Drivers of Mortgage Spreads across the Business and Housing Cycle

Abstract

This article provides a review of the underlying drivers of mortgage spreads at various points of the housing and economic cycle, with an in-depth look at the spreads between mortgage-backed securities (MBS) and Treasury rates and between mortgage and MBS rates. The authors provide evidence of the role of prepayment and credit-related risks, as well as lender capacity issues and large-scale asset purchases by the Federal Reserve in explaining these spreads. They also investigate recently observed differences in rates across purchase and refis as additional evidence of the role of capacity constraints in the persistent widened spreads during the ongoing COVID-19 outbreak. TOPICS:MBS and residential mortgage loans, real estate, legal/regulatory/public policy Key Findings • Mortgage spreads, especially the primary–secondary spread (mortgage rate versus current coupon yield on MBS), remain historically wide following the COVID outbreak in the US. • Increases in liquidity in the mortgage-backed securities (MBS) market coinciding with the Federal Reserve’s increased MBS purchases have historically been correlated with declines in the secondary spread (current coupon yield on MBS versus Treasuries), consistent with the post-COVID surge in Fed MBS purchases and subsequent decline in the secondary spread. • Increases in the primary–secondary spread have historically been correlated with increased capacity constraints faced by lenders, for instance, measured by increases in production per mortgage-related employee. The persistent widened primary–secondary spread in the aftermath of COVID-19 is consistent with this historical pattern.