The difference between the rates of two debt products is generally referred to as a “credit spread” and is a tool commonly used to evaluate how a market prices risk at a point in time. Some traditional credit spreads used are over length of the loan (i.e., rate for 30-year note vs. 1-year note) or credit quality (i.e., investment-grade vs. below-investment-grade).

An interesting credit spread in the housing market is the difference between rates offered for jumbo vs. conforming mortgages (hereafter referred to as the Jumbo-Conforming Spread). The first question that might arise is why is there a credit spread between these kinds of mortgages to begin with? Why wouldn’t a higher income offset a bigger loan and give me the same credit profile? It comes down to risk, as all credit spreads do, but not from the consumer-side. Conforming loans got that name because they conform to the standards set by the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac for inclusion in implicit (and now explicit) government guarantees. The government guarantees led to the development of a highly liquid secondary market, and this in turn made conforming mortgages less risky loans for banks to make compared with jumbo loans to a borrower with an identical credit profile.

We thought it would be interesting to use Zillow Mortgage Marketplace (ZMM) data to examine how this spread has varied during the 2007-2010 financial crisis, and look at how different events may have impacted the spread. To do this, we calculated a mean weekly rate for mortgages of three sizes: conforming, expanded, and jumbo. Conforming mortgages are under $417,000. Expanded mortgages exist in high-price areas and are between $417,000 and the county-specific limit. Jumbo mortgages are over $417,000 or higher, county-specific limit for high-price areas. From these three rates, three spreads were calculated: Jumbo-Conforming, Expanded-Conforming, and Jumbo-Expanded. The Expanded-Conforming and Jumbo-Expanded spreads sum up to the Jumbo-Conforming spread. For more information on these calculations, please see the more detailed methodology description at the bottom of the page. 

The spreads we calculated are plotted below in Figure 1. Each of the numbers on the chart below corresponds to an event (or several if multiple noteworthy events happened in a week) during the crisis and the full list of events is listed below. Let’s see how financial events affected spreads over time.

Calm before the Storm: Events 1-4

The crisis began in early 2007– more than a year before we have ZMM data. The first event listed on the St. Louis Federal Reserve Bank’s Financial Crisis Timeline is Freddie Mac’s February 2007 announcement that it would no longer buy subprime mortgages and mortgage-related securities. In the early part of our time series, we have a drop from a spread of over sixty basis points (bps) to a spread of almost twenty bps from April-August 2008.

Between mid-March and April 2008, the Federal Open Market Committee made the biggest cuts (1.25% drops) in the federal funds and the primary credit rates to 2% and 2.25% respectively. For reference, in early September 2007, the rates were 4.75% and 5.25% respectively.

The fact that Fannie and Freddie went under government conservatorship, as well as the news about Lehman’s bankruptcy and AIG’s liquidity crisis in mid-September 2008 caused spreads to widen a bit, but they were still pretty tight at under forty bps. There was a twenty bps jump in the conforming rate at this time though.

Crisis in the Secondary Market and Credit Tightening: Events 5-7

The spread then made a steep climb in November 2008 with some rough mortgage market news: The Troubled Asset Relief Program (TARP) funds would not be used for illiquid mortgage securities, and both Fannie and Freddie announced a suspension of foreclosures. Because neither Fannie nor Freddie purchased jumbo loans, this likely had more of an indirect effect on the jumbo mortgage market. There was a secondary market for jumbo loans, but not through the GSEs. So when foreclosures started to happen, but without federal government protection for these jumbo mortgage-backed-securities, that market dried up, which drove up rates and spreads. It’s noteworthy that the sharp uptick was driven by an increase in the Expanded-Jumbo spread (see the growth in the red line in Figure 1) because those were the loans that were not eligible for agency securitization.

The spreads were at their widest (over 100 bps) in late December 2008/early January 2009 right after the Federal Reserve Board (FRB) allowed for more institutions to become bank holding companies, citing “unusual and exigent circumstances affecting the financial markets” as a reason to expedite the processes.

