NEW YORK (MNI) – New York Federal Reserve Bank President William Dudley
Monday called attention to the impediment that significant widening of the
spread between yields on mortgage-backed securities in the secondary market and
primary mortgage rates is posing to the Fed’s drive to boost growth through
housing.

“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,” Dudley said in opening remarks at ‘The Spread between Primary and
Secondary Mortgage Rates: Recent Trends and Prospects’ Workshop.

“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,” he
said.

The following are excerpts from his prepared remarks:

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 study,
by authors including New York Fed staff, adjusts for these factors to come up
with a measure of originator 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.

** MNI **

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