Tony Crescenzi
Chief Bond Market Strategist
Miller Tabak + Co

Mortgage rates and yields on debt securities issued by Fannie Mae

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[FNM  Loading...      ()   ]and Freddie Mac

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[FRE  Loading...      ()   ] have plunged in response to an announcement by the Federal Reserve that it is initiating programs to purchase mortgage-backed securities backed by government-sponsored enterprises and direct obligations of the GSEs.

The Fed said that it would purchase up to $500 billion of mortgage-backed securities beginning before year's end, and up to $100 billion of direct obligations of the GSEs beginning next week. The Fed said that the actions were taken "to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.

The Fed's $500 billion in MBS purchases will far exceed the roughly $50 billion of MBS the Treasury has thus far purchased through its MBS purchase program. The $100 billion of agency purchases represent about 5% of the debentures outstanding for Fannie, Freddie, and the Federal Home Loan Banks.

Fannie Mae's current-coupon 30-year mortgage-backed security, which is tightly correlated on a spread basis to Freddie Mac's weekly survey of consumer mortgage rates, has fallen 38 basis points on the day, which means that the 30-year mortgage rates are likely to fall a similar amount. If they do, it would bring the average rate to 5.66%, its lowest since January when the average 30-year mortgage rate was 5.48% (the 2008 average is 6.11%).

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We don't know yet how it is that the Fed will finance its $600 billion of purchases. What we do know is that it can't do it with its current Treasury holdings, which total a comparatively smaller $489 billion, a level that has persisted for about 6 months. In other words, the Fed is unlikely to draw down its Treasuries much if at all in order to pay for its planned $600 billion of purchases. The Fed will instead expand its balance sheet and its actions will boost the amount of bank reserves, a powerful act that will ultimately fuel an expansion of bank credit. The downside to these actions is its potential impact on the value of the U.S. dollar, which could fall if investors believe the U.S. is creating excessive supplies of dollars.

Oddly, Treasury yields have fallen despite gains in equities and improvements in the credit markets. The Treasury rally is related to the rally in the mortgage market. When mortgage rates fall, mortgages are prepaid faster because an increasing number of people refinance their homes and there is usually some relative improvement in home purchase activity.

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This means that holders of mortgage securities will be paid back faster, a situation that results in more cash in the hands of portfolio managers who would rather maintain a steady level of average maturities in their portfolios. To recalibrate their portfolios, portfolio managers purchase Treasuries to boost their average maturity levels.

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Tony Crescenzi is the Chief Bond Market Strategist at Miller Tabak + Co., LLC where he advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of the forthcoming book, "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market." Crescenzi is a contributor to RealMoney.com."

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