August 26, 2021
The Federal Reserve has responded quickly to significant financial market disruptions with the onset of the COVID-19 pandemic in March 2020 by providing stability in a variety of ways. This included large-scale purchases of US Treasury bonds and Mortgage Backed Securities (MBS).
Although market performance improved in the following months, the central bank continued to buy these assets in order to maintain smooth operations and to help create a favorable financial environment. We investigate the Federal Reserve purchases of MBS – mortgage bonds guaranteed by Jeannie Mae, Fannie Mae and Freddie Mac – and the corresponding market dynamics during the pandemic, including the reasons why mortgage rates fell to historic lows.
MBS agency and mortgage prepayment
The agency MBS market is one of the world’s largest fixed income markets ($ 7.6 trillion) and serves as the pricing benchmark for fixed rate mortgages covered by agency guarantees.
These securities distribute monthly payments of principal and interest on underlying mortgages to investors. Although MBS investors are protected from credit risk by government guarantees, they still face the risk of early repayment.
Homeowners with a fixed-rate mortgage pay principal and interest on a monthly basis according to a predetermined repayment schedule. However, the borrower has the option to repay the additional principal on the mortgage at any time. (This usually happens when the borrower refinances a loan or sells a house.) The initial cost of this early repayment option is reflected in the borrower’s mortgage interest rate and passed on to the MBS investor.
A significant decrease in mortgage rates could lead to a significant number of fixed rate mortgage borrowers with in-the-money refinancing options. When this occurs, a sharp decline in the agency’s existing MBS fund balances with a higher coupon rate is expected due to the prepayment and a corresponding increase in the issuance of new securities with a lower coupon rate.
Evolution of Federal Reserve Policy and Purchases
As the economic consequences of the pandemic develop, the Federal Open Market Committee (FOMC) announced On March 15, 2020, it will increase MBS holdings by at least $ 200 billion, plus reinvest all received principal payments. A week later, this directive was amended to prohibit procurement.
The FOMC changed its approach at its June 2020 meeting, increasing MBS holdings to about $ 40 billion per month plus reinvestment, and this policy remains in place. (For more information on FOMC directives throughout 2020, contact the Federal Reserve Bank of New York. Annual report on open market operations.) From March 2020 to June 2021, the Federal Reserve increased its MBS agency assets from $ 1.4 trillion to $ 2.3 trillion.
Chart 1 shows the Federal Reserve’s monthly gross purchases by MBS over the past decade and the current MBS coupon spread, or yield at par, minus the average yield of five-year and 10-year Treasuries.
The central bank acquired agent MBS for a total of $ 580 billion over a two-month period from March to April 2020, and has averaged about $ 114 billion per month since then, including reinvestment of core payments. During that time, the current coupon spread narrowed steadily to its lowest level in nearly a decade (62 basis points, or 0.62 percentage points, in May 2021). Primary mortgage rates have also dropped over this time, according to research by Freddie Mac. data…
Chart 1 also includes a metric known as the current coupon-adjusted spread (OAS), which includes the likelihood of homeowners paying off their mortgages early due to changes in interest rates. OAS is a derivative risk premium that equates the agency’s model-based MBS values (using simulations of future interest rate trajectories) with prices observed in the market. Accounting for interest rate volatility OAS reflects the residual compensation received by agency MBS holders as a result of factors other than interest rate, such as the characteristics of the underlying mortgages.
While the OAS is usually positive, the metric shown here – produced by Bloomberg for a hypothetical MBS valued at par – has been steadily declining since March 2020 and turned negative for the first time since 2013, the only time in the series history that this has occurred. …
Taken together, the data in Chart 1 shows that recent large-scale purchases by the Federal Reserve of agent MBS contributed to historically tight secondary market spreads.
