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Why the Fed's Taper Has Done Little to Move Mortgage Rates

APR 24, 2014 5:32pm ET
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The big bugaboo when word got out in 2013 that the Federal Reserve would taper government mortgage bond purchases this year was that long-term rates would skyrocket as a result.

The fear was that as the Fed pulled out of the market for the securitized government loans that currently dominate lending, there would not be enough private investors to replace it as a buyer.

Reduced demand would theoretically decrease the prices of government-related mortgage-backed securities prices and thus increase their yields, which in turn would push up consumer mortgage rates.

Rates indeed climbed to a new, higher range on the news that the Fed planned to reduce its MBS purchases last year. But now that the actual tapering of its so-called quantitative easing program has begun there is very little concern that rates will soar into the stratosphere.

Mortgage sponge

"We started 2014 with everybody positive that rates were going to go through the roof, but they went down," says Tom Millon, president and chief executive of the Capital Markets Cooperative in Ponte Vedra Beach, Fla.

The Freddie Mac primary rate average during the survey week ended Thursday was 4.33% for the 30-year securitized mortgage that most consumers get. It's wavered a bit since then, but generally has been lower than where it started in January at 4.53%. This contrasts to the more than 1% increase over the course of 2013.

One factor is that the decline in securitized originations has outpaced the Fed's tapering of government-related MBS purchases, says Walter Schmidt, a senior vice president and the manager of mortgage strategies at FTN Financial Capital Markets in Chicago.

"You don't have to have 'somebody else' coming in at this point" to buy up mortgages, "simply because now what they are buying is a higher percentage of the market than even when they were full-tilt with QE," he says. "They're tapering, but as a percentage of the market they're really not tapering much at all."

"For the time being they are purchasing a much higher percentage of the market than when they were doing their full QE allocations," says Schmidt.

But the balance is shifting, and data suggest the Fed's percentage has peaked and now is declining, he says.

Data from Millon's cooperative and Fannie Mae, comparing recent net trading of Fannie, Freddie Mac and Ginnie Mae MBS through broker-dealers to Fed purchases, appear to support this. (See related table, above.) This trading represents about one-third of total agency/Ginnie issuance.

The statistics suggest that the Fed purchased a roughly estimated $150 billion in MBS in the first quarter compared to about $180 billion in new originations, he says.

Even with the Fed remaining a heavy buyer in the market, private investors have continued to show an appetite for MBS as these bonds have remained attractive compared to competing Treasury investments. That is another factor that has prevented rates from rising much this year.

"The relative demand for MBS stays strong just because there are so many people out there looking for yield," Millon says, noting the market supply of higher yielding, riskier assets has been falling short of demand. (Government MBS are more attractive from that perspective, relative to Treasuries.)

"At the margin," the Fed's tapering "might raise rates a little bit," says Brent Nyitray, the director of capital markets at iServe Residential Lending in Stamford, Conn. But "there are certainly other buyers out there." For example, "mortgage REITs could end up getting bigger and absorbing some of the supply."

While the Fed has remained the dominant buyer of new government-related MBS this year, despite tapering due to origination declines, at some point under the plan in place it will leave the market.

The Fed is slated to stop new purchases by year-end and thereafter decide how to deal with the runoff from the existing portfolio.

At this point the government-related MBS market will be left without a "buyer of last resort," Schmidt says. Fannie Mae and Freddie Mac at one point filled that role, but they are unlikely to ever resume doing so because it is politically untenable, he says.

Millon agrees that it looks politically problematic for the government-sponsored enterprises or their successors to ever step back into that role, but he is confident the Fed could resume it if needed.

"If the Fed takes it to zero, it doesn't mean they can't buy again. They can step back in if necessary," he says.

If the market does become dependent on private investors again, origination supply and the attractiveness of MBS relative to other investments will remain be key factors in shaping investors' interest in government-related securitizations and hence long-term rates.

"In my opinion, the buyers will be there," says Millon. "Where rates go, who knows?"

Among the factors that could affect the relative attractiveness of MBS is the yield curve, representing the relationship between short- and long-term bonds. The differences between short- and long-term rates create opportunities for certain investors.

So if the curve remains steep and other competing investments fail to offer more attractive alternatives, private market buyers will likely be broadly drawn to MBS. Some types of investors will stop buying if the curve flattens, though.

Though such a move in the shape of the curve would discourage buyers like banks, there would be money managers active in the market, Schmidt says.

The curve is unlikely to flatten unless economic indicators show very clear signs of inflation, given what Federal Reserve chair Janet Yellen has signaled so far about Fed policy.

"I just think the chances of a flattening curve are so remote," says Millon.

For now, it looks like the status quo will continue, as far as monetary policy, rates and MBS investor demand are concerned.

That may be better than the skyrocketing rates originally expected to manifest this year, but it still leaves originations and housing in the doldrums, says Millon. Some improvement in the economy may be worth the risk of higher rates as it could at least reinvigorate those markets a bit.

"I'm hoping for maybe not higher rates, but economic growth," he says, noting that lower rates at this point probably would be of little benefit to the housing market given that they would probably be a sign of more weakness in the economy. Also, many borrowers have already refinanced at record-low rates.

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