Did the Federal Reserve's MBS purchase program lower mortgage rates?

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Journal of Monetary Economics

Journal of Monetary Economics 58 (2011) 498–514

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Did the Federal Reserve’s MBS purchase program lowermortgage rates?

Diana Hancock, Wayne Passmore n,1

Board of Governors of the Federal Reserve System, Washington, DC 20551, USA

a r t i c l e i n f o

Available online 27 May 2011

Keywords:

MBS

Federal Reserve

GSEs

Mortgage

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a b s t r a c t

On November 25, 2008, the Federal Reserve announced it would purchase mortgage-

backed securities (MBS). This program affected mortgage rates through three channels:

(1) improved market functioning in both primary and secondary mortgage markets, (2)

clearer government backing for Fannie Mae and Freddie Mac, and (3) anticipation of

portfolio rebalancing effects. We use empirical pricing models for MBS yields and for

mortgage rates to measure relative importance of channels: The first two were

important during the height of the financial crisis, but the effects of the third depended

on market conditions. Overall, the program put significant downward pressure on

mortgage rates.

Published by Elsevier B.V.

1. Introduction

On Tuesday, November 25, 2008 the Federal Reserve surprised almost everyone when it announced that it wouldinitiate a program to purchase up to $500 billion in mortgage-backed securities (MBS) backed by the housing-relatedgovernment-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, and backed by Ginnie Mae.2 The goal of this newprogram was to ‘‘reduce the cost and increase the availability of credit for the purchase of houses.’’3

There is, of course, a disparity between rates in mortgage secondary markets (i.e., MBS yields) and the rates paid byhomeowners to purchase houses in the primary mortgage market. This paper is focused on the question: ‘‘Did the FederalReserve MBS purchase program lower mortgage rates?’’

The Federal Reserve’s MBS purchase program affected mortgage rates though three channels: (1) improved marketfunctioning in both primary and secondary mortgage markets, (2) clearer government backing for Fannie Mae and FreddieMac, and (3) anticipation of portfolio rebalancing effects. The first channel reflects the signal to market participants that alarge and reliable MBS purchaser would be available in the secondary market under all market conditions. The second

B.V.

e Board, Washington, DC 20551, USA. Tel.: þ1 202 452 6432.

smore).

d Wayne Passmore is an Associate Director in the Division of Research and Statistics at the Board of

expressed are the authors and are not necessarily those of the Board of Governors of the Federal

n Goodfriend, Burton Hollifield, Shane Sherlund, participants at the Carnegie-Rochester Conference

e in Light of the Credit Turmoil,’’ and seminar participants at the Federal Reserve Banks of Atlanta,

thank Owen Hearey, Melissa Hamilton, and Benjamin J. Unterreiner for their excellent research

arted a modest MBS purchase program. Its program was announced as an expression of support for

ere placed into government conservatorship on September 5, 2008.

/press/monetary/20081125b.htm.

www.elsevier.com/locate/jme

dx.doi.org/10.1016/j.jmoneco.2011.05.002

mailto:[email protected]

http://www.federalreserve.gov/newsevents/press/monetary/20081125b.htm

dx.doi.org/10.1016/j.jmoneco.2011.05.002

D. Hancock, W. Passmore / Journal of Monetary Economics 58 (2011) 498–514 499

channel reflects the mitigation of concerns by investors about the value of the implicit government guarantee against creditrisk that was offered by Fannie Mae and Freddie Mac after they were placed into conservatorship in September 2008.

As for the third channel, Federal Reserve purchases were expected to have a portfolio rebalancing effect (alsosometimes referred to as a ‘‘stock effect’’). The portfolio rebalance channel works as follows: (1) when the Federal Reservepurchases an asset, it reduces the amount of the security that the private sector holds, while simultaneously increasing theamount of short-term, risk-free, bank reserves held by the private sector, (2) in order to induce private sector investors toadjust their portfolios (i.e., reduce their holdings), the expected return on the asset must fall (i.e., the purchases bid up theprice of the asset and lower its yield). This adjustment by investors has two components: (1) a willingness to take lesscompensation for hedging the interest rate risks of financial assets and (2) a willingness to take less compensation forhedging the prepayment and volatility risks associated with holding MBS.4

We use empirical pricing models for MBS yields in the secondary mortgage market and for mortgage rates paid byhomeowners in the primary mortgage market to measure the relative importance of the three channels described above.With regard to the first two channels, both improved market functioning and clearer government backing are likely tolessen the extent of abnormal market pricing in the primary and secondary mortgage markets. However, a decline inunusually high mortgage rates in the primary mortgage market may mainly reflect improved market functioning becausethe primary mortgage originators who sell their mortgages to Fannie Mae and Freddie Mac are only concerned about theprice and the speed of the transaction, and not the counterparty risk, when they deal with the GSEs. In contrast, clearergovernment backing might be better reflected by declines in the size of the abnormally high mark-ups in the pricing ofMBS that are guaranteed by Fannie Mae or Freddie Mac. In the secondary mortgage market, the credibility of Fannie Maeand Freddie Mac’s guarantees is crucial to MBS investors.

As for the third channel, we estimate the portfolio rebalancing effect by examining changes in the expected yield on afully-hedged MBS held by the marginal MBS investor. Many MBS investors, who are not interested in taking the interestrate or prepayment risks associated with MBS, still have a strong preference for holding MBS (e.g. for diversificationreasons or owing to regulatory capital standards). By withdrawing MBS from the financial markets, the Federal Reservereduces the demand for hedging instruments and thus the hedging costs for the marginal MBS investor (as well as for allother investors who are engaged in hedging), causing expected MBS yields to decrease. This decline in MBS yields caninfluence mortgage rates under conditions where GSE securitization is the preferred method of financing mortgages byprimary market mortgage originators.

We estimate that the announcement of the Federal Reserve’s MBS purchase program resulted in lower mortgage ratesof about 100 basis points for purchasing houses. About half of this decline resulted from the anticipation of portfoliorebalancing. The other half resulted from improved market functioning, and perhaps mainly from investors’ perceptions ofclearer government backing for Fannie Mae and Freddie Mac. As the Federal Reserve initiated actual MBS purchases, thereis evidence of some continued modest improvements in market functioning. As we describe below, after May 2009 theprogram had successfully returned mortgage markets to normal. Finally, the Federal Reserve’s MBS purchasing programput significant downward pressure on mortgage rates even after the program ended because of its effect on investor’sportfolio rebalancing decisions.

The remainder of this paper is structured as follows: Section 2 provides a brief description of mortgage markets duringthe autumn of 2008, when the Federal Reserve’s MBS program was announced, through early 2010, when the program waswound down. Section 3 provides a brief historical account of the intervention period. Section 4 presents our secondarymarket and primary market mortgage pricing models and our time-series estimates of the effects of the Federal Reserve’sMBS program on mortgage rates. Section 5 provides the conclusion.

