Maybe the Fed Should Buy More Mortgage Bonds?

Mortgage interest rates are rising. If they continue to do so, then the Federal Reserve will probably become pretty frustrated. Today it reaffirmed its latest round of quantitative easing, explicitly designed to keep down longer-term interest rates, like those for mortgages. So what's going wrong? Apparently mortgage bonds aren't selling so well right now. Less demand is leading to higher yields. Perhaps the Fed should consider buying some of these securities too.

Here's the problem, via Jody Shenn at Bloomberg:

Yields on Fannie Mae-guaranteed securities that most affect loan rates jumped to 4.22 percent as of 11:28 a.m. in New York, an increase of more than 1 percentage point from an all-time low in October, according to data compiled by Bloomberg.

Higher loan rates "won't be fun" for a fragile housing market, said Scott Simon, head of mortgage bonds at Newport Beach, California-based Pacific Investment Management Co., manager of the world's biggest bond fund. "If you were looking at buying a house a few weeks ago, the same house, to you, looks as much as 9 percent more expensive," he said.

As a part of the Fed's financial crisis intervention, the central bank purchased $1.25 trillion in mortgage securities through March 2010. But as the Fed noted earlier this year, those securities in holds are paying off more quickly than anticipated, as very low interest rates had helped to create a mini-boom for refinancing. As a result, the Fed's balance sheet was shrinking faster than it wanted, which prompted it to begin buying additional assets in August to keep its size level. But it chose to replace those mortgage bonds with longer-term Treasuries. Of course, the Fed's additional $600 billion quantitative easing was announced a few months later. It also focused on longer-term Treasury purchases, however.

If the Fed broadened its purchases to include mortgage securities, then this additional demand could help keep mortgage interest rates low. That, consequently, would help to prevent high rates from frightening away perspective home buyers.

If you're not on board with the Fed's strategy of purchasing additional assets to keep interest rates low, then you probably won't like the idea of the central bank purchasing mortgage either. But to the extent that the Fed hopes that mortgage interest rates will benefit from its quantitative easing strategy, this might help. If mortgage interest rates continue to rise, then this argument will become even more compelling. As long as the housing market remains weak, the sector will be a drag on the broader economic recovery.