Volatility and Government Intervention: Events 8-13

The drop from the peak followed news of the NY Fed’s purchase of mortgage-backed securities from Fannie, Freddie and Ginnie, and the FRB’s announcement of a policy to avoid preventable foreclosures. It’s unclear that any particular event might have driven the second steep spread widening that occurred in mid-February to mid-March; rates for jumbo loans went up while rates for conforming fell. The widening might have been an effect of additional policy and support for middle class homeowners (i.e., the conforming market) or just a result of increased market uncertainty driving volatility.

This second peak was capped with the news of the U.S. Treasury granting the government the ability to put financial institutions into conservatorship or receivership to avert systemic risks posed by the potential insolvency of a significant financial firm. This bold move by the federal government was a strong statement to calm market uncertainty.

Financial Markets Tenaciously Return to a New Normal: Events 14-17

The markets saw further spread tightening as additional policy was effected to support homeowners, and as news was released suggesting the financial crisis was turning. Early in the summer of 2009, the U.S. Treasury announced that a number of important banks passed the “stress test”, raising government and consumer confidence in the financial industry.

Additionally, Bernanke’s July 2009 testimony that “the extreme risk aversion of last fall has eased somewhat, and investors are returning to private credit markets,” also precipitated a further tightening of spreads.

Reset at a New Level: Events 18-23

Generally speaking, spreads were fairly stable (within a 20 bps band) from Q309-Q210. During this period, the Dow returned to 10,000 for the first time in almost a year (Event 18) and a number of the short-term fixes for the crisis expired (Events 19-22). The Greek sovereign debt crisis during Spring 2010 (Event 23) may have also been a leading indicator of a widening of spreads, though there was a lag of about a month and a half between the news of the potential default and spreads settling at the slightly higher level (around sixty bps) that they have been at since June 2010.

It will be interesting to see if the Jumbo-Conforming Spread narrows over time and returns to pre-crisis levels in the next few months or years. The pivotal determinant will be what happens with Fannie and Freddie, and how the new Congress approaches GSE reform in 2011.

Full list of events:

PRIOR TO April 10, 2008:

February 27, 2007 The Federal Home Loan Mortgage Corporation (Freddie Mac) announces that it will no longer buy the most risky subprime mortgages and mortgage-related securities.

April 2, 2007 New Century Financial Corporation, a leading subprime mortgage lender, files for Chapter 11 bankruptcy protection.

June 7, 2007 Bear Stearns informs investors that it is suspending redemptions from its High-Grade Structured Credit Strategies Enhanced Leverage Fund.

August 6, 2007 American Home Mortgage Investment Corporation files for Chapter 11 bankruptcy protection.

August 9, 2007 BNP Paribas, France’s largest bank, halts redemptions on three investment funds.

August 16, 2007 Fitch Ratings downgrades Countrywide Financial Corporation to BBB+, its third lowest investment-grade rating, and Countrywide borrows the entire $11.5 billion available in its credit lines with other banks.

January 11, 2008 Bank of America announces that it will purchase Countrywide Financial in an all-stock transaction worth approximately $4 billion.

February 13, 2008 President Bush signs the Economic Stimulus Act of 2008 (Public Law 110-185) into law.

EVENT 1:

July 13, 2008 The Federal Reserve Board authorizes the Federal Reserve Bank of New York to lend to the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), should such lending prove necessary.

The U.S. Treasury Department announces a temporary increase in the credit lines of Fannie Mae and Freddie Mac and a temporary authorization for the Treasury to purchase equity in either GSE if needed.

EVENT 2:

September 7, 2008 The Federal Housing Finance Agency (FHFA) places Fannie Mae and Freddie Mac in government conservatorship. The U.S. Treasury Department announces three additional measures to complement the FHFA’s decision: 1) Preferred stock purchase agreements between the Treasury/FHFA and Fannie Mae and Freddie Mac to ensure the GSEs positive net worth; 2) a new secured lending facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks; and 3) a temporary program to purchase GSE MBS.