2. Structure of the U.S. secondary mortgage market

The U.S. secondary market is primarily focused on the hedging of the risks associated with 30-year fixed rate mortgagesthat do not penalize the borrower for early prepayment.

2.1. Pricing the 30-year fixed-rate mortgage contract

When a homeowner finances a home with a 30-year fixed-rate conforming mortgage, the borrower receives the optionto prepay the mortgage at any time. The option is implicitly paid for with an upward adjustment in the mortgage raterelative to the rate that would be charged on a mortgage without the prepayment option. Therefore, the provider of themortgage has to estimate how much to increase the mortgage rate over its cost of funds to cover the expected costsassociated with this prepay option. The valuation of the prepay option entails estimating when the homeowner is likely toprepay the mortgage.

4 These types of portfolio readjustments are described in Gagnon et al. (2010) and in Tobin (1958). More generally, there are currently three papers

that consider the effects of the Federal Reserve’s MBS purchase program: Fuster and Willen (2010), Stroebel and Taylor (2010), and Gagnon et al. (2010).

Each of these papers uses a different empirical technique to determine the effects of the Federal Reserve’s purchase program. All of the papers find

evidence of substantial announcement effects for the program, with estimates for the decline in interest rates ranging from 30 basis points to slightly

over 100 basis points.

D. Hancock, W. Passmore / Journal of Monetary Economics 58 (2011) 498–514500

2.1.1. Pricing MBS yields

Suppose a mortgage is incorporated into an agency MBS. The holder of the MBS has no credit risk (because the MBS isguaranteed by Fannie Mae, Freddie Mac or Ginnie Mae), but still must manage interest rate risk and prepayment risk. Inthe event that the homeowner prepays the mortgage, the cash payment is sent to the holders of the agency MBS on a pro-rata basis. Although the holders of the MBS are uncertain about when such a prepayment will be received, the prepaymentis more likely when mortgage rates become lower than the original rate.

Investors adjust the stated yields on MBS for the homeowner’s prepay option when they compare yields across fixed-rate securities. The ‘‘option-adjusted spread,’’ or OAS, is the additional return from holding an MBS relative to abenchmark, such as a swap rate or a Treasury yield. Estimating OAS requires forecasting future paths for interest rates,including future paths for the slope of the yield curve. In addition, investors must model the propensity of homeowners toprepay their mortgage when current or expected mortgage rates are low compared with previous mortgage rates.Homeowners are more likely to refinance their mortgage in low rate environments (unless the future path of mortgagerates suggest even lower mortgage rates are likely to be forthcoming), with the result that the investor receives cash atexactly the wrong time—just when reinvestment possibilities all provide low returns.5

The same process used to calculate the OAS for an MBS generates an estimated duration for the security. Generally, MBSduration is the sensitivity of a fixed income security to interest rate changes. Like the OAS, duration calculations for MBSmust account for changes in the value of the homeowner’s option to prepay his or her mortgage. When interest ratesbecome higher, the value of existing MBS declines because new bonds pay higher rates and because the effective maturityof the MBS extends in a relatively high rate environment (because homeowners are less likely to prepay their mortgage). Incontrast, when interest rates become lower, the likelihood of prepayments by homeowners with fixed-rate mortgagesrises, and the effective maturity of the cash flows shorten.

2.2. Demand for GSE MBS

The Federal Reserve (over time) committed to purchasing $1.25 trillion of MBS by the end of 2010:Q1.6 Even undernormal market conditions, the Federal Reserve would have become the largest ‘‘buy-and-hold’’ investor in MBS. But theautumn of 2008 was a period of severe financial market turmoil and deep recession, so private sector buyers of MBS wereon the sidelines. Moreover, the Federal Reserve’s MBS purchases far outpaced net MBS issuance throughout the period ofits purchase program because the refinancing of mortgages and new home sales remained relatively weak in spite of thehistorically low level of mortgage rates. In short order, the Federal Reserve became the dominant buyer in the secondarymortgage market.

Up until the autumn of 2008, the major buyers in the MBS market were the two housing-related GSEs (Fannie Mae andFreddie Mac), depository institutions, foreign buyers (including central banks and sovereign wealth funds), and moneymanagers. Among these buyers, the GSEs had typically operated with the lowest funding costs.

2.2.1. GSEs: Fannie Mae and Freddie Mac

On September 7, 2008, the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservator-ship. At the same time, Treasury took three additional steps to complement FHFA’s decision to place both enterprises inconservatorship. First, Treasury and FHFA established Preferred Stock Purchase Agreements – contractual agreementsbetween the Treasury and the conserved entities – to ensure that each company would maintain a positive net worth.Second, Treasury established a new secured lending credit facility that would be available to Fannie Mae, Freddie Mac, and theFederal Home Loan Banks, thereby implementing the temporary liquidity backstop authority that had been granted byCongress in July 2008. This backstop would be available until those authorities expired in December 2009. Third, to furthersupport the availability of mortgage financing, Treasury initiated a temporary program to purchase GSE MBS.7 The Treasury’sGSE MBS program began later in September 2008 and expired with the Treasury’s temporary authorities in December 2009.

2.2.2. Depository institutions

Banks and other depository institutions have tended to compare MBS yields to their own loan yields. During arecession, GSE MBS had traditionally been a ‘‘parking spot’’ for banks’ excess funding while they waited for clearer signalsconcerning loan demand. More specifically, when MBS yields rose relative to loan yields, and loan demand remainedsubdued, then banks stepped-up their MBS purchases.

5 During 2008 and 2009, OAS calculations became much more difficult because of the uncertainty about how declining home values and sharply

rising unemployment would influence homeowners’ propensity to prepay.6 On Wednesday, March 18, 2009, the Federal Open Market Committee (FOMC) announced that it would provide ‘‘greater support to mortgage

lending and housing markets’’ by increasing the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of

agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion by the end of the year. See: FOMC (2009). On

that date, the MBS-Treasury spread was almost unchanged and mortgage rates moved slightly lower.7 When announcing the Treasury’s GSE MBS program, Secretary Paulson stated: ‘‘As the GSEs have grappled with their difficulties, we’ve seen

mortgage rate spreads to Treasuries widen, making mortgages less affordable for homebuyers. While the GSEs are expected to moderately increase the

size of their portfolios over the next 15 months through prudent mortgage purchases, complementary government efforts can aid mortgage

affordability.’’ See Paulson (2008).


