Upcoming headlines may read: "Fed Set to Raise Interest Rates Though Economy Remains Fragile." The Federal Reserve is now winding down its $1.25 trillion purchases of mortgage backed securities (MBS) and has announced its intent to terminate the program by March 31, 2010. The vast majority of economists and investment analysts predict that the termination of this program is likely to increase interest rates on 30 year fixed rate home loans by anywhere from 25 basis points to 100 basis point (a full percentage point).
Why, you may ask, does the Fed want to bring about an increase in mortgage rates when the overall economy, and especially the housing economy, is in such fragile shape? Add to this the widespread recognition that premature tightening of monetary policy poses a substantial risk of a "double dip" - such as occurred following the Great Depression. Part of the reason is that there is an unusual twist at work. Normally, for the Fed to increase interest rates, it must be proactive. It must increase the Fed Funds rate and/or discount rate. In the context of the mortgage security purchase program, the opposite is true. Simple inaction will lead to higher rates. But a proactive response will require the Fed to add billions more in MBS purchases to its balance sheet, further increasing the money supply, and thereby risking downstream inflation. They have, therefore, opted for inaction, meaning termination of the program.
It is generally accepted that the Fed's purchase of $1.25 trillion in mortgage bonds has significantly contributed to 50 year lows for interest rates on 30 year fixed rate mortgages. If the Fed stops purchasing, the assumption is that those rates will rise. But beyond that assumption, the uncertainty factor in all of this is huge. A key uncertainty, as noted above, is how much rates will increase when the purchase program ends. Consider the following:
William Dudley, President of the New York Fed, and close ally of Chairman Bernanke: "There's a big debate about whether (any interest rate increase) will be small or medium or large. So I think we'll have to wait and see."
Bill Gross, CEO of PIMCO, the largest U.S. bond fund: "I think it will (put upward pressure on interest rates). I mean, the mortgage market would be your first place to look, in terms of something that's overvalued that would become normalized. Nobody knows what the Fed's buying is worth -- we think about half a percentage point on rates, but we don't know." (Emphasis added)
The Federal Reserve, in its December minutes, took the unusual step of reporting that there was a dispute among the members about the impact of terminating the MBS purchase program.
A key contributor to this uncertainty is the radical nature of what the Fed has been doing. Before the Great Recession, the Fed did not purchase MBS securities. It is now the dominant purchaser of such securities. No one knows to what extent the private market will step back in and fill the void when the Fed stops purchasing. Thus, according to the Wall Street Journal, the issue has become "one of the hottest debates between economists, investors and analysts."
A recent Washington Post front page headline story summed up the situation this way, offering its own highly attention grabbing spin:
"The wind-down of federal support for mortgage rates, set to end in two months, is a momentous test of whether the Obama administration and the Federal Reserve have succeeded in jump-starting the housing market and ensuring it can hold its own. The stakes for the economy are massive." (Emphasis added)
Fortunately, there are safety nets. The Treasury has announced that it will cover any losses incurred by purchasers of Fannie Mae and Freddie Mac mortgages. At present, these entities can expand their purchases by $300 billion before hitting the current federally mandated limits on mortgage purchases. In the short run, they may simply run up their balance sheets in place of the Fed running up its balance sheet. Further, the Fed can re-enter the fray and reinstitute its MBS purchase program. If interest rates rise to levels that threaten the housing market, it will do so, given its "whatever it takes" attitude. While some have suggested that the Fed would be reluctant to reinstitute the purchase program because of dollar/treasury bond risk or potential political backlash, these concerns are unlikely to inhibit action.
The bottom line for investors is that while there is substantial uncertainty, I would argue that the fears concerning the termination of the MBS purchase program are overblown. Uncertainty often gives rise to unrealistic fear, and in the MBS context, this is certainly the case. In the short run, terminating MBS purchases may create a market downdraft but the existing safety nets will be deployed, if it becomes necessary.