Fed Jumps Out, Buyers Jump In!

The Wall Street Journal posted the following story on 1/28/10. We are all eagerly anticipating what will happen next with the housing market and thought you might be too. The Federal Reserve believes that when they pull out of the mortgage market, that investors will be looking to jump on the bargain mortgages and that will keep mortgage rates low. Good news for all you potential home buyers! We will have to wait and see what the market brings… keep your fingers crossed!
Mortgage Bulls Bid Fed Adieu
. Say Rates Won’t Soar When Central-Bank Buying Ends; ‘People Will Jump In’ By MARK GONGLOFF

Conventional wisdom holds that the end of the Federal Reserve’s $1.25 trillion mortgage-buying spree will be catastrophic for housing. But a growing number of investors are betting that the fears are overstated and mortgage rates won’t soar when the Fed leaves the market in just over two months.
Associated Press

Traders on the floor of the NYSE get the news on interest rates.

Following a two-day policy meeting, the Fed on Wednesday reiterated its plan to end the program on schedule. The policy makers ignored weak home-sales data that had some observers, worried the market wouldn’t be able to wean itself from Fed support, expecting an extension.

Fed officials believe they can pull back successfully. And a growing group of optimists are joining their camp. They argue that investors, searching for higher-yielding securities, will find government-backed mortgage-backed securities a bargain relative to other investments, like corporate debt, that have rallied for much of the past year.

“People will jump in and buy” if there’s weakness in the mortgage-backed securities market, said Brian Yelvington, a strategist at fixed-income brokerage Knight Libertas.

The optimistic view hinges on the government remaining an enormous presence in the mortgage market, both through its mortgage-backed securities holdings and the widespread expectation that it could jump back in if the market falters.

If this view is right, then the end of Fed purchases will barely cause a ripple in interest rates on mortgage-backed securities, which move in the opposite direction of price. That, by extension, could mean mortgage rates could stay relatively low, buoying housing.

So far, the numbers support the optimists. In recent weeks, the Fed has slowed its average weekly net purchases of mortgage-backed securities from $21 billion to about $12 billion. Despite this slower purchase rate, the “spread” between mortgage-backed securities yields and risk-free Treasury yields is thinner than last September, when the Fed said it was extending its mortgage buying program by a quarter.

This spread is the basis for the rate people on Main Street pay when they borrow to buy a home. Any widening typically pushes mortgage rates higher by an equal amount almost immediately.

To be sure, mortgage prices could suffer when the Fed stops buying. Pessimists worry spreads could rise a full percentage point, which could take 30-year conforming mortgage rates to 6% from 5%, a potentially crippling blow to a still-shaky housing market.

But spreads mightn’t have to widen nearly that much to attract private investors hungry for yield at a time when cash yields nothing.

For one thing, riskier credit investments, such as corporate debt, may have little upside left after rallying furiously for nearly a year. Corporate bonds with an “A” credit rating, for example, yield 160 percentage points over Treasury debt, according to Merrill Lynch indexes. MBS issued by government-backed mortgage agencies, in comparison, yield about 138 percentage points more than Treasurys, according to Kevin Cavin, a mortgage strategist at FTN Financial in Chicago. Even a small widening of that MBS spread would offer investors a similar spread as risky corporate debt, but this debt would be guaranteed by the U.S. government.

The Fed’s purchase program, meanwhile, has likely kept spreads on mortgage-backed securities issued by government-backed mortgage agencies artificially narrow, which has turned off many private investors.

“Our interest in residential mortgage product is next to zero right now,” given the low spread over Treasurys, said James Camp, head of fixed income for Eagle Asset Management, a St. Petersburg, Fla. investment firm.

But if mortgage spreads over 10-year Treasurys were to widen by just half a percentage point—taking them back to their long-term average—buying government-backed mortgage securities “starts to make sense again,” Mr. Camp said.

A half-point increase in spreads might push mortgage rates up by half a percentage point. But subsequent private buying of mortgages could push spreads and rates right back down again, limiting the damage to the housing market, bulls say.

Large bond mutual-fund managers, such as Pimco, have dialed back on their mortgage investments in the past year and now may be short of their usual allocations to mortgages by up to $350 billion, estimates Ohmsatya Ravi, head of U.S. securitized products research at Nomura Securities International.

Their buying could be enough to replace three or four months’ worth of Fed purchases, notes Mr. Ravi, who said he doubts mortgage spreads will widen more than 0.2 percentage point when the Fed stops buying.

Anthony Crescenzi, a portfolio manager at Pimco, wouldn’t speculate about whether he might be tempted to buy more mortgages in the event spreads widen later this year. But he said the prospect of the government jumping back into the market “would be a basis for considering increasing allocation to that sphere,” depending on conditions in the broader economy and other factors.

Meanwhile, the government will remain an enormous presence in the mortgage market even after the Fed stops buying.

The Fed will have a $1.25 trillion mortgage-backed securities portfolio after March. Unless the Fed sells its securities, its holdings mean a lot of supply is being held off the market, at a time when new mortgage originations are anemic, keeping prices from falling too far.

Meanwhile, the Treasury Department in December said it would provide unlimited support to Fannie Mae and Freddie Mac and wouldn’t require the agencies to reduce their $1.5 trillion mortgage holdings, as previously planned, a show of government commitment that has lifted mortgage prices.

Some analysts even suggest that Fannie and Freddie, now with greater government backing, could eventually buy more mortgages if spreads widen drastically and the Fed declines to help.

“The Fed withdrawal will be a non-event because Fannie and Freddie will step into the breach,” said Michael Toporek, chief investment officer at Manhattan investment advisory firm Brookstone Partners Asset Management. “They have unlimited balance sheets to buy mortgage-related assets.”

—Jon Hilsenrath contributed to this article

Write to Mark Gongloff at mark.gongloff@wsj.com