But the recession that began in December 2007 was atypical. By autumn 2008, some banks were facing capitalconstraints that limited their ability to increase their MBS purchases. Moreover, to enhance their capitalization, such bankshad an incentive to sell their MBS holdings when OAS spreads were falling, in order to book capital gains and build theircapital. Indeed, with bank capital in short supply, some banks found it appealing to purchase Ginnie Mae securities (with azero risk-weight in regulatory capital calculations), rather than Fannie Mae or Freddie Mac MBS (with a 20 percent risk-weight in regulatory capital calculations).

2.2.3. Foreign buyers

Foreign buyers, including central banks and sovereign wealth funds, greatly curtailed, or ceased, their purchases of GSEMBS in the months leading up to the establishment of the GSE conservatorships in September 2008. Afterwards, in the faceof persistent dollar accumulations, they occasionally entered the MBS market, but persistent uncertainty about the futureof Fannie Mae and Freddie Mac put these foreign institutions ‘‘on-hold,’’ and they generally limited any increases in theirU.S. dollar dominated assets to U.S. Treasury securities.

2.2.4. Money managers

The money managers, who participate in bond markets on behalf of themselves and others, usually compare therelative return on holding GSE MBS to holding other forms of fixed-income securities. These investors did not make largepurchases of GSE MBS during the Federal Reserve MBS purchase program. The relatively low level of MBS OAS, during andafter the Federal Reserve’s MBS purchase program meant that their attention turned elsewhere.

Looking back to December 31, 2009, the total outstanding MBS that were backed by Fannie Mae and Freddie Mac togethertotaled roughly $3.9 trillion.8 These entities each held about $850 billion of their own MBS. Depository institutions heldabout $1.3 trillion in GSE MBS. Foreign entities’ held about $600 billion in GSE MBS. Insurance companies, mutual funds,pension funds, and state governments held about $2.5 trillion in both agency debt and MBS.9 Given these holdings by theother major players in the GSE MBS markets, the Federal Reserve’s purchase of $1.25 trillion agency MBS would amount toabout one-third of the outstanding agency MBS at year-end 2009. Because of the sheer magnitude of its MBS purchaseprogram, there is no doubt that the Federal Reserve became the predominant purchaser of MBS during its purchase program.

2.3. Supply of GSE MBS and mortgage rate determination

When a bank (or other type of entity) originates a mortgage that is eligible for GSE securitization, it must decidewhether to (1) bear the credit risk of the mortgage itself (i.e., hold the mortgage in its own portfolio) or (2) have a GSEguarantee the mortgage by converting the mortgage into MBS. If a bank converts its mortgage into GSE MBS, then it mustalso decide whether to hold the MBS in its portfolio or to sell the MBS into the secondary market.

For this second decision, the bank compares its return from holding GSE MBS on its balance sheet – funding it at a costequal to its weighted average cost-of-funds, which consists mainly of FDIC insured deposits, Federal Home Loan Bankadvances, and an imputed cost to equity – to the return it receives from selling the GSE MBS to another secondary marketpurchaser. In essence, the bank compares its own marginal cost of funds to that of the marginal cost of funds for themarginal secondary market purchaser of GSE MBS.10 Moreover, since a bank’s liabilities have a much shorter expectedmaturity relative to the expected life of a mortgage loan, a bank, as well as most other MBS investors, almost always incursignificant costs to hedge against the interest rate and prepayment risks associated with mortgages and MBS.

Consequently, to actually influence the primary conforming mortgage rate (the mortgage rate that applies to mortgageseligible for GSE purchase), the Federal Reserve had to change the economic calculations associated with the mortgageoriginator’s two decisions described above. The purchases of GSE MBS in the secondary market that were made by theFederal Reserve and by the U.S. Department of the Treasury were passive; that is, the MBS were purchased at prevailingmarket prices. Such purchases removed supply from the secondary market, with the hope of causing banks and otherprivate market purchasers of MBS to bid more aggressively for the remaining MBS in the marketplace. Thus, FederalReserve MBS purchases in the secondary market influenced primary mortgage rates only to the extent that (1) thesecondary market itself was providing the marginal funding of primary mortgages and (2) the lower yields on currentcoupon MBS were effectively determining the primary mortgage rate.

With regard to the first condition, the secondary market was indeed the likely source of marginal funding during therecent financial crisis. Almost all newly originated mortgages were securitized using Fannie Mae and Freddie Mac duringthat time. The cost of capital was very high for mortgage originators, reflecting extreme investor uncertainty regarding thecredit and prepayment risks associated with mortgages. Capital-starved mortgage originators likely had very highmarginal costs and, as a result, they generally decided not to hold their newly originated mortgages in their own portfolios.

8 The amounts of MBS backed by each GSE were not equal. Fannie Mae backed about $2.4 trillion of MBS and Freddie Mac backed about $1.5 trillion

MBS.9 Unfortunately, the dollar amount for holdings by insurance companies, mutual funds, pension funds, and state governments cannot easily be

parsed into GSE MBS holdings versus agency debt holdings or into separate financial sectors. That said, it appears that between one-half and one-third of

the total dollar amount, $2.5 trillion, was held in MBS.10 See Heuson et al. (2001) or Hancock and Passmore (2010) for details with respect to the model.


With regard to the second condition, the Federal Reserve’s strategy of creating a shortage of MBS and therebypromoting housing market activity by lowering mortgage rates was expected to be difficult to achieve for at least tworeasons: First, the Federal Reserve could only purchase agency- and Ginnie Mae-backed MBS and many recent mortgageborrowers had mortgages that were outside of the revised GSE and FHA underwriting standards. Such borrowers wouldcontinue to find it difficult to refinance their mortgages and thus they might not benefit from lower mortgage rates.

Second, the segmentation in the market between current coupon MBS and higher (i.e., older) coupon MBS was imperfect.11

If MBS market investors found a shortage of current coupon MBS, such investors could simply substitute to higher coupon MBSby purchasing older MBS from the outstanding stock of existing MBS. Ex ante, the elasticity of this potential substitution acrossMBS with different coupons was unknown. If the MBS in the outstanding stock was a close substitute for current coupon MBS,it would be difficult to get investors to perceive there was a shortage of MBS. Given the difficulties faced by the Federal Reserveto use the tools at its disposal to influence primary market mortgage rates, it was an empirical matter whether the FederalReserve’s large purchases of GSE MBS would actually have a significant effect on primary mortgage rates.

3. Description of the Federal Reserve’s GSE MBS market intervention

The large-scale GSE MBS purchase program was an integral component of the ‘‘credit easing’’ by the Federal Reserve,which focused on using the asset side of the central bank’s balance sheet to eliminate illiquidity and abnormally highcredit spreads in financial markets.12 Federal Reserve MBS purchases were mostly securities issued by Fannie Mae andFreddie Mac. Ginnie Mae securities, with explicit full faith and credit government guarantees, were generally not the focusof Federal Reserve MBS purchases.

As shown in the top panel of Fig. 1, the Federal Reserve generally purchased between four and six billion dollars of agencyMBS per day until the announcement of the end of the program on September 23, 2009. After that date, MBS purchases taperedoff. These purchases were implemented in a rather mechanical manner, with the average amount purchased during each daytargeted to hit the desired total quantity of MBS holdings target by the last day of the MBS purchase program.

As shown by the black line in the bottom panel of Fig. 1, Federal Reserve purchases accounted for between 50 and 150percent of the gross issuance amount of current-coupon MBS issued by Fannie Mae, Freddie Mac, and Ginnie Mae. Sincenet issuance ran between one-third and one-half of gross issuance during the time period that is depicted (because ofprepayments and repayments of mortgage principle amounts), the Federal Reserve generally purchased substantially morethan the net MBS issuance amount. Indeed, the supply of ‘‘floating’’ MBS – the MBS that could be traded because it was notheld in the portfolios of ‘‘buy and hold’’ investors – that was available to private sector market participants generallydeclined throughout the period. Also shown in the bottom panel of Fig. 1, Federal Reserve agency MBS purchases (shownby the gray line) eventually amounted to about one-third of all outstanding agency MBS.

The Federal Reserve’s intervention in the MBS market can be divided into three distinct time intervals—one associatedwith the announcement, another associated with uncertainty about the intent of government actions, and another thatbrought the return to normal market pricing conditions.

3.1. Announcement period

Mortgage market analysts generally praised the Federal Reserve MBS purchase program when it was announced.13

They argued that it was a needed statement of support for a market that was supposedly already government-backed, butnot acting like it. The program was applauded by market participants because it would potentially help resolve persistentproblems associated with illiquidity, price discovery, and ambiguity about government guarantees in the secondarymortgage market. Moreover, the Federal Reserve’s announcement lessened increasing market unease about the potentialramifications on the mortgage market that would result from (1) the constraints on the sizes of the GSE portfolios thatwere imposed when Fannie Mae and Freddie Mac entered into conservatorship, and (2) the significant and sharplyincreasing delinquency rates on the GSEs’ mortgage holdings.14

Within minutes of the Federal Reserve’s announcement, Fannie Mae option-adjusted current coupon mortgage-backedsecurity spreads over swap yields plummeted from about 65 basis points to almost zero (not shown). And by the end of the

11 MBS is sold with coupons at half-percentage intervals (e.g., 4.0 percent, 4.5 percent, or 5 percent). The ‘‘current coupon’’ is the one most commonly

produced on new issues of MBS. For example, if the prevailing mortgage rate is 4.625 percent, the current coupon will likely be 4.0 percent because, after

the deduction of servicing and guarantee fees (generally 50 basis points), 4.0 percent is the first half-percentage-point value that is lower than the

prevailing mortgage rate. The stock of MBS outstanding consists of MBS with many different coupons.12 Credit easing involves the expansion of the Federal Reserve’s balance sheet with a focus on the mix of loans and securities it holds and an attention

to how this composition will affect credit conditions for households and businesses. For a discussion of credit easing versus quantitative easing, see

Bernanke (2009).13 Hilsenrath and Solomon (2008), reported that Michael Feroli, an economist at JP Morgan Chase, wrote in a note to clients that: ‘‘We expect this

action will measurably improve conditions in the mortgage markets and will have beneficial effects on housing and the broader economy.’’14 The rate of loans 90 or more days past due in Fannie Mae’s portfolio rose to 1.72 percent in September 2008 (the latest data available at the time of

the Federal Reserve MBS purchase program announcement), up from 1.57 percent in the previous month. The single-family delinquency rate for Freddie

Mac was 1.34 percent in October 2008, up from 1.22 percent in September 2008. With the Federal Reserve announcement, market participants became

more confident that the government would stand behind the GSEs regardless of the performance their portfolios.

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Fig. 1. Federal Reserve intervention in the Agency MBS market. MBS purchases are from the Federal Reserve Bank of New York, and issuance and

outstanding numbers are from eMBS.com.


day on November 25, many large MBS holders had entered the market and were selling off their MBS in large quantities inorder to realize capital gains. As a result, the OAS (over swap yields) was only 37 basis points lower than the previous dayby the end of the announcement day.15 At the same time, press reports indicated that mortgage rates for prime borrowers(that is, borrowers of good credit quality with a 20 percent or larger down-payment) fell by as much as half of a percentagepoint. Indeed, this immediate and significant effect on mortgage rates likely resulted from expectations by marketparticipants that the Federal Reserve would act to re-establish a functioning secondary mortgage market in which primarymortgage market originators would be able to finance their mortgages – at the margin – with certainty. These lowermortgage rates, in turn, set off a burst of mortgage refinancing activities by homeowners.

Because consultation with market participants was necessary to work out the operational details of the Federal ReserveMBS purchase program, there was a fairly long delay between the announcement of, and implementation of, the FederalReserve’s intervention into MBS markets. As a result, the Federal Reserve did not actually begin purchasing MBS until thefirst weeks of January 2009.16

15 OAS (over Treasury yields) closed about 40 basis points lower than the previous day. However, the ‘‘flight to quality’’ by investors towards U.S.

Treasuries had preceded the Federal Reserve’s actions. Because Treasury yields had already declined significantly, the change in OAS MBS spreads to

Treasuries are more difficult to interpret.16 Federal Reserve Bank of New York (2009) publishes an explanation of open market operations each year in its Annual Report. The 2009 Annual

Report describes the mechanics associated with the Federal Reserve’s purchases of agency MBS and provides information on agency MBS purchases by

maturity and by issuer. Such purchases were made across securities with different issuers, maturities, and coupon rates, but were generally concentrated

in low coupon, 30-year securities issued by Fannie Mae and Freddie Mac. Also, the agency MBS purchase program arranged transactions in dollar rolls


3.2. Market transition before and after May 27, 2009

As will be discussed below, once the Federal Reserve’s MBS purchase program was up and running, it resulted in agradual elimination of the extreme risk aversion of investors that had built up after the events that occurred in the autumnof 2008. Once purchases had begun, however, investors were uncertain about whether or not the Federal Reserve, and thegovernment more generally, was committed to creating an artificially low mortgage rate. This uncertainty disappeared onMay 27, 2009.

Mortgage rates increased 38 basis points during the week of May 27, 2009 in tandem with sharply higher yields onMBS. An increase in longer-term Treasury yields, combined with investors’ fears associated with higher future longer-termTreasury yields, had caused many mortgage traders to sell off large quantities of MBS. Moreover, fears of a substantialmortgage amplification effect had created belief among many investors that if the Federal Reserve was ever going to targeta particular mortgage rate, this would be the time to intervene aggressively in the market.

To understand the mortgage amplification effect, consider the classic way to hedge an MBS by selling a fixed-rateinterest swap. The value rises for the fixed-rate swap when rates increase, offsetting the loss in value on the MBS. Dealerswho provide the swap to mortgage holders (thus receiving the fixed-rate leg of the swap) often hedge their risks using theTreasury markets. In response to increased demands for fixed-rate interest swaps, these dealers shed their longer-termTreasury holdings to reduce the effective maturity of their own portfolios. This shedding of Treasury securities puts furtherpressure on longer-term Treasury rates to rise. This feedback cycle is called the ‘‘mortgage amplification effect’’ onTreasury rates.17

Until May 2009, many market participants believed that the government or the Federal Reserve was targeting a lowmortgage rate and would increase purchases of MBS when interest rates were rising to keep downward pressure on mortgagerates.18 As a result, these mortgage market participants left their MBS positions relatively un-hedged. That is, they werecounting on the Federal Reserve to effectively ‘‘hedge’’ against MBS interest rate risks by keeping mortgage rates low.

But as overall Treasury rates began to increase in May, the Federal Reserve did not substantially increase its purchasesof MBS, even though it had room to do so within the cap for its MBS purchase program. This lack of action convinced mostmarket participants that the Federal Reserve was not targeting a mortgage rate. With the elimination of the uncertaintyconcerning the Federal Reserve’s objective, the market returned to more normal market hedging and pricing relationships.

4. Using regressions to determine the effect of the Federal Reserve’s MBS program

We employ time series regressions to examine the determinants of mortgage rates and the possible effect of the FederalReserve MBS purchase program on such rates. To do so, we consider a decomposition of the mortgage rate-swap spread –shown in the top panel of Fig. 2 – that is a common measure of investors’ gross risk compensation required to hold MBS.

The time-series of the mortgage rate-swap spread can be described using its two components: (1) the MBS-swap spread(shown in the middle panel, Fig. 2); and (2) the mortgage rate-MBS spread (shown in the bottom panel). The firstcomponent – the MBS-swap spread – reflects actions taken in the secondary market by banks to hedge their portfolios ofMBS against interest rate, funding, prepayment, and liquidity risks. And the second component – the mortgage-MBS yieldspread – reflects mark-ups by banks to compensate for costs associated with the origination, servicing, and credit risks ofmortgages. We consider the time-series properties of these two components using two regression models of (1) thedeterminants of yields on MBS; and (2) the determinants of mortgage rates.

Strikingly, the time-series movements of these spreads over the past ten years can be broken into five distinct periods:(1) the ‘‘pre-subprime’’ or ‘‘normal’’ mortgage period (July 2000–March 2004); (2) the ‘‘subprime dominance’’ period (April2004–July 2007); (3) the financial crisis (August 2007 until the Federal Reserve’s intervention on November 25, 2008); (4)the period of Federal Reserve intervention in the MBS market (November 25, 2008–March 31, 2010), and (5) the post-Fedintervention period (April 1, 2010–August 2010).19 The beginning- and end-points for the crisis period, the Federal Reserveintervention period and the post-Federal Reserve periods are unambiguous, as they are defined by events. The crisis periodbegan with a seizing-up of the intra-bank market in August 2007, which signaled the widespread contagion of the financialcrisis (Swagel, 2009). The announcement of the Federal Reserve intervention and the end of the Federal Reserve’s purchaseprogram define the Federal Reserve intervention period. The split between the ‘‘normal’’ and ‘‘subprime dominance’’period is, however, somewhat arbitrary. That said, the persistently low level of spreads during the ‘‘subprime dominance’’period is evident in all panels in Fig. 2.

(footnote continued)

(i.e., short-term financing vehicles that function similarly to repo, and hence, historically imply similar financing rates in well-functioning markets) in an

effort to support MBS financing. For dollar roll purchases, implied financing roll rates were used to indicate dislocations that warranted Desk support.17 See Duarte (2008) and Perli and Sack (2003).18 Support for this perspective is found in Solomon and Paletta (2008).19 A weighted average of MBS yields that bracket current coupon MBS is used. The Treasury yield is chosen from an interpolated yield curve using the

average duration of the bracketed current coupon MBS. Bloomberg information on durations and MBS yields are used in these calculations. Bloomberg’s

calculations are representative of the type of estimates used by market participants, but as mentioned earlier, all calculations of durations had difficulties

during this time period.

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Fed

Fed

Fig. 2. Decomposition of the mortgage-swap spread. The mortgage rate - swap spread is a common measure of investor’s gross risk compensation

required to hold MBS. This spread has two components. The first component, the MBS - swap spread, reflects actions taken in the secondary market by

banks to hedge their portfolios of MBS against interest rate, prepayment, and liquidity risks. The second component, the mortgage - MBS yield spread,

reflects mark-ups by banks to compensate for costs associated with origination, servicing, and credit risks of mortgages. Average MBS yields and swap

spreads are derived from Bloomberg data. Mortgage rates are from Freddie Mac. Means for each period are indicated by horizontal dashed lines.


4.1. Determinants of MBS yields

MBS yields are described as a linear function of four variables: (1) a long-term swap rate; (2) a short-term swap-to-Treasury spread; (3) a proxy for prepayment risks; and (4) a proxy for rollover risks. As discussed above, private investorsin MBS often purchase an interest rate swap, for which they pay the fixed-portion of the swap and receive the short-termvariable payment; almost always a payment based on the three-month Libor rate. This interest rate swap removes theinterest rate risk associated with holding MBS if the holder is funded by short-term (three-month) liabilities. We averageacross the five-year and ten-year swap rates to approximate these average costs of hedging MBS, which typically havedurations that run between three and six years. The ten-year history of long-term swap spreads is provided in Fig. 3.Strikingly, during the period of the Federal Reserve’s MBS purchase program, these swap rates fell to their lowestlevels ever.

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Long Swap

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Fig. 3. Long swap. This interest rate swap removes the interest rate risk associated with holding MBS if the holder is funded by short-term (three-month)

liabilities. The five-year and ten-year swap rates are averaged to approximate the costs of hedging MBS. Average swap spreads are derived from

Bloomberg data. Means for each period are indicated by horizontal dashed lines.

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Fig. 4. Basis risk proxy. Using a long-term swap to hedge mortgage interest rate risk would still leave the holder of the MBS with maturity mismatch and

basis risks if their underlying funding structure is not similar to three-month Libor. This risk is approximated with the spread between averaged short-

term swap rates and the Treasury rate derived from Bloomberg data. Means for each period are indicated by horizontal dashed lines.