Federal Reserve Agency for Purchasing MBS in the Forward Market
The Federal Reserve is buying MBS in the TBA, a large and liquid forward market with contracts that are settled monthly on a calendar installed Association of the Securities Industry and Financial Market… The central bank usually aligns its purchases with the top-selling coupons for next month’s settlement. This is done in advance. auctions held within a month.
Given the forward nature of the market, the volume of TBA contracts sold in a particular billing month may not match the offer available for delivery when the billing date arrives.
To cope with this discrepancy and avoid delivery disruptions, market participants conduct “dollar roll” transactions. The dollar bill assumes the simultaneous sale (purchase) of the contract subject to adjustment for one settlement month and the purchase (sale) of the contract subject to adjustment for the next month. Thus, the change in the dollar exchange rate allows market participants to postpone (advance) settlements on contracts subject to clarification. The value of this transaction is reflected in the difference in price between contracts payable in adjacent months.
When the price of a TBA for the next month becomes greater than the fair value of holding that security for the next month, it is said to be trading “special.” This may indicate an expected shortage of collateral for monthly settlements. The specificity of the dollar movement could weaken if the price signal prompts market participants to provide additional collateral to the TBA market for delivery.
Federal Reserve Dollar Roll Sales Activity
The Federal Reserve is conducting dollar throws to facilitate settlement of its TBA purchases if there is a notable level of specialization. The timing and volume of these transactions depends on an internal assessment of market conditions and changes in the estimated funding rates.
Chart 2 shows the Federal Reserve’s monthly dollar roll sales since early 2013 and their share of the expected monthly calculations. The expected settlements represent the sum of regular scheduled purchases ($ 40 billion), principal reinvestments from prior months payments, and contracts already withheld for this month’s settlement from previous dollar rolls. The central bank has been continuously involved in dollar translation operations since April 2020, peaking at $ 48 billion in November 2020.
The data in Chart 2 begs the question as to why the Federal Reserve has had so many dollar roll sales. There are several explanations.
First, the FOMC directive on monthly agency purchases of MBS has resulted in the central bank acquiring nearly 40 percent of newly issued securities since May 2020. months ago. This created a timing discrepancy. In response, the central bank bought short-term bank transfers from dealers for the coming months, which were then often rolled back for settlement a month ago.
Second, commercial banks represent the only other investor base that has grown their MBS agent holdings during 2020 and through the first quarter of 2021 ($ 580 billion). But banks generally do not conduct transactions in dollars to defer settlement, due to the nature of their business and accounting considerations.
Third, the sharp decline in mortgage rates has led to periods of collateral shortages for lower coupon securities. A useful example is a Fannie Mae 30 year old coupon or Freddie Mac Uniform MBS (UMBS) coupon with a 2 percent coupon. In the summer of 2020, mortgage makers sold most of the TBA forward in these securities. However, the volume of issued shares of UMBS with 30-year 2% coupons was modest, which limited the ability to transfer existing securities for settlement. As the number of UMBS 30-year 2% securities in circulation increased, the Federal Reserve’s interest rate on coupons declined commensurately.
In addition to the 30-year 2% UMBS coupon, the Federal Reserve sold eight other securities in dollar rolls. This indicates that the feature was more common at times, although the issuance of other coupons was more sporadic. Chart 3 shows the Federal Reserve’s dollar roll sales for 30-year UMBS 2 percent coupon contracts versus all other TBA contracts.
Large-scale purchases by MBS by the Federal Reserve likely contributed to the particular change in the dollar during the current procurement program. In response, the central bank used dollar roll sales to extend settlement of some of its future purchases.
Tight spreads, low mortgage rates
In response to the pandemic, the Federal Reserve has resumed its large-scale purchases of agent MBS and now owns more than $ 2.3 trillion, representing nearly 30 percent of outstanding bonds. These purchases were associated with historically tight spreads in this market, leading to historically low mortgage rates.
With occasional supply shortages, the Federal Reserve smoothed out purchases using dollar roll sales that extend settlement into the future and help the market function.
The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve.