What The Fed's MBS Exit Means For Fannie, Freddie And Rates

I sometimes worry I complain too much about the government mortgage companies Fannie Mae and Freddie Mac. But then I remember that the government is doing nothing to fix the problem they pose and realize that I need to keep writing about them. Bloomberg/BusinessWeek has an excellent article today about the future of the once quasi-private mortgage giants. It asks an interesting question: what happens when the music, supplied by the Federal Reserve, stops?

The fact is that the Federal Reserve has had a significant influence on the mortgage market during 2009. It had purchased around a trillion dollars in mortgage-backed securities (MBS), and a lot of that came from the anything-but-dynamic duo of Fannie/Freddie. B/BW explains:

The Federal Reserve has bought $1.1 trillion of Fannie Mae and Freddie Mac's home-loan bonds and $124.1 billion of their corporate debt this year. Those actions have lowered the companies' funding costs and pushed mortgage rates to a record low 4.71 percent this month.

Think about it: if there was ever a time in history, government intervention aside, when banks should be charging more for credit, it was 2009. In 2008, they woke up to the fact that their credit policies were entirely too easy, and they made many billions of dollars in bad loans. Their response should have been to provide fewer loans, and charge more, on average, for those they do give. Instead, we've seen mortgage rates actually decline to historically low levels.

Why has the Fed's action here had such a dramatic effect on mortgage rates? Because, as the article points out, Fannie/Freddie financed "as much as 75 percent of the new U.S. mortgages this year." Since most of that money is coming from the Fed, really, the central bank has backed most of those mortgages, via the cheap MBS financing it's provided to Fannie and Freddie. This action drove down rates.

Yet, in March, that will all change. At that time, the Fed is implementing a step in its exit strategy to stop propping up the MBS market. Instead, if Fannie and Freddie wish to continue financing mortgages, and I'm sure they intend to, then they must do so by going to investors for financing instead. Good luck with that.

Investors are sure to be cautious and wary: they're dealing with companies that have lost over $188 billion since 2007. The firms are still doing so badly that the government has essentially uncapped the lifeline that it's willing to provide to the firms.

Bloomberg's piece also says that the companies' future is very much in limbo. But there certainly doesn't appear to be any rush on the government's part to wind down the institutions. That would make too much sense.

So what I think you'll see is that investors will take the government's inaction as meaning that it intends to continue to prop up the disastrous mortgage firms. And as long as the government's backing them, then they're a pretty safe bet. Of course, investors probably won't be quite as generous as the Fed in the risk premium they charge -- even if there is apparently an explicit government guarantee in place. After all, if Americans manage to elect an executive in 2012 who sees these firms for what they are -- an utter and complete mess -- he or she might decide to end that guarantee in winding down the firms. Politics is notoriously fickle.

I expect higher mortgage rates to result when the Fed pulls back. Yet, due to the likely government guarantee, I don't think borrowers with good credit have to worry about 9 or 10 percent mortgage rates. But after March, assuming the Fed keeps its word, I think those sub-5 percent mortgage rates will become a thing of the past.