Using a long-term swap to hedge mortgage interest rate risk would still leave the holder of the MBS with a significantmaturity mismatch and some basis risk if their underlying funding structure is not similar to three-month Libor.20 Among thetypes of major holders of MBS described above, it is difficult to know who the ‘‘marginal’’ holder of MBS is at any point in time.For our description of MBS yields, we will assume that the marginal portfolio purchaser of MBS is a ‘‘bank,’’ which typically wouldhave a fairly short maturity of liabilities (e.g., one or two years). Our ‘‘bank’’ is modeled as using a swap to convert its three-month Libor payment for an average yield on one-year and two-year Treasury securities to help match the effective maturity ofits liabilities. Because the ‘‘bank’’ would still likely continue to have basis risk (since its liability structure would probably be moresensitive to Treasury rates than to the average swap rates), we also include the spread between the short-term swap rate and the

20 In many structural models, mortgage prepayment risks would depend on the volatility of predicted mortgage rate volatility, as well as the history

of mortgages. Our ‘‘marginal risk’’ regression can be interpreted as incorporating these useful variables for modeling mortgage prepayment risks as used

for hedging by market participants. For an example of a structural model, see Sharp et al. (2008).

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Fig. 5. Prepayment risk proxy. Prepayment risk is estimated using the difference of the mortgage rate averaged over the past three years and the current

mortgage rate. Mortgage rates are from Freddie Mac. Means for each period are indicated by horizontal dashed lines.


Treasury rate in the regression as a proxy for the cost of this basis risk. As shown in Fig. 4, our proxy for basis risk increasedsignificantly during the crisis, but fell to relatively low levels after the Federal Reserve’s intervention in the MBS market.

Recall that MBS holders are compensated for in their yields for offering homeowners a prepay option. Usually, anestimate of the cost of the prepay option is a model-based estimate of the fair value of selling the option to thehomeowner. It reflects the cost to the investor of either being forced into a low-yielding asset during a period of lowinterest rates, or the risk of carrying un-hedged interest rate risk, if interest rates rise and the mortgage is outstandinglonger than expected (so-called extension risk).

The valuation of the prepay options of homeowners is difficult and complex even in normal circumstances. Since thefinancial crisis, prepayment models have become less reliable. Given that even the best prepayment option models often couldnot reliably gauge prepayment risk over our estimation periods, we use a simple measure—the difference of the mortgage rateaveraged over the past three years and the current mortgage rate. The variable measures the risk that the stream of MBSpayments is terminated either sooner because of a relatively low mortgage rate environment, or later because of a relativelyhigh mortgage rate environment than was expected. Like more sophisticated models of prepayment risk, this measureindicates that such risks were high during the period of the Federal Reserve’s intervention (Fig. 5), even though the actualrefinancing rate of mortgages was very low compared to the past. In fact, the level of actual prepayments was low relative tothe historical level associated with low mortgage rates because many households had home values that had fallen near (or evenbelow) their outstanding mortgage value (i.e., their mortgages were ‘‘under water’’), the credit quality of many households haddeteriorated, and the costs associated with refinancing a mortgage had become much higher.

Lastly, we account for the ‘‘rollover risk’’ that is associated with the shorter-term swap in our MBS yield specification.We use the volatility (measured by the 90 percent confidence interval) of the forward swap rates implied by swaptionsbetween two and ten years to proxy for rollover risk during the life of the mortgage that results from financial marketdisruptions, credit downgrades, and other unanticipated events.21 As shown in Fig. 6, this measure of rollover risk followsthe expected pattern; falling sharply during the period of subprime dominance, rising sharply during the crisis, and thendeclining to something near a ‘‘normal’’ level after the Federal Reserve’s intervention into the MBS market.

4.2. Regression analysis of MBS yields

The data during the ‘‘normal’’ period provide the basis for our benchmark regressions, as this time period represents thefunctioning of mortgage market prior to the market’s enthusiasm about non-traditional mortgages and the resultingunusually low risk premiums for mortgage assets.22 Our results for the regression that describes MBS yields during the‘‘normal’’ period (July 2000–March 2004, inclusive) are provided in Table 1.23 As expected, long swap rates are highly

21 A swaption is an option to enter into an interest rate swap at a future date.22 In our working paper, we also analyze pricing models based on the ‘‘subprime dominance’’ period and demonstrate that it was a period of

abnormally low risk premiums in mortgage markets. See Hancock and Passmore (2011).23 We used standard Dickey–Fuller tests to determined that the variables used in the regressions are I(1) variables, and that each of the regressions

are cointegrating regressions with residuals that are I(0).

Table 1MBS Yield Regression: Estimates.

Daily Data, Estimated Over July 2000–March 2004 (n¼976)

Parameter Estimate Standard Error t value

Factor (1) (2) (3)

(1) Long swap rate 1.06 0.01 76.61

(2) Basis risk proxy �0.20 0.06 �3.09

(3) Prepayment risk proxy 0.25 0.02 11.56

(4) Roll-over risk proxy 0.82 0.06 12.92

(5) Intercept �0.37 0.12 �2.95

(6) Memo item: R-squared 0.99

The dependent variable of the MBS pricing regression is the MBS yield. Yields are calculated using a weighted average of Bloomberg generic MBS yields

bracketing current Freddie Mac mortgage rate (within a 50 basis point bracket). The independent variables are described in the notes for Figs. 3 through 6.

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Fig. 6. Rollover risk proxy. Rollover risk is measured using the volatility (measured by the rolling 90 percent confidence interval) of the forward swap

rates implied by swaptions between two and ten years. Over the life of the mortgage, the short-term swap rate may jump because of financial market

disruptions, credit downgrades, and other unanticipated events. The 90 percent confidence interval is calculated by the authors from Bloomberg data.

Means for each period are indicated by horizontal dashed lines.


correlated with MBS yields with an estimated coefficient nearly equal to one. This high correlation results from almost allmarket participants making reference to long swap rates when pricing MBS.

The coefficient on our measure of basis risk, measured by a short-term swap-to-Treasury spread, could have been eitherpositive or negative since it depends on (1) the liability structure of the institutions that finance the mortgages, and (2) thesupply and demand conditions in both the swap and Treasury markets, which are not possible to measure with availabledata. Using data from the ‘‘normal’’ period, the regression coefficient for our measure of basis risk is slightly negative,suggesting that the marginal holder of MBS during the ‘‘normal’’ period may have needed to make only a small mark-upadjustment to the MBS yield for basis risk.

Prepayment risks and rollover risks, which were proxied using the uncertainties involved with extending two-yearswaps into the future, both added to the costs of holding MBS during the ‘‘normal’’ period. MBS yields were higher byabout 25 basis points for prepayment risks and by about 82 basis points for rollover risk, on average.

