much wider. Just look at what happened to the credit card market

Rates have gone up substantially regardless of an individuals credit quality...