Mortgages are still too expensive and too hard to get says the Fed as it plans to hold a conference in New York where it will investigate reasons why banks are holding up on mortgages.

“The spread between primary mortgage rates and agency MBS yields has widened and this has limited the drop in primary mortgage rates,” says New York Fed President William Dudley.

Fed has been buying up mortgage backed securities (MBS) in order to drive the interest rates on mortgages down but the rates consumers are getting have not dropped as much as the Fed has managed to shave off on MBS rates.

Bernanke also thinks that the banks have gone in the other extreme by it unnecessarily harder to get a mortgage and that is threatening the housing recovery, Bernanke says.

“While some tightening of the terms of mortgage credit was certainly an appropriate response to the earlier excesses, the pendulum appears to have swung too far, restraining the pace of recovery in the housing sector,” Bernanke says.

The conference will be held on December 3.

Subprime mortgages – those pesky investments that nearly collapsed the economy in 2008 – are in a bull mode and increasing number of investors are lining up cash to buy even more.

“The subprime gains are double the 15 percent rise this year through yesterday for the Standard & Poor’s 500 Index, and more than eight times greater than S&P’s GSCI Total Return Index of 24 commodities,” writes Bloomberg.

Besides the Fed’s $40 billion per month QE demand for mortgages, the subprime space has also shrunk while the underlying security of these mortgages, property, has stabilized and in some places risen in value.

“Issuance of non-agency bonds peaked at $1.2 trillion in both 2005 and 2006 before collapsing… About $3.5 billion of new loans have been packaged into the securities since 2008,” notes the report.

As a result, returns on senior-ranked subprime from 2005 to 2007 was 1.4% while gains in 2012 are 29.6%.

Deutsche Bank’s Greg Lippmann, trader who bet against the bonds before their collapse, has doubled his subprime stake this year to $2 billion with returns, claims are made, of 16%.

Subprime-mortgage paper has a 6% yield on 5-year life versus 1.9% on government MBS and 2.7% corporate paper, Barclays data shows.

Huge proportion of analysts are convinced that the Fed will, soon, announce a plan to drive down mortgage rates and along with the hints by the White House that the administration will “do something” about the ailing housing market, the conviction is increasing that another QE-type action by the Fed is on the way.

…and what is the real goal of such policy?

Ostensibly, Fed, and perhaps the White House, argues that by having the Fed buy up the MBS it will drive the interest rates lower, initiating refinances which will free up some disposable cash for households and the freed cash will move into consumption.

Fed recently presented an argument that refinancing is not a zero-sum game because the decrease in income that investors incur via refinance has nearly negligible impact on their spending decisions while the extra cash households get enters the economy and impacts it more via its multiplier effect.

Some doubt this and are vocal about that.

One criticism of this policy is that it may have very little impact because so many people who are current on their mortgages may not be able to refinance because the value of their home has shrunk so much that it would not satisfy the current underwriting loan-to-value standards. Unless this issue is tackled with “politically” gains in consumption that the Fed is counting on is a pipe-dream.

Others quip that the Fed will, once again, temper with the “natural” evolution of the house price discovery so the housing bottom may never be reached.

Yet others say that targeting MBS is done not for the reasons of helping the households but to bolster the bankers.

Banks are saturated with MBS paper and that, these critics say, is a drag on their balance sheets so another trillion of freshly printed dollar bills would go a long way in perpetuating corporate welfare.

In addition to 6.2 million bad loans, the banks may hold as much as 10 million additional delinquent loans that have not been booked yet so the MBS purchase program would off-load these from the banks’ balance sheet.

“Of course, the Fed’s (proposed) purchases have nothing to do with ‘driving down interest rates’ (which are already at historic lows) or ‘stimulating the economy’. That’s just more public relations hype. It’s all about inflating the prices of droopy financial assets that are eating up banks’ balance sheets,” writes editor of Eurasia Review.

Not to mention renewal of claims that the program will spring-load inflationary pressures that will, inevitably, burst sometimes in the future (buy gold trade).

Cash has already loaded up on this MBS trade, with PIMCO reportedly already in the MBS while others, like AG Mortgage Investment Trust, have issued 5 million new shares in order to use the cash to speculate in “agency securities, non-agency residential mortgage-backed securities and other target assets”. 

Some, however, are talking of a possibility that MBS purchases would be scaled down from a trillion to $400-500 billion.

Still others even go as far as to warn that, with too much European uncertainty, the Fed may just shift its reinvestment cash gotten from securities already held into the MBS – a significantly smaller figure then some are betting.

It is widely believed that the Fed is set to target mortgage rates lower but with so many prime borrowers under water with their equity the effect of what Fed wants to do would be a waste: the appraisal would never come in line with the existing loan-to-value (LTV) guidelines.

Recent “resignation” of Fannie Mae boss may be just what the Fed needed in order to remove these LTV guidelines.

Removal of the current LTV guidelines is referred to as a streamlined process that would make many homeowners who are current on their mortgage but under water on equity, eligible for a refinance.

New York Fed came out with a position paper today making the case that such as streamlined process, with low fees, has numerous macroeconomic benefits and reduces mortgage default risk.

“Refinancing lessens the likelihood that a borrower defaults on a mortgage by creating additional cash flow that helps the borrower absorb any adverse income shock,” write Joseph Tracy and Joshua Wright.

Authors also show numbers that explain why refinancing is not a zero-sum game in which income is reduced on the MBS investor and given to the refinancing borrower.

Since 55% of MBS paper is held by governmental, foreign and long term investors, then, authors argue, their spending does not depend on income from the MBS paper. In other words, 55% of MBS investors will not change their spending habits just because bunch of people pay less on their mortgage.

The other 45% may reduce their spending but their reduction in spending would be way offset by a much larger increase in spending by the refinanced borrowers.

A conservative baseline calculation with 20% tax rate suggests that each refinance dollar translates into 44 cents of new household income. If 90% of that income is spent, then each refinance dollar pumps in 40 cents of new spending into the economy (.55 x 80% x 90% = .396).

“However, this estimate of 40 cents per dollar is overly conservative, because the tendency for borrowers to spend out of increases in their disposable income likely exceeds the tendency for investor households to cut back spending in response to decreases in their interest income,” note the authors.

Paper is available here.

From IFR Mortgages:

In the first three days of the MBS purchase program, the Fed bought $3.95 billion – 88.6%, or $3.5 billion, in 30-year 3.5% and 4% coupons, and 11.4%, or $450 million, in 15-year 3.0% and 3.5% coupons. All were for November and December settlements. Within 30s, 61.4% was in 3.5s and 38.6% in 4s; 47.1% in Fannies, 35.7% in Freddies and 17.1% in Ginnie Is and IIs.

Over this same period, mortgage banker selling totaled nearly $7 billion, which means the Fed covered 58.1% of the supply.