EVENT 3:

September 15, 2008 Lehman Brothers Holdings Incorporated files for Chapter 11 bankruptcy protection.

Bank of America announces its intent to purchase Merrill Lynch & Co. for $50 billion.

September 16, 2008 AIG suffers a liquidity crisis and 60% drop in stock price due to downgrade in credit quality below AA. Federal Reserve announces an $85 billion credit facility for AIG.

EVENT 4:

October 3, 2008 Congress passes and President Bush signs into law the Emergency Economic Stabilization Act of 2008 (Public Law 110-343), which establishes the $700 billion Troubled Asset Relief Program (TARP).

EVENT 5:

November 10, 2008 The Federal Reserve Board and the U.S. Treasury Department announce a restructuring of the government’s financial support of AIG. The Treasury will purchase $40 billion of AIG preferred shares under the TARP program, a portion of which will be used to reduce the Federal Reserve’s loan to AIG from $85 billion to $60 billion. The terms of the loan are modified to reduce the interest rate to the three-month LIBOR plus 300 basis points and lengthen the term of the loan from two to five years. The Federal Reserve Board also authorizes the Federal Reserve Bank of New York to establish two new lending facilities for AIG: The Residential Mortgage- Backed Securities Facility will lend up to $22.5 billion to a newly formed limited liability company (LLC) to purchase residential MBS from AIG; the Collateralized Debt Obligations Facility will lend up to $30 billion to a newly formed LLC to purchase CDOs from AIG (Maiden Lane III LLC).

November 11, 2008 The U.S. Treasury Department announces a new streamlined loan modification program with cooperation from the [Federal Housing Finance Agency(FHFA), Department of Housing and Urban Development, and the HOPE NOW alliance.

November 12, 2008 U.S. Treasury Secretary Paulson formally announces that the Treasury has decided not to use TARP funds to purchase illiquid mortgage-related assetsfrom financial institutions.

EVENT 6:

November 20, 2008 Fannie Mae and Freddie Mac announce that they will suspend mortgage foreclosures until January 2009.

November 21, 2008 The U.S. Treasury Department announces that it will help liquidate The Reserve Fund’s U.S. Government Fund. The Treasury agrees to serve as a buyer of last resort for the fund’s securities to ensure the orderly liquidation of the fund.

The U.S. Treasury Department purchases a total of $3 billion in preferred stock in 23 U.S. banks under the Capital Purchase Program.

November 23, 2008 The U.S. Treasury Department, Federal Reserve Board, and FDIC jointly announce an agreement with Citigroup to provide a package of guarantees, liquidity access, and capital. Citigroup will issue preferred shares to the Treasury and FDIC in exchange for protection against losses on a $306 billion pool of commercial and residential securities held by Citigroup. The Federal Reserve will backstop residual risk in the asset pool through a non-recourse loan. In addition, the Treasury will invest an additional $20 billion in Citigroup from the TARP.

November 25, 2008 The Federal Reserve Board announces a new program to purchase direct obligations of housing related government-sponsored enterprises (GSEs) and MBS backed by the GSEs. Purchases of up to $100 billion in GSE direct obligations will be conducted as auctions among Federal Reserve primary dealers. Purchases of up to $500 billion in MBS will be conducted by asset managers.

EVENT 7:

December 22, 2008 The Federal Reserve Board approves the application of CIT Group Inc., an $81 billion financing company, to become a bank holding company. The Board cites “unusual and exigent circumstances affecting the financial markets” for expeditious action on CIT Group’s application.

December 24, 2008 The Federal Reserve Board approves the applications of GMAC LLC and IB Finance Holding Company, LLC (IBFHC) to become bank holding companies, on conversion of GMAC Bank, a $33 billion Utah industrial loan company, to a commercial bank. GMAC Bank is a direct subsidiary of IBFHC and an indirect subsidiary of GMAC LLC, a $211 billion company. The Board cites “unusual and exigent circumstances affecting the financial markets” for expeditious action on these applications. As part of the agreement, General Motors will reduce its ownership interest in GMAC to less than 10 percent.

