How Will the Fed's MBS Exit Affect Mortgage Rates?

Today marks the end of the Federal Reserve's $1.25 trillion mortgage security shopping spree. There has been a broad spectrum of opinion on what this means for mortgage rates, and ultimately, the mortgage market. Which argument is more compelling?

Mortgage Rates Will Rise

Late last year, the predominant view was that mortgage rates would increase significantly once the Fed removed its support of mortgage bonds. I explained why in posts from November and December. The general idea is this: if there's no one to pick up the slack on buying mortgage securities once the Fed stops, then banks won't have as easy a time obtaining funding for originating more mortgages. That would drive up mortgage interest rates, since they would probably have to rely on investors, who are still wary about mortgage-backed securities (MBS) after getting burned during the housing boom and will demand a lofty premium for the perceived risk and uncertainty.

So if the private market can't step in to make up the Fed's buying, then mortgage interest rates should rise. If the Fed decides to begin selling some of the mortgage securities it purchased during its buying binge, that could make matters worse. More than $1 trillion in MBS could flood market supply, making new issuance more difficult.

Mortgage Rates Will Be Unaffected

Yet, recently, the prevailing view has changed. Back in February government-sponsored entitles Fannie Mae and Freddie Mac announced that they'd be buying back close to $200 billion in bonds backing delinquent mortgages from investors. Once investors get that cash, they may reinvest it in the mortgage market. If they do, then this would temporarily increase demand for agency-backed securities as the Fed exits, keeping mortgage rates down.

Even though the MBS market isn't expected to revisit its 2006 heights anytime soon, I have heard rumblings of some small deals being privately placed. But even if the market does pick back up, I have to believe that the yield demanded by investors will be higher than what the Fed was willing to pay. If that's the case, it could still cause mortgage interest rates to rise a bit. But for bonds guaranteed by Fannie and Freddie, given their explicit government guarantee, investors may feel they have little to worry about.

As for the possibility that Fed begins selling its mortgage securities, I'd be pretty surprised if that happened anytime soon. So the supply will mostly consist of just new issues and whatever investors are trying to get rid of in the secondary market, for now.

So Which Will It Be?

It's hard to tell, but I'm leaning towards the latter view. Wall Street's seemingly relaxed attitude about the economy continues to surprise me, though I worry it's driven more by naïve optimism than realism. But either way, if that sense of safety drives investors to feel better about mortgage securities again, then perhaps mortgage rates will be mostly unaffected, in general. I would suspect, however, that rates for borrowers who don't have perfect credit will be high, since those mortgages will be very hard to sell to investors.

Finally, it should be noted that, after April, demand for new mortgages could be very, very low -- even lower than it was in February. So a whole lot of investor demand might not be necessary to support the market. This also suggests that rates could remain low, if even a weak investor appetite can outweigh the supply of new mortgage originations packaged into securities.