An Explanation of the MBS vs. Treasuries Debate

Federal Reserve efforts are stalling as a lack of demand for 10 year treasuries is causing yields to rise on new mortgages. From Bloomberg:

Federal Reserve Chairman Ben S Bernanke's efforts to bring down borrowing costs to revive the housing market and help the economy are stalling. Mortgage rates are almost back to where they were in March before the 30-year rate fell to a record and sparked a refinancing boom.

For those who don’t know, the process works like this. One must first make the distinction that there is a primary and secondary market for mortgages. The primary market for mortgage origination takes its cues from the secondary market for mortgage backed securities (MBS).

The central bank purchases MBS guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae which causes prices to rise and yields of those securities to fall. A robust secondary market sends the cue to mortgage originators to reduce the rates on new home loans (they can make more loans at lower rates). GSAs-- comforted by the fact that the Federal Reserve is propping up the market-- will buy loans from originators to pool, securitize, and sell at a profit.

If the secondary market softens, then rates must invariably rise. This is currently occurring as investors opt out of MBS and Treasuries in anticipation of higher market interest rates going forward.

But, mortgage rates aren’t necessarily tied to those of Treasuries as reports would have us believe:

Yields on Fannie Mae and Freddie Mac mortgage bonds rose earlier this week, driven higher in part by climbing Treasury rates. The yield on the 10-year Treasury note was at 3.64 percent yesterday, compared with 3 percent the day before the Fed’s March 18 announcement [Bloomberg].

Although MBS track treasuries they can and do move in the opposite direction. Since there is no loan that uses the 10yr or 30yr as an index there is no iron-clad correlation. Theoretically, it would be possible for the spread between treasuries and mortgage rates to tighten if the Fed picks up its purchases of MBS.