Bulls & Blogs

Today was the last day of the Federal Reserve's direct intervention in the mortgage market. To recap, the Fed allocated $1.25 trillion in Jan 2009 to purchase mortgage based securities (MBS). The goal of this program was to support the mortgage and housing markets and to foster improved market conditions. The question is what happens now?

Mortgage rates clearly have benefited from the Fed's involvement. In very simple terms, markets set interest rates to earn a certain spread above what they consider a risk-free investment, the 10-year treasury bond. When the Fed began the MBS purchase program, this spread was 170 basis points (1.70%). Within about a month, the spread had tightened to 120 bp and has continued to tighten to roughly 65 bp today.

There are many reasons why spreads increase and decrease. One big reason is supply and demand. With the Fed ending its purchases, who will step in to provide the demand for MBS? First, be clear that the Fed was buying AND selling MBS (though it certainly was a net buyer). There are other buyers in the market. Domestic and foreign banks also were net buyers. Hedge funds and money managers, on the other hand, were net sellers.

The Director of the FHFA (conservator of Fannie and Freddie) has made it clear that Fannie and Freddie are not going to hold the MBS on their books. Thus, they will be net sellers.

For the short term, it appears supply and demand may be out of balance. In order to draw private investors to soak up excess supply it's likely mortgage rates will rise. The most believable predictions I've seen estimate that spreads will rise to as much as 100 basis points. If the 10-year treasury hits 4.0%, this would equate to a 30-year fixed mortgage rate of 5.5%. (The extra 50 basis points is eaten in servicing and guarantee fees.) It's unlikely this will happen all at once. Instead, rates probably will be volatile as the market seeks out a new equilibrium.

Will the higher rates dampen the housing market? That's the big question. Mortgage application volumes are still depressed, which may help keep the spread tighter (because of less supply entering the market).

One last question: What will happen to the MBS the Fed purchased? Will it flood the market and put further pressure on rates? The Fed says it plans to hold the securities on its books for an extended period of time and sell them only as market conditions allow.