Mortgage Rates: Will They Rise As The Fed Withdraws MBS Support?

(MoneyWatch)  About a month ago, the Federal Reserve took the first, small step toward getting monetary policy back to normal, by increasing its discount rate. The Fed Open Market Committee meets again today (Tuesday March 16), but the financial world expects no repeat of an increase, and probably no substantive action on the fed funds rate until next year.

The bigger concern for higher rates, however, may be what happens to the market prices for mortgage rates, as the Fed stops supporting the market for mortgage-backed securities (in the course of the various rescues it has bought over a trillion dollars' worth). Most economists are nonchalant, but they also confess to not really knowing what might happen.

The Fed's increase of its discount rate last month was an important signal, but one that will not have much impact. Because the discount window deals mostly in overnight loans, this increase to a rate of 0.75 percent from 0.50 percent affects only about $15 billion in lending. Not a big deal in terms of cost to banks in the aggregate, but it does allow the Fed to show it remembers where the control room is, and still knows how to push the levers.

A bigger concern, however, is the mortgage market. By now we all know that banks seldom keep the mortgage loans they write; they are sold to government agencies or private companies to be packaged into mortgage backed securities (MBS) and then re-sold to all sorts of investors.

And we know that when the credit markets seized up in 2008, so did the MBS market. The Fed came in and bought up much of the MBS on hand, and since then has been buying much of the new supply of MBS, and thus has been a crucial source of funds for creating new mortgages. And because the Fed is the Fed, and wants to help the economy get going again, rates on mortgages have held at very low levels. Here is the rate on a 30-year traditional fixed mortgage since the 1970s:


Consider this -- even though the structure through which most of the mortgages in the U.S. have flowed since the early 1980s went through a big freeze in late 2008, interest rates are at record lows. That illustrates how powerful our Fed is.

What happens at the end of March, when the Fed stops its support of the mortgage market? (MoneyWatch also considered this question a few weeks ago.)

In the latest report of its balance sheet, the Fed owned $1.029 trillion of MBS, an increase of $960 billion from a year ago. I don't know how much was just laying around unbought, and how much was created since the crisis, or how much slack the "real" MBS market will have to pick up. But it has to be big, even in a slow housing market.

Today I listened to a conference call with two economists from Deutsche Bank Asset Management, mostly on what to expect from the report on today's FOMC meeting (not much), although they also addressed mortgages.

These two, Josh Feinman and Joe Benevento, don't expect a big impact on mortgage rates, because the Fed has been active in telegraphing its intentions, as it did last month with the rise in the discount rate. I've heard other economists say there might be an increase of a half of a percentage point. (After I first put this up, I saw Bill Gross, the head of bond investing giant PIMCO, putting the potential increase as high as one percent.)

But we're still in uncharted territory -- the size of the intervention is, to use the popular term, unprecedented. Not only that, the Fed does not know what to expect when such a large subsidy/stimulus/support is withdrawn. The Fed surely won't be dumping all the bonds it bought on the market, but as for what the unaided free market will demand for a home mortgage in 2010 -- nobody knows.