The Fed and MBS: An End in Sight
Sam Chandan April 15, 2010, 2:15 p.m.
Residential mortgage rates are inching up. Freddie Mac reported on Thursday that rates for 30-year fixed-rate conforming mortgages had climbed to an eight-month high of 5.21 percent, up from 5.08 percent a week earlier and a low of 4.71 percent last December. Because conditions in the housing market remain fragile, the rise in borrowing costs is of serious concern for policy makers and for a range of market participants, who have come to expect low financing costs to offset the prevailing woes of the housing sector.
The current rate increases coincide with the Federal Reserve’s anticipated winding down of its purchases of residential mortgage-backed securities (MBS). The Fed’s purchases of MBS issued by Fannie Mae and Freddie Mac have been a keystone of the government’s program to support the housing market. The program was first announced in November 2008, a few months after the Federal Housing Finance Administration placed the government-sponsored enterprises into conservatorship under the authority of the Housing and Economic Recovery Act. The first purchases of agency MBS followed two months later, in January 2009, and reached just under $1.25 trillion as of last week.
The Fed’s investments have been financed through the creation of new bank reserves and have fueled the swelling of the Fed’s balance sheet. As of last week, agency MBS represented 46.7 percent of the Fed’s $2.3 trillion in assets. In a relatively short time, the Fed has grown from a neophyte investor to the market’s dominant player and the owner of more than one in five agency MBS dollars outstanding.
The importance of the MBS market follows from the dependence of the domestic housing finance system on the participation of the government-sponsored enterprises. It was not always so.
Fannie Mae was originally chartered to facilitate a secondary market for mortgages insured by the Federal Housing Administration. The role of Fannie Mae and Freddie Mac has grown considerably in the decades since Fannie’s 1938 establishment. The most significant evolutionary jump occurred in 1970, when Congress established Freddie Mac and modified Fannie Mae’s charter, allowing it to purchase conventional mortgages not insured by the FHA. In the mid-1970s, roughly three-quarters of all residential mortgage debt was held by banks. As the government-sponsored enterprises have expanded, and securitization has matured as a platform, bank lenders’ share of the market has fallen to approximately 35 percent, as of 2008.
It is generally believed that the implicit government guarantee of Fannie Mae and Freddy Mac’s MBS has allowed the agencies to trade at more favorable spreads over the risk-free rate. Similarly, the Fed’s purchases of MBS have been critical to supporting the secondary market, as domestic private investment has diversified away from exposure to the housing sector. Yields and spreads on agency MBS have remained relatively flat in the months leading up to the purchase program’s expiration, even though the Fed’s intentions have been communicated clearly.
THE CURRENT MORTGAGE-RATE increase warrants attention, but it’s unclear whether it’s the result of the Fed’s no longer buying MBS. For example, the increase may simply reflect the coincident rise in the long-term treasury rate. A straightforward analysis of treasury and mortgage rates shows a strong and statistically significant relationship between the two rates, even though spreads may narrow or widen during any given period. Weaker demand for treasuries in recent weeks’ auctions has pushed rates higher in recent weeks; mortgage rates may be moving in kind, even as MBS spreads have narrowed against treasuries.
Absent government MBS purchases, we might expect mortgage rates to rise by 30 to 40 basis points, all else being equal. In its March economic forecast, Fannie Mae projected that 30-year fixed rates would rise to 5 percent at the end of the first quarter, edging up slowly before ending the year at 5.4 percent. That forecast will need to be revised unless rates fall back from their current levels. If the general relationship between treasuries and conforming mortgage rates holds, the latter could rise to significantly higher levels.
Investors are reasonably concerned about the capacity of markets to clear record treasury issuance at current yields. The 10-year treasury rate edged over 4 percent last week before slipping back to 3.93 percent at week’s end. Projections for the 10-year rate at year’s end range from 3 percent to more than 5 percent. In the latter case, long residential rates would almost certainly surpass 7 percent, barring new policy interventions. Our baseline projection shows rates rising to 4.5 percent, slightly higher than the market’s current expectation.
In the best case, an absence of Fed purchases of MBS and an implicit target rate for mortgages will mean greater volatility in borrowing costs for homeowners. Still, rates will revert to a low mean as long as treasury rates remain relatively low. In the worst case, both treasury and mortgage rates will rise as a result of broader fiscal challenges, or the indirect link between the two rates will be sundered as part of the government-sponsored enterprises’ restructuring. In his March 23 testimony before the House Committee on Financial Services, Treasury Secretary Timothy Geithner outlined a set of reform objectives that could result in a fundamentally different long-term role for Fannie Mae and Freddy Mac. At this early juncture, all options are on the table. As a next step in evaluating those options, the Treasury and HUD will release a list of questions for public comment this Thursday.
Since new and existing home sales have barely inched off their lows, what can we expect if borrowing costs rise materially? Mortgage rates in the range of 6 to 7 percent will certainly undermine housing market stability and the government’s related policy objectives.
Holding incomes constant, higher rates mean that households can bear smaller mortgages. With less credit, households demand less housing. On the margins, some potential homeowners will not purchase homes in this higher-rate regime.
The coincidence of these possibilities with the expiration of the housing tax credit and an opaque jobs outlook means that we’re not out of the woods yet.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.