Fed purchases of MBS have helped keep FHA mortgage rates near record lows for months, creating savings for homeowners and a cushion during the U.S. recession.  But the U.S. central bank may still begin weaning the market from its support, at least in part, in a bid to raise yields and entice other investors, said Mahesh Swaminathan, a strategist at Credit Suisse in New York. To keep mortgage rates down, the Fed can boost purchases of Treasury debt to reduce U.S. government yields, another key input to home loan levels, he said. “One part of the Fed’s mandate is to broaden participation and get private investors more engaged,” Swaminathan said. “We think the Fed should pool its MBS and Treasury purchase commitments and use its flexibly” to keep rates low.

The Fed, in minutes released on Wednesday from its April policy meeting, said it had left open the possibility of increasing its purchases of mortgage-related and government debt to keep credit flowing and spur the economy.

The Fed has purchased $457 billion in mortgage bonds issued by Fannie Mae, Freddie Mac and Ginnie Mae year-to-date to help boost prices that lenders can get for loans in the secondary market. Since March, the Fed has bought nearly $123 billion in government debt, part of a $300 billion six-month program.

MBS purchases by the Fed have reduced the extra yield on the bonds relative to Treasuries to 0.64 %age point from 1.67 %age points at the start of 2009.  By slowing purchases, the Fed would keep MBS prices from being “prohibitively tight” to investors who want to reinvest principal from prepaid bonds, Swaminathan said.

Jack Donahue, head of MBS trading at Jefferies & Co in New York, recommended investors avoid bonds the Fed is buying, which contain loans at currently low interest rates. MBS paying higher coupon rates offer investors the best values, despite greater prepayment risk, he said.  “It is hard to fight the Fed,” he added. “The further away from the coupons the Fed is buying, the cheaper.”

The Fed may also be saving some of its $1.25 trillion pledge to support the mortgage market “well into 2010,” to prod a gradual housing recovery, Swaminathan said At the current pace, the MBS purchase program could end by January, he said.

Rising home inventories put downward pressure on home prices, and the reduced availability of jumbo loans appears to have worked its way through much of the market, NAR said.  In addition, many homeowners are unable to refinance their existing jumbo loans to take advantage of lower rates, which has contributed to a rise in default rates and crimped consumer spending. Many jumbo mortgage holders could save $6,000 to $15,000 in annual interest costs if they were able to refinance, the report said.

The secondary market for jumbo mortgages fell apart in late 2007, when investors stopped buying bad credit mortgage securities not backed by Fannie Mae, Freddie Mac or the FHA.  Because mortgage lenders must now hold such loans as investments, they’ve instituted stricter underwriting standards and are charging higher interest rates.

While bad credit mortgage rates on conforming mortgage rates that are eligible for purchase by Fannie and Freddie are near historic lows, the “spread” between jumbo and conforming mortgage rates has increased to between 150 and 200 basis points. Before the credit crunch, rates on jumbo mortgages were 20 to 50 basis points above rates on conforming home loans. Although jumbo mortgage loans are often thought of as primarily for the wealthy, they are also a necessity for many middle-class families in high-cost coastal states, NAR said. Jumbo loans (those greater than $417,000) accounted for 30% of the dollar volume of mortgages originated in 2007. The share was much higher in California (63%), New York (51%), and Florida (29%).

Congress last year raised the conforming loan limit in high-cost markets to up to $729,750. But underwriting standards on conforming and FHA mortgages remain stricter than those for conforming mortgages under the $417,000 conforming loan limit that remains in place for “normal” housing markets. Borrowers generally need FICO scores of at least 700 to obtain fixed-rate super-conforming mortgages, and to provide at least a 10 % down payment. Freddie Mac is requiring down payments of at least 20 % for loans above $625,500 (see story).

According to NAR, 60% of recent home financing that used jumbo mortgage loans made down payments of at least 20%. In California, more than 75% of recent home purchase loans who used jumbo mortgages put more than 20 percent down.  “Such high down-payment requirements have no doubt deterred buyers, leading to higher inventories, falling home prices, and rising defaults,” NAR said.

The volume of bad credit mortgage loans continues to drop but the demand for bad credit mortgages continues to rise.  The growing disparity has significantly contributed to the foreclosure crisis.