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Cheaper Mortgages May Linger as Bond Investors Take Over When Fed Departs

The Federal Reserve’s completion this week of its program to buy $1.25 trillion in mortgage bonds probably won’t mean significantly higher U.S. home loan rates as investors return to the market, replacing the Fed.

Fixed mortgage rates likely will rise less than a quarter of a percentage point in the next three months, the smallest increase for the second quarter since a drop in 2005, according to estimates by Fannie Mae and Freddie Mac. The gain would add about $30 to the monthly payment for a $250,000 mortgage.

“What we are seeing is an effective handoff occurring between the Fed and industry buyers such as banks and pension funds,” said Christopher Sebald, chief investment officer for Advantus Capital Management in St. Paul, Minnesota, which oversees $18.5 billion, including about $5.6 billion in mortgage bonds. “I thought the Fed’s exit would leave a bigger void.”

Advantus is purchasing mortgage bonds after the Fed’s program drained supply in the $5.4 trillion market. A recovering U.S. economy means institutions have more capital to invest, and stricter lending standards have made the securities more attractive to money managers like Sebald by limiting the number of loans. About $1.5 trillion of agency mortgage-backed securities will be issued this year, down 12 percent from 2009, according to a March 25 Morgan Stanley report.

“The constraints on borrowers are much higher now, and that’s reducing supply quite a bit,” Sebald said in an interview.

Lower Borrowing Costs

The Fed began buying bonds guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae in January 2009 with the aim of bolstering the housing market by reducing financing costs. The plan helped drive the average rate for a 30-year fixed mortgage to an all-time low of 4.71 percent in December. The central bank began tapering off its purchases in January to prepare for its exit from the market tomorrow.

“The Federal Reserve’s purchases have had the effect of leaving the banking system highly liquid,” Fed Chairman Ben Bernanke told Congress on March 25. “A range of evidence suggests that these purchases and the associated creation of bank reserves have helped improve conditions in mortgage markets and other private credit markets and put downward pressure on longer-term private borrowing rates and spreads.”

Narrowing Spreads

In December 2008, two weeks before the start of the Fed bond-buying program, the spread between the 10-year government bond yield and the average U.S. 30-year fixed mortgage rate was 3.07 percentage points, the widest since 1986, as investors demanded higher payment to compensate for risk. Last week, the difference was 1.14 percentage points, narrower than the 20-year average of 1.65 percentage points.

“Private buyers are going back into the market to pick up where the Fed is leaving off,” said David Berson, chief economist of PMI Group Inc. in Walnut Creek, California. “Credit spreads have narrowed significantly, and not just for mortgages, because investors believe the worst of the financial crisis is behind us.”

The world’s largest economy probably will grow 3 percent in 2010, according to the median estimate of 53 economists in a Bloomberg poll. Gross domestic product expanded at a 5.6 percent annual pace in the fourth quarter, the most in more than six years, after a 2.2 percent increase in the prior period.

‘Subdued’ Inflation

Inflation remains below the Fed’s long-term forecast even with record budget deficits. The central bank’s preferred price measure, which is linked to consumer spending and excludes food and energy costs, rose 1.3 percent in February from a year earlier. Policy makers project the gauge will climb to 1.7 percent to 2 percent over the long run. Fed officials cited “subdued inflation trends and stable inflation expectations” in their March 16 decision to keep interest rates near zero.

The U.S. 30-year fixed mortgage rate probably will average 5.13 percent in the second quarter, up from 5.02 percent in the current period, Washington-based Fannie Mae said March 10. Freddie Mac expects a 5.2 percent average, rising from 5 percent this quarter, the McLean, Virginia-based company said in a March 12 report. The average rate in the past decade was 6.2 percent.

A “significant run-up” in mortgage rates may jeopardize a recovery in the housing market, Federal Reserve Bank of San Francisco President Janet Yellen said in a March 23 speech in Los Angeles. That would add another hazard to a market already facing a challenge with next month’s expiration of a federal tax credit of up to $8,000 for homebuyers.

“The big cloud on the horizon is the withdrawal of government support for the housing market,” Robert Shiller, co- creator of the S&P/Case-Shiller home-price index, said today on Bloomberg Television. “People are getting a little worried about that, and so they are hesitating to buy.”

Sales Decline

Sales of existing U.S. homes fell in February for a third month and the number of properties on the market climbed by the most in almost two years, the National Association of Realtors said March 23. Purchases dropped 0.6 percent to a 5.02 million annual rate, the lowest level in eight months, and there were 3.59 million houses for sale, the biggest gain since April 2008.

At the same time, the S&P/Case-Shiller home-price index covering 20 U.S. cities showed signs that real estate values may be stabilizing. Home prices dropped 0.7 percent in January from a year earlier, the smallest annual decrease in three years, according to a report issued today. Measured monthly, the gauge rose 0.3 percent from December.

Fed’s ‘Gamble’

“There is an element of a gamble in the Fed ending its mortgage securities buying -- they are removing a key support at a point where the recovery housing recovery is still looking quite rickety,” said Zach Pandl, an economist at Nomura Securities International Inc. in New York.

Fed policy makers have made it clear in statements following the end of rate-setting meetings that they will restart the mortgage-bond buying program if needed, according to Pandl. That “backstop” has reassured investors and encouraged them to re-enter the market, he said.

Much of the demand for mortgage bonds is coming from money managers seeking to diversify their portfolios, said Berson, of PMI Group.

“Investors are full up with Treasuries,” he said. “They haven’t been able to diversify into mortgage bonds because the Fed has been buying the bulk of them. Give them an opportunity to diversify into that market, and they will.”

To contact the reporter on this story: Kathleen M. Howley in Boston at kmhowley@bloomberg.net.

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