EVENT 8:

January 5, 2009 The Federal Reserve Bank of New York begins purchasing fixed-rate mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae under a program first announced on November 25, 2008.

January 8, 2009 Moody’s Investor Services issues a report suggesting that the Federal Home Loan Banks are currently facing the potential for significant accounting write-downs on their $76.2 billion private-label MBS securities portfolio. According to Moody’s, only four of 12 Banks’ capital ratios would remain above regulatory minimums under a worst-case scenario

EVENT 9:

January 30, 2009 The Board of Governors announces a policy to avoid preventable foreclosures on certain residential mortgage assets held, controlled or owned by a Federal Reserve Bank. The policy was developed pursuant to section 110 of the Emergency Economic Stabilization Act.

EVENT 10:

February 17, 2009 President Obama signs into law the “American Recovery and Reinvestment Act of 2009”, which includes a variety of spending measures and tax cuts intended to promote economic recovery.

February 18, 2009 President Obama announces The Homeowner Affordability and Stability Plan.   The plan includes a program to permit the refinancing of conforming home mortgages owned or guaranteed by Fannie Mae or Freddie Mac that currently exceed 80 percent of the value of the underlying home. The plan also creates a $75 billion Homeowner Stability Initiative to modify the terms of eligible home loans to reduce monthly loan payments.  In addition, the U.S. Treasury Department will increase its preferred stock purchase agreements with Fannie Mae and Freddie Mac to $200 billion, and increase the limits on the size of Fannie Mae and Freddie Mac’s portfolios to $900 billion.

EVENT 11:

March 4, 2009 The U.S. Treasury Department announces guidelines to enable servicers to begin modifications of eligible mortgages under the Homeowner Affordability and Stability Plan.

EVENT 12:

March 18, 2009 The FOMC votes to maintain the target range for the effective federal funds at 0 to 0.25 percent. In addition, the FOMC decides to increase the size of the Federal Reserve’s balance sheet by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. The FOMC also decides to purchase up to $300 billion of longer-term Treasury securities over the next six months to help improve conditions in private credit markets. Finally, the FOMC announces that it anticipates expanding the range of eligible collateral for the TALF (Term Asset-Backed Securities Loan Facility).

EVENT 13:

March 25, 2009 The U.S. Treasury Department proposes legislation that would grant the U.S. government authority to put certain financial institutions into conservatorship or receivership to avert systemic risks posed by the potential insolvency of a significant financial firm. The authority is modeled on the resolution authority that the FDIC has with respect to banks and that the Federal Housing Finance Agency has with regard to the GSEs. The authority would apply to non-bank financial institutions that have the potential to pose systemic risks to the economy but that are not currently subject to the resolution authority of the FDIC or the Federal Housing Finance Agency.

EVENT 14:

May 12, 2009 Freddie Mac reports a first quarter 2009 loss of $9.9 billion, and a net worth deficit of $6.0 billion as of March 31, 2009. The Director of the Federal Housing Finance Agency (FHFA) submits a request to the U.S. Treasury .Department for funding in the amount of $6.1 billion in his capacity as conservator of Freddie Mac. Further, on May 6, 2009, the Treasury Department and FHFA, acting on Freddie Mac’s behalf as its conservator, entered into an amendment to the Purchase Agreement between the company and Treasury that increases the Treasury’s funding commitment to the firm to $200 billion from $100 billion, increases the allowed size of Freddie Mac’s mortgage-related investments portfolio by $50 billion to $900 billion, and increases the firm’s allowable debt outstanding to $1,080 billion until December 31, 2010.

EVENT 15:

May 20, 2009 President Obama signs the Helping Families Save Their Homes Act of 2009, which temporarily raises FDIC deposit insurance coverage from $100,000 per depositor to $250,000 per depositor.  The new coverage at FDIC-insured institutions will expire on January 1, 2014, when the amount will return to its standard level of $100,000 per depositor for all account categories except IRAs and other certain retirement accounts.  This action supersedes the October 3, 2008 changes.

