Mortgage rates had been at or near historical lows for a long time. These tend to go in cycles, and rates have started to inch back up. There’s more than one reason for this.
The first is that the Federal Reserve has started to slowly raise short-term interest rates, (the rates at which banks borrow money), which has a couple of effects: It becomes more expensive for banks to borrow money. This cost is then passed on to clients who pay a higher interest rate for things like personal, car and home loans.
While increased costs isn’t great news for consumers in the market for anything, there’s a second effect of these rate increases that is beneficial: If it costs a bank more money to borrow funds, the funds they already have on hand – the dollars you and I deposit – are more valuable. Over time, you could start to see increased interest rates on the money in your savings accounts, for example.
More valuable currency also keeps prices from spiking too high too fast. Ultimately, the control of short-term interest rates is the biggest tool the Fed has to keep inflation in check.
We’ve previously covered the impact the Fed has on all kinds of interest rates, including mortgage rates, through its control of short-term interest rates. Today, we’re taking a look at a different lever the Fed has been pulling to keep mortgage interest rates low: buying mortgage-backed securities.
Let’s take a look at what a mortgage-backed security is, how the Fed is helping mortgage rates by purchasing them and what happens when they stop.
What’s a Mortgage-Backed Security?
A mortgage-backed security (MBS) is a pool of home loans packaged together by mortgage lenders and sold on the open bond market to investors. The investors who buy the securities then receive the payback on a monthly basis when homeowners make their principal and interest payments.
The investors also have certainty in their investments. The vast majority of mortgages are backed by the U.S. government, either directly or indirectly. FHA and VA loans have direct government endorsement; Fannie Mae and Freddie Mac are government-sponsored entities (GSEs).
Investor Guarantee
Each of these entities has specific requirements for the loans they sponsor. In exchange for the lender making sure the client is properly vetted and meets the appropriate qualifications up front, these agencies agree to take the responsibility to recover as much as they can for investors or the lender if something happens and the client ends up going into default. In this way, investors have some guarantee of returns.
How is it decided which mortgage loans go into any given MBS? Let’s take a brief look.
MBS Pools
Let’s say John Doe just closed on his conventional loan. He has a 640 credit score, paid a 3% down payment and has a 30-year term. Freddie Mac insures his loan because it meets their guidelines.
Once the loan is insured, it’s put into an MBS with other loans that have similar characteristics, such as credit score, down payment size, term length or, in the case of a refinance, loan-to-value (LTV) ratio.
After all the loans are in the MBS, it’s ready to go out on the open bond market. Mutual fund managers, 401(k) custodians and even individuals can buy an MBS based on the characteristics of a particular pool. If the entity managing your retirement funds happened to buy into the right pool, you could even own a piece of your own mortgage without knowing it.
Now that you know how the MBS market works, where does the Federal Reserve fit into all of this? The short answer is they own a lot of mortgage-backed securities. Let’s take a look at why.
The Federal Reserve and MBS
The Federal Reserve has a vested interest in the housing industry succeeding in this country. Housing makes up a huge portion of this country’s gross domestic product (GDP). GDP places a real dollar value on all finished goods and services produced in the U.S., taking into account consumer spending, the value of inventories, government spending and exports while subtracting imports. GDP may be the single most important measurement when we look at how fast the economy is growing.
According to the National Association of Home Builders, in the fourth quarter of 2016, housing accounted for 15.6% of overall GDP. Of that number, 3.6% came from residential investment (construction costs for single- and multi-family homes; costs associated with remodeling, the construction of manufactured homes and broker fees).
The bulk of that number (12%), however, came from spending on housing services. This includes gross rent and utilities for renters as well as the estimated cost of what it would take for a homeowner to rent in their area and utility payments.
Housing is a huge economic driver, so it makes sense for the Fed to encourage homeownership and construction.
One of the ways it helped accomplish this was to move short-term interest rates down to near 0% for quite a while so that lenders could pass that savings on to their clients. Still, that only drove mortgage rates down so far. In order to drive borrowing costs even lower, the Federal Reserve took the unusual step of entering the market for mortgage bonds.
Quantitative Easing
In order to further stimulate economic growth and drive interest rates down even lower, the Federal Reserve instituted a policy of quantitative easing. Although it has a fancy name, it basically just means that the Fed chose to enter the bond market, buying various securities and other assets, in order to keep interest rates low.
When a new buyer enters the bond market and buys a lot of any particular bond, the yield or rate of return for that particular bond may be driven to low amounts because the return doesn’t have to be high in order to attract investors – there’s already a motivated buyer out there.
The biggest beneficiaries of the buying brought on by quantitative easing were agency MBS and, by extension, mortgage rates. Quicken Loans Chief Economist Bill Banfield explained the effect this had on the mortgage market.
“Lower interest rates help stimulate economic growth, and because [the Fed] also focus on mortgage-backed securities, it drove rates down for purchases and refinances,” he said. “The current strategy of the Federal Reserve is to reinvest the payments received from their securities into new securities, but they are not increasing the size of their holdings.”
As of this writing, the Federal Reserve holds about $1.76 trillion worth of mortgage debt. Each time they reinvest money from the principal and interest payments back into MBS, that number grows. All of this investment in mortgage bonds has helped to keep mortgage rates low.
Ending MBS Purchases
Recently, talk among people on the Federal Reserve has turned to when the Fed might end its purchase and reinvestment program for mortgage bonds. We’ll get into the impact, but first, let’s briefly discuss why the Fed would exit the mortgage bond market.
The Fed only purchases assets and other types in stimulus programs when it absolutely needs to in response to an economic crisis. It worked for quite a while, keeping mortgage rates low and stimulating the housing market.
Now that the economy is doing well, this stimulus soon won’t be needed. It also gives the Fed more room on the balance sheet if measures need to be taken to stimulate the economy again.
Fed officials like Neel Kashkari have said it may soon be time to lessen the Fed’s assets. When the Fed chooses to end its purchases of MBS, what effects will that have on the mortgage market?
Mortgage Rate Effects
In order to truly understand the effects of the Federal Reserve exiting the bond market, Banfield said it’s important to understand just how big of a player the Fed is.
“The Federal Reserve stepped in as the single largest buyer of various securities in the market,” he said. “With a new buyer and more demand, prices of those securities went up. In the bond market, price and yield are inverse to each other, and the increased prices from the Fed’s purchases drove rates down.”
Among the bonds being purchased in huge quantities are the fixed-rate MBS offered by Fannie Mae, Freddie Mac, FHA and VA. What happens when the biggest buyer of mortgage bonds start offering them up for sale?
“If the Fed decides to start liquidating bonds or stops buying any new bonds,” Banfield said, “we would have fewer buyers and less demand, and prices would move lower on a relative basis. A lower price means rates would increase.”
A new buyer, or more likely several of them, would have to pick up the slack and buy lots of MBS in order to keep mortgage rates where they are right now. No one has a crystal ball as to when the Fed will start to get out of the MBS market, either.
What’s the bottom line if you’re looking for a mortgage? Banfield suggests not waiting around.
“In the short run, it looks like interest rates are lower than they would be without the Fed’s involvement,” he said. “Knowing that any pull-back from the Fed could send rates higher, a person looking to get a mortgage may want to take advantage sooner rather than later.”
If you’re in the market for a mortgage, it’s still a great time to get one. You can get started online or call (888) 980-6716, and one of our Home Loan Experts will be happy to take care of you.
All this mortgage stuff can get confusing, so if you have any questions, leave them for us in the comments.
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