Soothing the Mortgage Markets

The mortgage securities market has gotten a shot in the arm today, helping create a smoother, less volatile trading environment, reducing investor nervousness, at least somewhat.
Mortgages
The decision by the Office of Federal Housing Enterprise Oversight to reduce the required amount of capital Fannie Mae and Freddie Mac need to hold against their mortgage portfolio has calmed investors somewhat and caused market spreads to improve, and in concert with the Federal Reserve’s recent efforts, the freak-out that enveloped last week’s trading has subsided.

“Clearly the various and sundry branches of the federal government care about the smooth functioning of the mortgage market,” says Arthur Frank, head of mortgage-backed securities research at Deutsche Bank.

Against the five-year Treasury, the current Fannie Mae bond now trades with a premium of 279 basis points, compared with 287 basis points at Tuesday’s close, Mr. Frank says. The Fannie Mae bond, when considered against the seven-year swap spread (where Treasurys are swapped for a floating rate), fell to 157 basis points from 163 basis points on Tuesday.

In addition, the Wall Street Journal reported that the Federal Housing Finance Board, which oversees 12 Federal Home Loan Banks, is close to voting on a proposal that would increase the amount of mortgage-backed securities those banks can hold against capital.

One benefit of these developments is increased liquidity, and with that, presumably, more accurate pricing. “The effort to bring liquidity back is an effort to bring some certainty,” says Adolfo Laurenti, senior economist at Mesirow Financial. “It doesn’t matter that if with certainty comes big write-downs — at least know the value of what you have.”

Some have questioned this move, particularly considering the accounting and risk-control problems that both government-sponsored entities found themselves in over the last few years, which caused OFHEO to initiate these caps. “It wasn’t that long ago when Fannie and Freddie were the problem, now they are the solution,” writes Calculated Risk.

The move should reduce Freddie’s capital requirement by about $2.6 billion and Fannie’s by $3.2 billion. Shares of the stocks are rallying as well, with Freddie up 16% and Fannie ahead by 10%.