The Federal Reserve's MBS Purchase Program comes to an end today.

Mortgage market participants must now face the reality of a life without the supportive, flow balancing, volatility calming bid of the Federal Reserve. It's time to ensure everyone's knowledge base is adequately prepared to explain some of the factors that will be moving mortgage rates over the next few days, weeks, and months.

Without going into servicing valuations and best execution options, mortgage rates are generally dependent upon the mortgage basis. The mortgage basis can be generally thought of as a guidance giver for mortgage rates.

This requires a proper explanation of yield spreads....

Debt issued by the US Government (Treasury bills, notes, and bonds) is considered to be the highest credit quality....also known as 'Risk Free'.

These 'RISK FREE' securities (TSY bills, notes, and bonds) are the foundation for all other interest rates. This is why Treasury securities are called 'benchmarks'. All other debt issued is considered to be less quality than US Treasuries. To compensate for higher risk of investing, because other debt is considered lower quality than US Treasuries,  all other debt trades at a yield spread over the 'risk free' rate.

This is referred to as a 'yield spread' over a comparable benchmark and is quoted in basis points.

For example, we can compare a 10yr corporate note yielding 6.00% to a 10yr Treasury note yielding 4.00%.

Yield Spread = Yield of Riskier Asset - Yield of Risk Free Benchmark

For the example above...

6.00% - 4.00% = 2.00% or 200 basis points

To quote the yield spread you would say the 10yr  corporate note is trading 200 basis points over the 10yr Treasury note...written shorter it looks like +200/10yr Treasury.

Generally speaking, when yield spreads are tight, the riskier asset is said to be "rich" vs. its benchmark. When yield spreads are wide, the riskier asset is considered to be cheap compared to its benchmark. (all things constant)

Now to relate to Mortgages....

When discussing MBS yield spreads we are comparing the yield of an MBS coupon to the yield of its benchmark. For instance we relate the secondary market current coupon, essentially the yield lenders use to derive base par mortgage rates, to the 10yr TSY note yield and 10yr swap rate. These are our benchmark guidance givers..meaning "rate sheet influential" mortgages generally follow the directional movements of these benchmarks. (and agency debt)

There are several reasons why yield spreads move wider and tighter. It could be simple supply and demand dynamics or the credit quality of the underlying debt.  In terms of supply and demand dynamics, if there is less supply of "rate sheet influential" MBS, and the market needs "rate sheet influential" coupons... MBS current coupon yield spreads will likely tighten against benchmark Treasuries because more accounts need to buy MBS.

The supportive presence of the Federal Reserve in the agency MBS market (secondary mortgage market)  has served to tighten secondary market current coupon MBS yield spreads vs. comparable benchmark Treasury yields.  SIGNIFICANTLY! This is evident in the chart below.

When the Fed announced the MBS Purchase Program in late November 2008, the MBS current coupon yield spread vs. the benchmark 10 year TSY note yield tightened from around +170 basis to +120 basis points. This "tightening" was consistent throughout the course of the program...all the way to the tightest levels on record!!!!

Currently, the secondary market current coupon (essentially the MBS yield  lenders use to derive par mortgage rates after servicing and guarantee fees) is 4.467%. The 10 year Treasury note yield is 3.841%.

Yield Spread Calculation: 4.467% - 3.841% = 62.6 basis points.

When the Federal Reserve does exit the agency MBS market, we estimate the secondary market current coupon yield could move as far 100 basis points over the 10 year Treasury note yield. Don't panic though, this will not happen all at once and yield spreads may not widen that much.  View this as a worst-case scenario.


If the 10 year Treasury note touches 4.00% and the current coupon yield spread widens to 100 basis points, the MBS yield lenders would use to derive the par mortgage rate would be 5.00%. This is the base yield used to determine mortgage rates (points). If 10 year Treasury yields do touch 4.00% in the months ahead and the secondary market current coupon yield spread reaches 100bps over benchmark yields...the best par 30 year fixed mortgage rate will hit  5.50%.

Again, we do not expect current coupon yield spreads to widen out this far, especially not in the days ahead. Where will yield spreads head then?

That depends on several factors including the direction of benchmark Treasury yields (MBS lag benchmarks in rallies), new mortgage loan demand (MBS Supply), prepayment reinvestments, and delinquency buyouts. (More to come on all these topics).

Here's what we expect, from a big picture perspective....

In the days and weeks ahead, the private investors left to support new originator loan supply will be looking to find a yield spread level that puts supply and demand into equilibrium. Specifically, these traders will be trying to figure out, based on demand from other traders, just how many yield spread basis points the Fed's bid was worth.

View this as a risk/reward relationship. Now that the Fed is exiting, MBS investment risk will be higher (more convexity in the market). To compensate for higher risk in the mortgage marketplace, investors will demand a greater return. This "greater return" will manifest itself via wider secondary market current coupon yield spreads  vs. benchmarks. Once a stable bid returns to the market,  we will be able to say risk matches reward.

This will be a "feeling out" process. If new loan supply from originators is greater than expected, the current coupon yield spread might move as wide as 85 basis points over the 10 year TSY yield. If new loan supply continues to be slow, yield spreads will likely gap out only 10-15 basis points (to between +70 to +80 range)

One thing is for sure: yield spreads will move wider. You should be expecting a rise in MBS price volatility during this "feeling out" process. Reprices for the worse will not be as easy to spot. Don't let this scare you though, once flows stabilize and the MBS market finds supply and demand (risk/reward) equilibrium...yield spread status quo will return.