Fed Holds Lenders' Feet to the Fire on Mortgages

By Jonathan Spicer and Leah SchnurrReuters

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 investors benefited.

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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.


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.


The New York and Boston branches of the central bank co-hosted the workshop, held just a couple blocks from Wall Street.

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.


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%.

That widened to a new equilibrium at about 0.5% 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%.

Today, the spread has declined to its pre-QE3 level of about 1.2%, 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."