We employ empirical pricing models for mortgage-backed security (MBS) yields and for mortgage rates to measure deviations from normal market functioning in order to assess how the Federal Reserve MBS purchase program-a 16 month program announced on November 25, 2008 and completed on March 31, 2010-affected risk premiums that were embedded in mortgage and swap markets. Our pricing models suggest that the announcement of the program, which signaled strong and credible government backing for mortgage markets in particular and for the financial system more generally, reduced mortgage rates by about 85 basis points between November 25 and December 31, 2008, even though no MBS had (yet) been purchased by the Federal Reserve. Once the Federal Reserve's MBS program started purchasing MBS, we estimate that the abnormal risk premiums embedded mortgage rates decreased roughly 50 basis points. However, observed mortgage rates declined only slightly because of generally rising interest rates. After May 27, 2009 fairly normal pricing conditions existed in U.S. primary and secondary mortgage markets; that is, the relationship between mortgage rates and its determinants was similar to that observed prior to the financial crisis. After the end of the Federal Reserve's MBS purchase program on March 31, 2010, mortgage rates and interest rates more generally were significantly less than they had been at the beginning. In sum, we estimate that the Federal Reserve's MBS purchase program removed substantial risk premiums embedded in mortgage rates because of the financial crisis. The Federal Reserve also re-established a robust secondary mortgage market, which meant that the marginal mortgage borrower was funded by the capital markets and not directly by the banks during the financial crisis-had bank funding been the only source of funds, primary mortgage rates would have been much higher. Lastly, many observers have attributed part of the Federal Reserve's effect from purchasing MBS to portfolio rebalancing. We find that if portfolio rebalancing had a substantial effect, it may have had its greatest importance only after the Federal Reserve's purchases ended, but while the Federal Reserve held a substantial portion of the stock of outstanding MBS.
Our paper compares mortgage securitization undertaken by government-sponsored enterprises (GSEs) with that undertaken by private firms, with an emphasis on how each type of mortgage securitization affects mortgage rates. We build a model illustrating that market structure, government sponsorship, and the characteristics of the mortgages securitized are all important determinants of mortgage rates. We find that GSEs generally-but not always-lower mortgage rates, particularly when the GSEs behave competitively, because the GSEs' implicit government backing allows them to sell securities without the credit enhancements needed in the private sector. Using our simulation model, we demonstrate that when mortgages eligible for purchase by the GSEs have characteristics similar to other mortgages, the GSEs' implicit governmentbacking generates differences in mortgage rates similar to those currently observed in the mortgage market (which range between zero and fifty basis points). However, if the mortgages purchased by GSEs are less costly to originate and securitize, and the if the GSEs behave competitively, then the simulated spread in mortgage rates can be much larger than that observed in the data. 2 Fannie and Freddie also directly held about $1.0 trillion of mortgages and mortgage-backed securities at year-end 2000. During the 1990s, their yearly securitization rate is estimated to have fluctuated between 45 percent and 78 percent of conventional conforming mortgage originations. Information about Fannie's and Freddie's holdings is from their quarterly and annual reports, whereas information about the fully private market is from Inside MBS & ABS, February 2, 2000, page 7. The securitization rate is from Inside Mortgage Finance Publications (2000). 3 For a review of efforts to measure the size of the GSE subsidy, see Feldman (1999). For an exposition of how the GSE subsidy benefits shareholders and others, see Congressional Budget Office (1996, 2001) and General Accounting Office (1996). 4 Note that Fannie and Freddie-like all insurers of credit risk-face an adverse selection problem that requires they include a "lemons premium" in the purchase price they offer for mortgages. Theoretically, their subsidy could be completely absorbed by the GSEs' efforts to avoid adverse selection (Passmore and Sparks, 1996 & 2000).
We derive a theoretical model of how jumbo and conforming mortgage rates are determined and how the jumbo-conforming spread might arise. We show that mortgage rates reflect the cost of funding mortgages and that this cost of funding can drive a wedge between jumbo and conforming rates (the jumbo-conforming spread). Further, we show how the jumbo-conforming spread widens when mortgage demand is high or core deposits are not sufficient to fund mortgage demand, and tighten as the mortgage market becomes more liquid and realizes economies of scale. Using MIRS data for April 1997 through May 2003, we estimate that the GSE funding advantage accounts for about seven basis points of the 15-18 basis point jumbo-conforming spread.
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