Will the Fed's Other New Policy Encourage Risky Mortgages?

The central bank will create more mortgage demand as interest rates fall, and credit standards may suffer

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By now, you've probably already heard about the Federal Reserve's "Operation Twist." That's the program through which the central bank hopes to push down longer-term interest rates. But in their September meeting they announced another policy changes that is arguably just as important. The Fed will begin reinvesting the maturing principal from their mortgage securities in new government-backed mortgage-backed securities. This could have a very significant effect on the housing market -- but not all good.

Creating Demand and Reducing Supply

To understand the effect this program could have, let's consider the economics of situation. Right now, mortgages are financed almost entirely by the government through the agencies Fannie Mae, Freddie Mac, and the Federal Housing Authority. After they bless mortgages with the full faith and credit of the U.S., some are packed into mortgage-backed securities, the bonds from which are sold to investors. Others are held in their portfolios, and agency debt is sold to investors to finance them.

The Fed will now become a very big investor in those mortgage securities. It currently has a massive portfolio of these bonds. Each month, as borrowers make payments, it gets distributions of principal and interest. Through its new policy, it intends to take that principal and reinvest it in more mortgage securities.

The precise amount of new mortgage bond demand that the Fed will create depends on how much principal is paid, and how many people refinance, in particular. Refinancing results in 100% of a loan's principal balance being repaid. Considering how far long-term interest rates will continue to fall through Operation Twist, we can expect something of a refinancing boom over the next nine months. As a result, we could easily see tens of billions of dollars in Fed mortgage security purchases each month.

Now here's the problem: right now there are plenty of investors eager to snatch up the current supply of mortgage securities. But with the Fed buying a huge number, there could be a shortage. While some of the principal used by the Fed to purchase new bonds will simply be turnover from refinancing, some principal that the Fed will be replacing will just be regular borrower payments. As a result, we should see the market clamoring for more mortgage supply than is currently being produced.

Moving Down the Credit Spectrum

What will banks do to acquire additional supply? They'll have to write more mortgages. And assuming that prime borrowers already qualify for mortgages, banks will have to move down the credit spectrum in order to write more loans. This means more near-prime or non-prime borrowers should be able to get mortgage credit due to the Fed's new reinvestment policy.

On one hand, this is very good news for the housing market. Realtors have been complaining for some time that banks' strictness is one of the reasons for the lackluster home sales. They're angry that banks haven't been looser with their underwriting criteria so that more potential home buyers could get mortgages. Those realtors might get their wish.

On the other hand, non-prime mortgages were what got the U.S. into this mess last decade. If banks start racing towards the bottom again to satisfy the Fed and investor demand, then borrowers may get loans that they can't ultimately afford. The insatiable demand for mortgage bonds by Fannie, Freddie, and investors is one of the chief reasons of why so many bad mortgages were written in the early 2000s.

It Gets Worse: Low Interest Rates Mean More Adjustable-Rate Mortgages

You may also recall that one of the most dangerous products out there during the bubble was the adjustable-rate mortgage. In particular, option ARMs resulted in borrowers getting mortgages that they ultimately couldn't afford, when their interest rates jumped. But what do we also know about the current credit environment? Interest rates are very, very, very low.

One reason why ARMs became so popular during the housing boom was because interest rates were being held very low at that time by the Fed as well. It was trying to avoid a deeper recession from 2002-2003. Since some bond investors didn't want to be locked into very low fixed interest rates for an extended period, they sought adjustable-rate debt instead. With adjustable-rate bond demand high, ARMs took off.

As the Fed keeps interest rates at historically low levels, we're already beginning to see the same thing today. Annamaria Andriotis at Smart Money reports:

After two years of little demand, ARMs, which offer borrowers a fixed interest rate for a set period, after which rates rise or fall with prevailing rates are making a comeback. For the first six months of this year, ARMs accounted for 13.4% of the total mortgage market, according to the latest data available from Inside Mortgage Finance, a trade publication. That's up from 9.5% for all of 2010 and 6.3% in 2009.

So the Fed's policies are already encouraging more risky mortgage products and will likely push banks to loan to riskier borrowers. This does sound familiar.

Image Credit: REUTERS/Jason Reed