You already know that what the Federal Reserve does with interest rates has a huge impact on the housing market. And as I wrote in my last column, interest rates are going up in the near future. This will make mortgages more expensive and will, in turn, decrease the amount you can afford to pay for a house.
But what you might not know is that the Fed influences housing prices in another significant way—through its purchasing of mortgage-backed securities (MBS)—and now the question is that when the Fed stop buying those securities in the near future, how will it affect the housing market?
Some background will help explain what is going on. Let's start with a definition. An MBS is a basket of (mortgage) loans that are pooled together and sold as a bond.
Part of a Pool
It is easy to understand how MBS come about and how they work. When you go to a bank or mortgage broker to borrow money to purchase a home, the home is collateral, and your mortgage—the promise you'll pay principal and interest each month—is the anticipated cash flow the lender receives from you.
That bank or broker then sells your loan to an entity that aggregates your loan with a bunch of other loans into a big "pool" of various types of loans with various maturity dates (fixed, adjustable rate, one-year, 30-year, good credit, bad credit, etc.) The aggregator then issues these pooled mortgages as bonds, the MBS, which promise investors an attractive stream of interest payments.
Who are these aggregators?
They are government sponsored entities (GSEs). One large group is the Federal Home Loan Banks (FHLB), a private corporation made up of 8,100 member banks. All of the member banks must own stock in FHLB in order to participate in its loan program, in other words, they need to have "skin in the game." Other GSEs, which I'm certain you have heard of, are Fannie Mae (FNM), Freddie Mac (FRE), and Ginnie Mae.
Great, so now we know what an MBS is: a pool of home loans sold as a bond. And we know who issues them: government sponsored enterprises such as Freddie and Fannie, etc. So, how does this help us understand where real estate prices are going?
Easier to Get a Home Loan
Well, most banks have neither enough money, nor any desire, to hold a large number of home loans for an extended period of time. Absent a place for the banks to sell them, as many of us found out over the last year, it then becomes difficult for us to get a new loan. Thus, the MBS market is currently providing us all with an important means of loan supply, albeit indirectly via our bankers and mortgage brokers. The easier it is for banks to sell our loans to MBS aggregators, the easier it is for us to get a loan on our dream home. The more difficult it is, the harder (and more costly) it is for us to get a mortgage.
As you may recall around this time last year, our entire financial system found itself on shaky ground. And the housing market was no different. Anticipating a big increase in homeowners defaulting on their mortgages, investors no longer wanted to own their existing MBS, let alone buy newly issued MBS.
With no buyers for those securities, the GSEs couldn't sell them or issue more. As a result, the supply of mortgage loans all but came to a screaming halt.
Cue the Fed: Last November, as part of its efforts to get the economy moving again, the Fed announced it would buy $500 billion in mortgage-backed securities. In March of this year it raised its target to $1.25 trillion, and it has followed through on its pledge. As of today, it has purchased roughly $775 billion of the $1.25 trillion MBS goal. These purchases have undoubtedly provided much needed liquidity to the MBS market and helped keep the long-term mortgage rates at historic lows.
Behind the Higher Rates
O.K., let's get back to the original question: What's next? Well, just as it has been with interest rates, the Fed has been transparent about its intentions toward MBS. It has said it will stop buying MBS once it fulfills its commitment of buying those $1.25 trillion worth of bonds. It will complete that purchase sometime during the first quarter of next year.
That means that, sometime within the next five months, the Fed will be withdrawing a prop under the housing market.
What remains to be seen is how other investors react as the Fed slows—and then eliminates—its purchase program.
My expectation: As the Fed pulls out, private investors will demand a higher interest rate for such securities—to compensate for their concern people will continue to default on their mortgages—and thus long-term mortgage rates will rise. The real question is how fast and how high.