EVENT 16:

June 9, 2009 The U.S. Treasury Department announces that 10 of the largest U.S. financial institutions participating in the Capital Purchase Program have met the requirements for repayment established by the primary federal banking supervisors. If these firms choose to repay the capital acquired through the program, the Treasury will receive up to $68 billion in repayment proceeds.

EVENT 17:

July 21, 2009 Chairman Ben Bernanke presents the second of the Federal Reserve’s semi-annual Monetary Policy Report to the Congress. Chairman Bernanke testifies that “the extreme risk aversion of last fall has eased somewhat, and investors are returning to private credit markets.”

July 23, 2009 The Federal Reserve Board proposes significant changes to Regulation Z (Truth in Lending) intended to improve the disclosures consumers receive in connection with closed-end mortgages and home-equity lines of credit. Among other changes, the Board’s proposal would improve the disclosure of the annual percentage rate on closed-end mortgages and require lenders to show consumers how much their monthly payments might increase for adjustable-rate mortgages. The proposal would also prohibit payments to a mortgage broker or loan officer that are based on a loan’s interest rate or other terms, and prohibit lenders from steering consumers to transactions that are not in their interest in order to increase the lender’s compensation.

EVENT 18:

October 14, 2009 The Dow Jones Industrial Average closes above 10,000 for the first time since October 3, 2008.

EVENT 19:

November 17, 2009 Citing continued improvement in financial market conditions, the Federal Reserve Board approves a reduction in the maximum maturity of primary credit loans at the discount window for depository institutions to 28 days from 90 days effective January 14, 2010. The Federal Reserve had lengthened the maximum maturity of primary credit loans first to 30 days on August 17, 2007, and then to 90 days on March 16, 2008.

EVENT 20:

January 21, 2010 President Obama proposes new restrictions on the trading activities and market shares of commercial banks. Specifically, he calls for prohibiting banks from owning, investing in or sponsoring hedge funds, private equity funds, or proprietary trading operations for their own profit. He also calls for broader market share limits on commercial banks.

EVENT 21:

February 1, 2010 The Commercial Paper Funding Facility, Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, Primary Dealer Credit Facility, and Term Securities Lending Facility programs expire.

EVENT 22:

February 18, 2010 The Federal Reserve Board announces an increase in the primary credit rate (generally referred to as the discount rate) from 1/2 percent to 3/4 percent, effective February 19, 2010. The Board also announces that, effective on March 18, the typical maximum maturity for primary credit loans will be shortened to overnight. In addition, the Board announces that it has raised the minimum bid rate for the Term Auction Facility (TAF) by 1/4 percentage point to 1/2 percent. The final TAF auction will be on March 8, 2010. The Board cites continued improvement in financial market conditions for the changes to the terms of its discount window lending programs.

EVENT 23:

April 23, 2010 Greek government requested that the EU/IMF bailout package (made of relatively high-interest loans) be activated. The IMF had said it was “prepared to move expeditiously on this request”

April 27, 2010 Greek Sovereign Debt downgraded to BB+ status by Standard & Poors

Methodology
Zillow Mortgage Marketplace data was used to determine the weekly 30-year fixed-rate loan rates for conforming, expanded, and jumbo products. Mortgages meeting the following criteria were examined:
1. Loans for a primary residence
2. Purchase loans (not refinances)
3. Loans with a loan-to-value ratio of 75%-85% 

A mean rate for each category was calculated for each week based on the quotes made through ZMM. Because there is a fair amount of week-to-week movement, 3 week rolling averages (week before, week of, week after) were calculated and are used as each data point in Figure 1.

Mortgage discount points associated with each rate were tracked as well. Mean points were generally in the same ballpark across loan sizes: out of the 136 weeks in the observation period, there is only one where the difference between the points associated with a jumbo loan (vs. conforming) is more than fifteen bps.

Photo courtesy exfordy/Flickr