The intercept can be interpreted as a ‘‘level adjustment’’ that accounts for residual risks, for the imperfect nature of ourdata, and perhaps adjusts for our assumption that a ‘‘bank’’ is the marginal holder of MBS, rather than a different type ofinvestor. Since GSE MBS is guaranteed against credit risk, the most important residual risk remaining is liquidity risk. Theintercept is negative and significant in the ‘‘normal’’ period, suggesting that well-hedged MBS might have had significantliquidity premiums on average during that time.

To consider the effects of the financial crisis and of the Federal Reserve’s intervention on MBS yields, we examine theout-of-sample fit of the regression estimated during the ‘‘normal’’ period. As shown in Fig. 7, the out-of-sample fit for the‘‘normal’’ period pricing regression is quite tight until mid-2005. In contrast, during the crisis actual MBS yields (shownusing a black line) become strikingly higher than predicted MBS yields (shown using a gray line) until May 27, 2009.Equally apparent is the fact that after May 27, the fit for the ‘‘normal period’’ regression estimates is once again fairly tight

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Fig. 7. MBS yield regression. The out-of-sample fit for the MBS pricing regression is the difference between the black and gray lines.

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Fig. 8. MBS yield deviations. The deviations for the MBS pricing regression falls after the Federal Reserve s intervention. Means for each period are

indicated by horizontal dashed lines.


and the observed MBS yield is only about 16 basis points lower on average than the predicted MBS yield. This transition tonormal pricing, however, was not immediate. As Federal Reserve MBS purchases progressed, the market graduallydeveloped an understanding of the Federal Reserve’s objectives and MBS yield deviations declined (Fig. 8).

4.3. Determinants of mortgage rates

Mortgage rates are determined by the funding cost for the marginal mortgage. During the financial crisis, the GSEssecuritized almost all mortgages that were originated. In this environment, the mortgage rate became a fairlystraightforward ‘‘mark-up’’ over the MBS yield for all mortgage market participants.

As shown in Fig. 9, the spread between the observed mortgage rate and the Treasury yield (represented by a gray line)declined substantially between the announcement of the Federal Reserve’s purchase program on November 25, 2008 andMay 27, 2009. After May 27, 2009, this mortgage rate spread once again aligned with its value on average observed duringthe ‘‘normal’’ period. The level of the mortgage rate (denoted by the black line in Fig. 9) quickly dropped about 125 basispoints at the time of the Federal Reserve’s MBS purchase program announcement.

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Suborime Dominance Crisis FedIntervention

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Fig. 9. Primary mortgage market rates and spreads. The primary mortgage rate and the spread between the mortgage rate and the Treasury yield

declined substantially after the announcement of the Federal Reserve s purchase program. Mortgage rates are from Freddie Mac and Treasury yields are

from Bloomberg.

Table 2Mortgage rate regression: estimates.

Weekly Data, Estimated Over July 2000–March 2004 (n¼186)

Parameter Estimate Standard Error t value

Factor (1) (2) (3)

(1) MBS yield (1-week lag) 0.63 0.02 32.41

(2) Home price index (10-Week lag) �0.54 0.09 �6.02

(3) Intercept 3.66 0.25 14.56

(4) Memo item: R-squared 0.97

The dependent variable of the MBS pricing regression is the Freddie Mac 30-year fixed rate mortgage rate. The independent variables are the one-week

lagged MBS yield (described in the note for Table 1) and the 25-MSA composite, 7-day average of the price-per-square foot paid for residential real estate

calculated by Radar Logic.


The mortgage rate is modeled as a mark-up over the MBS yield. This mark-up is proxied by a crude measure of the costsassociated with origination, servicing and managing the credits risk of mortgages—a daily index of house prices. We usedthis measure because house prices incorporate a forward-looking component that reflects expectations of interest rates, aswell as determinants of housing market conditions such as unemployment, delinquencies, and default. These determinantsunderlie the credit risks and the costs of servicing mortgages, which comprise the mark-up over MBS yields. We alsoincorporated lags into the regression specification for mortgage rates in order to reflect the timing of when informationbecomes available to investors. For example, the house price index was lagged ten weeks (i.e., the value of the index tenweeks prior is assumed to be the most current value that would be known at any specific date).

In our mortgage rate regression, the MBS yield is the key determinant of mortgage rates and this lagged variable isstatistically different from zero (Table 2). As expected, the lagged home price index is also an important determinant ofmortgage rates and is consistent with the view that as home prices rise, the credit and servicing costs of mortgages fall.That is, the coefficient for the home price index was negative and statistically significant.

In Fig. 10, the mortgage rate regression for the ‘‘normal period’’ is used to compute out-of-sample predictions for themortgage rate thereafter. These out-of-sample predictions suggest that the mortgage rate was ‘‘too high’’ during the latterpart of the subprime dominance period and also during the crisis period. In contrast, after the Federal Reserve’sintervention, the out-of-sample predictions (denoted by the gray line) are higher than the observed mortgage rate(denoted by the black line). The low level of observed mortgage rates after the Federal Reserve’s intervention reflects thegenerally lower MBS yield predicted by the MBS yield regression that was estimated using time-series data from the‘‘normal’’ period. During the period of the Federal Reserve’s intervention, the actual mortgage rate, by this estimation,became persistently low. In fact, actual-predicted mortgage rate deviations were 25 basis points on average (Fig. 11).

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Fig. 10. Mortgage rate regression. The out-of-sample fit for the mortgage pricing regression is the difference between the black and gray lines.

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Fig. 11. Mortgage rate deviations. The deviations for the mortgage pricing regression fall after the Federal Reserve s intervention. Means for each period

are indicated by horizontal dashed lines.


4.4. Summarizing the effects of the Federal Reserve’s purchase program

We use a simple decomposition of the mortgage rate to summarize the effects of the Federal Reserve’s mortgage purchaseprogram. The changes in the mortgage rate can be broken into the changes in (1) abnormal mortgage pricing(i.e., the change in the difference between the expected and actual mortgage rate), (2) abnormal MBS pricing (i.e., the changein the difference between the expected and actual MBS yield), (3) the compensation needed for bearing interest rate risks, (4)the compensation needed for bearing prepayment risks, and (5) primary mortgage market costs. In other words, if:

Mortgage Rate¼Fþa�MBS Yieldþb�Primary Mortgage Market Costsþe ð1Þ

then

DMortgage Rate¼DAbnormal Mortgage Pricingþa�DAbnormal MBS Pricingþa�gDInterest Rate Hedging Costs

þa�gDVolatility Hedging Costsþb�DChange in Primary Mortgage Market Costsþe: ð2Þ

As described above, changes in abnormal market pricing for both mortgage and MBS markets are measures of bothimproved market functioning and clearer government backing. The effects of portfolio balancing drive both changes in

Table 3Changes in key variables, market functioning and portfolio rebalancing effects.

