How the federal reserve keeps mortgage rates low
The federal reserve finally raised the federal funds rate 1/4 point on Wednesday, December 16, 2015. However, their oft-forgotten policy of buying mortgage-backed securities is actually far more meaningful to mortgage rates.
The monthly housing market reports I publish each month became bullish in late 2011 due to the relative undervaluation of properties at the time. I was still cautious due to weak demand, excessive shadow inventory, the uncertainty of the duration of the interest rate stimulus, and an overall skepticism of the lending cartel’s ability to manage their liquidations.
In 2012, the lending cartel managed to completely shut off the flow of foreclosures on the market, and with ever-declining interest rates, a small uptick in demand coupled with a dramatic reduction in supply caused the housing market to bottom.
Even with the bottom in the rear-view mirror, I remained skeptical of the so-called housing recovery because the market headwinds remained, and the low-interest rate stimulus could change at any moment. Without the stimulus, the housing market would again turn down.
It wasn’t until Ben Bernanke, chairman of the federal reserve, took out his housing bazooka and fired it in September 2012 that I became convinced the bottom was really in for housing. Back in September, Bernanke pledged to buy $40 billion in mortgage-backed securities each month for as long as it takes for housing to fully recover. With an unlimited pledge to provide stimulus, any concerns about a decline in prices was washed away.
In addtion to buying new securities, the federal reserve also embarked on a policy of reinvesting principal payments from agency debt and mortgage-backed securities back into mortgages — a policy they continue to this day.
Diana Olick, December 17, 2014
The Federal Reserve did it — raised the target federal funds rate a quarter point, its first boost in nearly a decade. That does not, however, mean that the average rate on the 30-year fixed mortgage will be a quarter point higher when we all wake up on Thursday. That’s not how mortgage rates work.
Mortgage rates follow the yields on mortgage-backed securities. These bonds track the yield on the U.S. 10-year Treasury. The bond market is still sorting itself out right now, and yields could end up higher or lower by the end of the week.
The bigger deal for mortgage rates is not the Fed’s headline move, but five paragraphs lower in its statement:
“The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way.”
Given how substantial this amount is, it’s like they never stopped quantitative easing in mortgage debt.
When U.S. financial markets crashed in 2008, the Federal Reserve began buying billions of dollars worth of agency mortgage-backed securities (loans backed by Fannie Mae, Freddie Mac and Ginnie Mae). As part of the so-called “taper” in 2013, it gradually stopped using new money to buy MBS but continued to reinvest money it made from the bonds it had into more, newer bonds.
“In other words, all the income they receive from all that MBS they bought is going right back into buying more MBS,” wrote Matthew Graham, chief operating officer of Mortgage News Daily. “Over the past few cycles, that’s been $24-$26 billion a month — a staggering amount that accounts for nearly every newly originated MBS.” …
In other words, the entire home finance system in the United States still depends on government insurance and federal reserve stimulus. (See The ongoing housing bailout: taxpayers own 50% of all residential mortgages)
“Also important is the continued popularity of US Treasury investments around the world, which puts downward pressure on Treasury rates, specifically the 10-year bond rate, which is the benchmark for MBS/mortgage pricing,” said Guy Cecala, CEO of Inside Mortgage Finance. “Both are much more significant than any small hike in the Fed rate.”
Those are the two key items to watch when considering the future of mortgage rates.
It’s entirely possible that the yield on the 10-year treasury will drop next year. Higher short term rates and a strengthening economy means the US dollar should appreciate relative to other currencies, attracting foreign capital. Once converted to US dollars, that capital must find someplace to invest, and US Treasuries are the safest investment providing some yield. If a great deal of foreign capital enters the country and buys treasuries, yields will drop, and mortgage rates may drop with them.
If that were to occur, it would be an opportunity for the federal reserve to start unwinding it’s MBS portfolio and stop reinvesting principal back into the MBS market. They could taper their purchases without causing rates to rise in that scenario. Mortgage interest rates could remain low for a very long time.
For now, the federal reserve will keep buying mortgage-backed securities. Apparently, when it comes to boosting housing, Yellen plans to stay the course.
May the Force be with you!
I will have limited participation in the comments this morning.
I have my ticket for the 10:30 showing of the new Star Wars Movie.