* Disconnect between rates on home loans, mortgage bonds
* Fed worries situation will undermine QE3 effectiveness
* Capacity constraints, put-back risks highlighted
* Still, a 'strong case' for continued bond buys -Rosengren
By Jonathan Spicer and Leah Schnurr
NEW YORK, Dec 3 Frustrated Federal Reserve
policymakers on Monday sought an explanation from mortgage
lenders as to why the benefits of lower interest rates were not
filtering to home buyers as quickly as in the past even as
At an all-day New York Fed workshop, officials from Wells
Fargo & Co, JPMorgan Chase & Co and other big
lenders were asked why there is a growing disconnect between the
rates Americans pay on home loans and the yields on
mortgage-backed securities (MBS).
The question has puzzled central bank policymakers who worry
the situation is undercutting their efforts to stimulate the
country's slow economic recovery from recession.
Since September, when the Fed targeted the U.S. mortgage
market with its latest round of large-scale bond purchases, the
closely watched spread between the interest rates homeowners pay
and what investors reap on mortgage-backed securities has
widened to record levels.
The Fed's purchase of $40 billion per month in agency MBS
has made a big splash in the secondary market. Yet in the
primary market, the drop in the mortgage rates that home buyers
can get from lenders has not been as pronounced as the central
bank wanted, lagging historical trend.
This clog in the passage between the primary and secondary
markets undermines an important reason for the Fed's monetary
stimulus: kick-starting a housing sector that was at the heart
of the 2007-2009 financial crisis and that has only just begun
to show some life.
"The impact of monetary easing on the economy through
housing and mortgage finance has been impeded to some degree" by
the primary-secondary rate spread, William Dudley, president of
the New York Fed, said at the workshop.
FOCUS ON LENDERS' PROFITS
A move toward more conservative underwriting standards since
the financial crisis explains part of the widening spread
between primary and secondary yields. A concentration of
mortgage originators since the crisis explains another part.
The Fed wants to know what role so-called put-back risk -
the possibility that underwriting of a loan violates Fannie Mae
and Freddie Mac guidelines, forcing a bank
to repurchase it from the agencies - plays in the wider spread.
It also wants to know what role bank profit plays.
In a paper published last week, Fed researches showed that
the market value of the typical offered mortgage has quadrupled
in the last five years. That implies, they argue, either a
parallel rise in a lender's profits or its costs, or a rise in
both profits and costs.
Dudley said those findings suggests "originator profits may
have increased," and that mortgage originators "enjoy pricing
power and elevated profits" on refinancings including the Home
Affordable Refinance Program (HARP), a federal program meant to
help stressed borrowers refinance their mortgages.
"The financial crisis and the housing bust created headwinds
to the recovery in part through adverse impacts on the
mechanisms of monetary policy transmission," Dudley said.
CAPACITY CONSTRAINTS, PUT-BACK RISKS
The New York and Boston branches of the central bank
co-hosted the workshop, held just a couple blocks from Wall
Among those on the hot seat were Fannie and Freddie senior
vice presidents Anthony Reed and Stephen Clinton, respectively,
as well as Mohan Chellaswami of Wells Fargo, Matt Jozoff of
JPMorgan and Kenneth Adler of Citigroup Inc, among others.
Stakeholders in the MBS market also took part in panel
discussions, including Scott Simon from bond-fund giant PIMCO.
Keith Ernst, associate director at the Federal Deposit Insurance
Corporation, also gave a presentation.
Industry experts raised some common reasons that could be
driving the spread higher, including the inability of lenders to
meet robust demand for loans.
One prominent analyst said a reason for the increase was
likely capacity constraints as mortgage bankers can't add
resources fast enough to process requests for loans with rates
at such low levels.
Another expert said lenders are unwilling to extend loans to
lower-quality borrowers because they could become delinquent,
leaving lenders on the hook if they are forced to buy back the
loan. Still, this put-back risk was relatively small given the
high quality of loans made since the crisis, the analyst said.
Not everyone saw a problem. One investor argued there was
nothing unusual in the wider primary-secondary spread and it was
a foreseeable consequence of the Fed's aggressive policies.
Journalists were restricted from identifying speakers.
FED UNLIKELY TO ABANDON MBS
Although the housing market has led the broader economy out
of recessions in the past, the sector has been absent from the
current recovery until recently. Fed Chairman Ben Bernanke has
pointed to this "missing piston" in the recovery in defending
the choice of buying mortgage bonds, and not Treasuries.
Despite its concerns about effectiveness, the Fed does not
appear ready to turn its back on the mortgage market.
At the workshop on Monday, Boston Fed President Eric
Rosengren said there is a "strong case" for the central bank to
stay the course on accommodative policies in the new year and
continue buying $85 billion in total bonds each month.
Rosengren, who regains a vote next year on the Fed's
policy-setting committee, said MBS may be preferable to Treasury
buys in order to improve market functioning and to stimulate
demand in interest-sensitive sectors.
Before 2000, the spread between yields on newly issued
agency MBS in the secondary market, and an average of mortgage
loan rates from the Freddie Mac Primary Mortgage Market Survey
in the primary market was mostly stable at about 0.3 percent.
That widened to a new equilibrium at about 0.5 percent
between 2000 and 2008, before doubling the following year,
according to the Fed paper.
Immediately after the central bank announced on Sept. 13 its
third round of quantitative easing, dubbed QE3, however, the
spread temporarily spiked to more than 1.5 percent.
Today, the spread has declined to its pre-QE3 level of about
1.2 percent, yet it remains lofty by historical standards.
"There is clearly something that is manifesting as a form of
constraint" in mortgage lending, Jeremy Stein, a Fed governor,
said at a Boston conference on Friday.
Stein highlighted odd differences in the availability of
credit, depending on the type of loan, where lenders seem to
treat mortgages more conservatively than they do auto loans made
to the same household.
"Whether it's a regulatory or a put-back risk," he said,
"there's clearly just quantitatively not the volume happening."