When the Fed Stops Buying Mortgage Bonds, Mortgage Rates Will Go Up. Or Will It?
The majority of mortgage professionals share the opinion that rates will be going up this spring. And why not? Several factors indicate rates could move up very soon.
The big one, the Fed’s expiration date of their MBS (Mortgage Backed Securities) purchase program set to expire in February of 2010. Even Spencer Rascoff, COO of Zillow.com, mentions this phenomenon on an interview he had on Bloomberg on October 12th.
Many of us have set our minds that rates will go up at this point and have patiently waited for this event to happen. Are we doomed to a fate of higher rates?
First, let’s look back to why the Fed first started this program and what it has done for interest rates.
In the summer of 2008, mortgage interest rates were in the low to mid 6% range. The 2008 Freddie Mac’s 30-Year Fixed-Rate history chart shows the average rate for interest rates were 6.32% in June, 6.43% in July and 6.48% in August. This coincidentally was also during the peak of commodity prices where we saw the price of oil as high as $150 a barrel and gas prices in the $4-5 a gallon range. Immediately after these months, commodity prices crashed and the stock market began the largest crash since the 1930’s. Many people felt that rates would go down with the stock market, but they didn’t. Why was that?
Many people think that mortgage rates are directly affected by the stock market. This is not true. Another misconception is that mortgage rates are related to the Federal Prime Rate, which also is not true. The only thing that determines whether mortgage rates go up or down is the price of a related mortgage backed security, which are also called mortgage bonds. When the price of a mortgage bond goes up, interest rates drop. When the price goes down, rates go up. Many factors do affect the pricing of these bonds which is why people may think rates are related to stock prices or other index rates like the Prime Rate. Many times when the stocks begin to drop in price, investors sell stocks and buy bonds such as a mortgage backed security. The price of the bond goes up when investors buy, thus rates go down. Since this often happens for all bonds, many people have used treasury bonds as a tracker for mortgage rates. This has worked often in the past but not always.
In the late summer of 2008, investors watched the Dow drop over 3,000 points in just a few months. This money did go to bonds, but not mortgage backed securities. Investors did not feel that mortgage bonds were the “safe haven” they used to be since the entire recession was caused by the mortgage industry. All of the money flooded into the treasury bond market creating a historically large gap between the prices and yields of treasury bonds versus mortgage backed securities. Many politicians expected low mortgage rates to help boost the real estate market as the stock market fell, which sent Washington politicians into a panic. The stock market appeared to be falling out of control and the safety net of low rates wasn’t there to stop it.
Washington responded quickly by creating a short term program to buy mortgage backed securities in hopes that their prices would improve. It worked. Investors felt the security of mortgage backed securities were safe since the government was purchasing them, thus giving them the confidence to buy the bonds. Investors quickly sold their overbought treasury bonds to buy mortgage backed securities bringing the gap between the two back to normalcy and bringing mortgage rates down.
The success of Fed’s MBS purchase program was so impactful they extended it until February of 2010 in one of the stimulus bills passed early in President Obama’s term.
Fast forward to today, we are less than 3 months away from the end of this program. It would seem higher rates are inevitable. Or is it?
A colleague of mine at Cobalt Mortgage, Jeff Bell, made an interesting point. The Fed had already begun slowing down the purchasing of these bonds. In fact, their purchase volume in recent weeks has almost halved. Yet rates had not begun moving up. In fact, we saw some of the lowest fixed rates of the year at the end of November. Additionally, the common trend of Wall Street is to move ahead of an event. If the price of the bonds are based on the Fed MBS purchase program, why is is rates have not gone up when the Fed slowed their purchasing and investors know the program ends in 3 months? Why would they go down?
Here’s a thought. Maybe the Fed’s plan was to add long term normalcy to MBS pricing. After all, the price gap between treasury bonds and mortgage bonds last fall were abnormal. If they were right, we may not need the Fed any longer to keep mortgage rates low.
The Dow Jones Industrial is currently above 10,000 again. The real estate market has yet to hit it’s national floor, the extended home buyer tax credit is only extended through spring of next year, foreclosure rates are still rising and unemployment is still an all-time high. Personally, I can’t see the stock market sustaining the levels we’re currently at. I believe there’s a good chance the Dow Jones Industrial will drop again.
If it does, maybe Wall Street won’t need the Fed’s intervention to buy mortgage bonds. Then we can watch mortgage rates go down on their own and let the real beginning of the housing recovery begin.