William C Dudley: The spread between primary and secondary mortgage
rates - recent trends and prospects
Opening remarks by Mr William C Dudley, President and Chief Executive Officer of the
Federal Reserve Bank of New York and Chairman of the Committee on the Global Financial
System (CGFS), at The Spread between Primary and Secondary Mortgage Rates: Recent
Trends and Prospects Workshop, jointly sponsored by the Federal Reserve Banks of Boston
and New York, New York City, 3 December 2012.
* * *
Good morning. I'm William Dudley, president of the Federal Reserve Bank of New York. I
would like to welcome all of you to the Bank and thank you for participating in today's
workshop. My colleague Eric Rosengren, president of the Federal Reserve Bank of Boston
and I asked our staffs to organize this workshop because the topic of the primary-secondary
mortgage rate spread is important for current efforts by the Federal Open Market Committee
(FOMC) to foster faster economic growth.
As I have said on a number of occasions, while the U.S. economy has expanded since
mid2009, the pace of the economic recovery has been too slow to make rapid inroads into the
spare capacity left over from the recession. As a result the unemployment rate remains
unacceptably high. To support a stronger economic recovery in the context of price stability,
the FOMC took action at its September meeting to provide additional monetary
accommodation. This included a new program to purchase an additional $40 billion a month
of agency mortgage-backed securities (MBS). The FOMC reiterated in October that it will
continue its purchases of agency MBS, undertake additional asset purchases, and employ its
other tools as appropriate until there is a substantial improvement in the outlook for the labor
market in a context of price stability.
Monetary policy works in large part through its effect on financial markets and financial
conditions. The impact on economic activity depends on the extent to which policy actions
are effectively transmitted to key sectors of the economy. While actions such as MBS
purchases help ease financial conditions more broadly, a key channel through which
monetary policy affects the economy is through the housing and mortgage markets. An
easing of policy lowers the secondary market rate at which mortgage-backed securities
trade, which puts downward pressure on the primary mortgage interest rate. A lower primary
mortgage rate enables borrowers to refinance their existing loans at lower rates, and
increases demand for home purchases, supporting house prices and household wealth,
which in turn may increase household access to credit.
We have seen this channel in operation since the September FOMC meeting. Yields on
newly issued agency MBS have declined about 45 basis points and the Freddie Mac survey
30-year primary rate has declined 23 basis points to 3.32 percent. These declines have been
even larger if measured from the release of the minutes of the previous FOMC meeting in
August, after which market expectations of easing in September increased. This is solid
evidence that our policy has been and continues to be effective - though it is certainly not
allpowerful in current circumstances.
However, the impact of monetary easing on the economy through housing and mortgage
finance has been impeded to some degree by two factors. First, not enough people can take
advantage of today's low primary mortgage rates. Mortgage underwriting standards have
tightened quite dramatically and the share of new mortgages going to households with better
credit metrics has risen. While it is difficult to disentangle how much of this is due to supply
versus demand factors, it appears likely that credit standards for home purchase loans have
not just tightened since the housing bust but overcorrected.
In addition, many homeowners find it difficult to refinance their existing mortgage because
they have little equity in their homes, or are outright "underwater" with mortgage balances
that exceed the current appraised value of their property. In a speech earlier this year, I
called for measures to ease refinancing and tackle other frictions and market failures that
lead to economically inefficient outcomes in housing. Some useful steps have been taken.
But, more could be done, and these issues warrant ongoing focus by policymakers.
Today, though, we are focusing on a second impediment to the impact of monetary policy on
the economy through housing and mortgage finance: the significant widening of the spread
between yields on mortgage-backed securities in the secondary market and primary
mortgage rates. Actions taken by the FOMC such as its MBS purchase program operate
principally on the secondary rate. For these actions to achieve their full impact, reductions in
the secondary rate need to also pass through to the primary rate. To the extent that the
primary-secondary rate spread widens the reduction in pass-through limits the full impact of
the policy actions.
In the late 1990s and early 2000s the primary-secondary spread was in the range of 30 to
50 basis points. In recent years and over the past 18 months in particular, the spread has
increased substantially. Following the September FOMC meeting it rose above 150 basis
points. A spike in the spread following a decision to ease monetary policy is not surprising
because the primary market may be slower to react. The spread has since retraced to its
pre-September FOMC meeting level of about 120 basis points. However, the spread remains
elevated by historic standards.
An important objective of this workshop is to gain a deeper and clearer understanding of the
determinants of the primary-secondary spread and its dynamics over time. This spread is
influenced by a number of elements, such as the valuation attached to the right to service the
mortgages underlying the security, and the annual guarantee fee that is paid to cover the
credit guarantee provided by the government-sponsored enterprises (GSEs).
The observed widening of the primary-secondary spread likely reflects many factors. Part of
this widening is due to higher annual agency guarantee fees which are a necessary and
overdue re-pricing of the credit guarantee provided to investors. While these guarantee fees
differ by mortgage and by seller, the average effective guarantee fee has increased from
20 to 25 basis points to around 50 basis points today. But this still leaves a significant part of
the spread left to be explained by other factors such as changes in originators' costs and
profits.
As you all know, the primary-secondary spread is a technically imperfect measure of the
pass-through from primary rates to secondary rates. A new
study1, by authors including New
York Fed staff, adjusts for these factors to come up with a measure of originator2 profits and
unmeasured costs, or OPUCs. The basic picture remains the same, with OPUCs at
historically elevated levels.
The paper evaluates a number of potential factors that could help explain this increase.
These include the decline in the value of mortgage servicing rights, credit losses and other
costs associated with put-back risk, possible changes in pipeline hedging costs and other
loan production expenses. It finds a potentially material role for the decline in the value of
mortgage servicing rights in particular, but concludes that the increase in the aggregate
measure of profits and unmeasured costs is "not likely to be driven exclusively or even
mostly by increase in costs".
This suggests that originator profits may have increased. The study examines a number of
potential explanations. These include capacity constraints, market concentration, pricing
power over Home Affordable Refinance Program (HARP) refinance loans and pricing power
on other loans. It finds that capacity constraints play a role and that there is evidence to
suggest that originators enjoy pricing power and elevated profits on HARP and other
refinancings.
I encourage everyone to take a look at this paper. It represents a good starting point for
today's discussion. However, as the authors are the first to acknowledge, the increase in the
primary-secondary spread and the underlying changes in originator costs and profits remain
something of a puzzle. I hope today's discussion will further deepen our collective
understanding of this important issue.
To sum up, for monetary policy to be as effective as possible in supporting economic
recovery in a context of price stability it is imperative that the key channels of the monetary
policy transmission mechanism are operating as effectively as possible. The financial crisis
and the housing bust created headwinds to the recovery in part through adverse impacts on
the mechanisms of monetary policy transmission. The topic of today's workshop is important
for understanding how to gauge and potentially improve the transmission of monetary policy
to the household sector. It is important that we correctly identify and to the greatest extent
possible quantify the forces that have been acting on the primary-secondary spread. This
requires bringing a broad range of informed perspectives to the table, perspectives that many
of you have. For this workshop to succeed, we need for you to be as open, frank and precise
in your discussions today as possible. President Rosengren and I thank you for your
participation in this effort and we look forward to the key findings from the workshop.