Actual data Predicted values Deviations

(actual-predicted)

Abnormal

mortgage

pricing

Abnormal

MBS

pricing

Interest

rate

hedging

cost

Volatility

rate

hedging

cost

Primary

mortgage

market

cost

Period of interest Mortgage

rate

MBS

yield

Swap

rate

Mortgage

rate

MBS

yield

Mortgage

rate

MBS

yield

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)

(1) Announcement Nov. 25, 2008–Jan. 7, 2009 �0.82 �1.27 �0.70 �0.76 �0.58 �0.06 �0.69 �0.06 �0.44 �0.44 0.08 0.05

(2) Market Transition Jan. 7,2009–May 27, 2009 �0.02 0.57 0.86 0.26 0.99 �0.28 �0.42 �0.28 �0.26 0.63 �0.01 �0.01

(3) Normal Pricing May 27, 2009–Mar. 31, 2010 0.09 �0.04 0.07 0.06 �0.09 0.03 0.05 0.03 0.03 0.08 �0.14 0.02

(4) Post-Fed Mar. 31, 2010–Aug. 10, 2010 �0.64 �0.95 �1.09 �0.62 �1.16 �0.02 0.21 �0.02 0.13 �0.74 0.01 �0.03

Changes are calculated using averaged end-points for each period to mitigate the effects of volatility. For daily data a 7-day average around the end point is used, and for weekly data a 3 week average around

the end point is used. The columns are the changes in following variables: (1) the Freddie Mac 30-Year fixed–rate mortgage, (2) the average of Fannie Mae and Freddie Mac current-coupon MBS yields described

in Table 1. (3) the long swap rate calculated as an average of 5- and 10-year rates, (4) the predicted mortgage rate from the regression described in Table 1, (5) the predicted mortgage yield from the regression

described in Table 2, (6) column 1 minus column 4, (7) column 2 minus column 5, (8) the mortgage rate regression residual from the regression described in Table 2 (same as column 6), (9) a from Eq. (1)

multiplied by the MBS yield regression residual from the regression described in Table 1, (10) the costs of interest rate hedging or a*g*[long swap rate þ basis risk proxy], (11) the costs of hedging volatility or

a*g*[prepayment risk proxy þ rollover risk proxy], and (12) the costs imposed in the primary mortgage market or b*housing price index þ mortgage rate intercept.

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interest rate hedging costs and changes in the volatility hedging costs because hedging activities were affected byinvestors’ strong preferences for holding long-maturity financial assets, including MBS, and because the purchases of MBSby the Federal Reserve lowered the demand for hedges.

As shown in Table 3 (row 1), mortgage rates fell 82 basis points during the announcement period. 24 This decline waspartially driven by a significant decline in measures of abnormal mortgage and MBS pricing (columns 8 and 9,respectively) during this period. In particular, the abnormal pricing in the MBS markets diminished significantly. At thesame time, portfolio rebalancing effects were also strong (column 10, row 1) because interest hedging costs declinedsubstantially (44 basis points). Overall, our estimates suggest that during the announcement period, the Federal Reserve’sactions significantly reduced mortgage rates by providing MBS market participants a clearer statement of governmentsupport and by raising the prospect of a future ‘‘shortage’’ of MBS.

During the market transition period (row 2, Table 3), there was almost no change in mortgage rates. However, this lackof change hides two offsetting effects. Federal Reserve actions seemed to continue to improve market functioning andprovide support for the GSEs (columns 8 and 9). But as described above, possibly poor Federal Reserve communicationabout the objective of the MBS purchase program, led to an offsetting increase in interest rate hedging costs (column 10).

We have highlighted the importance of May 27, 2009 as a date that the markets became clear about the FederalReserve’s goals regarding its MBS purchase program. During the normal pricing period during the Federal Reserve MBSpurchase program (row 3, Table 3), there is slight increase in mortgage rates. Overall, the mortgage market seems to havestabilized.

With the end of the Federal Reserve MBS purchase program, mortgage rates fell dramatically (64 basis points).Ironically, this may be the period when the Federal Reserve’s stock of MBS holdings had a significant effect on mortgagerates through the portfolio rebalancing channel. In early summer 2010, market participants had expected significant newnet issuances of MBS because of their perception that housing purchases were picking up and that mortgage refinancingswould be stronger, causing a shift in the stock of MBS holdings from the Federal Reserve to the private market. Instead, thehousing market and mortgage refinancings continued to be at disappointing levels and the demand for MBS by financialinstitutions to ‘‘park funds’’ only intensified. As a result, the Federal Reserve’s holdings of MBS measured as a proportion ofoutstanding MBS were held relatively constant. Our measures of market functioning and portfolio rebalancing effectssuggest that markets were in good shape (columns 8 and 9, Table 3), and that it was the portfolio rebalancing effects thatwere very strong and that pushed down mortgage rates substantially (column 10).

The causes of the interest rate declines associated with the announcement of the MBS purchase program are importantif one is considering whether or not the Federal Reserve’s experience with the announcement of the MBS purchaseprogram is repeatable. If the sharp drop in interest rates flowed mainly through the market functioning and governmentsupport channels, then the experience is unlikely to repeat itself outside of a financial crisis. However, if the drop in rateswas the anticipation of future Federal Reserve purchases reducing the supply of MBS, then future MBS purchases mightalso lead to lower MBS yields and mortgage rates. Our results suggest all three channels were important in creatingdownward pressure on mortgage rates.

5. Conclusion

The announcement of the Federal Reserve’s MBS purchase program clearly and substantially improved marketfunctioning and provided a strong statement of government support for U.S. mortgage markets. Moreover, the anticipationof portfolio rebalancing effects provided an important channel through which the Federal Reserve MBS purchase programsubstantially influenced mortgage rates.

In this paper, we develop an empirical technique that can be used to distinguish between three channels: (1) improvedmarket functioning, (2) clearer government support, and (3) anticipation of portfolio rebalancing. Our results suggest thataround half of the declines in mortgage rates after the announcement of the Federal Reserve’s purchases were associatedwith improved market functioning and clearer government backing, and about half with portfolio rebalancing. Once theFederal Reserve’s program stabilized the mortgage market, its portfolio purchases continued to create downward pressureon mortgage rates. However, some of this downward pressure was dissipated during the first quarter of 2009, perhapsbecause of market confusion about the objectives of the MBS purchase program. Lastly, we find that portfolio rebalancingcontinued to have a substantial effect even after the program ended because of the market conditions that evolved whilethe Federal Reserve continued to hold a substantial portion of the stock of outstanding MBS.

References

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24 The ‘‘changes over periods’’ shown in Table 3 are calculated using averaged end-points to mitigate the effect of volatility. For the daily data a 7-day

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Did the Federal Reserve's MBS purchase program lower mortgage rates?