Agency Mortgages Market Makes Gains Even As Fed Nears Exit

As the Federal Reserve wraps up its $1.25 trillion mortgage-purchase program, risk premiums on mortgage-backed securities backed by Fannie Mae (FNM) and Freddie Mac (FRE) have improved unexpectedly, indicating that investors are buying these bonds.

In the past week, the market prices of these securities, also called pass-throughs, have improved so much that risk premiums, or differences in spreads over comparable Treasury yields, are at the narrowest level of the year and pretty close to the firmest level last year.

Agency MBS risk premiums, an indication of yield, have narrowed to 1.26 percentage points over comparable Treasurys from 1.40 percentage points a month ago. Prices move inversely to yield.

This move is contrary to analysts' and traders' predictions that risk premiums on these securities would widen as the Fed began to wind down its unprecedented purchase program, which bolstered the secondary market for mortgage debt and thus kept mortgage rates low. The worry was that buyers would avoid the market until the Fed left and prices found their own level.

This belief was so widespread that some members of the Federal Reserve's Open Market Committee indicated at one point that they were willing to consider getting back into the mortgage market if rising spreads pushed up mortgage rates, which are now below 5%.

Analysts say much of this concern receded after Fannie and Freddie said last month that they would buy back $150 billion in delinquent loans from investors.

These investors, flush with cash, are expected to create demand for new agency debt for at least a few months after the Fed program ends, helping this corner of the credit market to weather the end of the central bank's support, said Nicholas Strand, mortgage strategist with Barclays Capital.

It was not a smooth transition. Agency mortgage-backed securities went through a few weeks of sharp gains and losses as investors adjusted their expectations and models to this prepayment. Over the past week, however, the new reality seems to be that mortgage bonds offer good value, even with the planned exit of the Fed.

Much of the changed sentiment reflects strong demand for riskier assets and higher yields throughout the bond market, from junk bonds to the cleanest corporates. These pass-through securities have also benefited from the fact that they carry Fannie and Freddie guarantees, or essentially the backing of the U.S. government.

Buyers who avoided these securities earlier, saying they were too expensive, have changed their view, said Mahesh Swaminathan, director of mortgage strategy at Credit Suisse. "When you look at how well corporate bonds are doing," he said, "mortgages don't look that tight any more."

-By Prabha Natarajan, Dow Jones Newswires; 212-416-2468; [e-mail]

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