The real estate market is in turmoil. Home prices, as measured by the Case-Schiller index, increased by 30% between March 2020 and December 2021. This is a steeper rise than the 2008 lead-up to the end of the housing bubble. And the spring 2021 30-year mortgage rate was just 2.65%.
The effects of Fed interference could last for years. In the spring of 2020, the Fed, desperate to avoid an economic collapse, reverted to its 2008 strategy. We cut interest rates to zero, resumed quantitative easing, and bought long-term government bonds and mortgage-backed securities (MBS). Most mortgages are securitized by Fannie Mae or Freddie Mac and resold in what are known as agency MBS.
The mortgage-backed securities market has been in trouble in 2020, and the Fed has been even more aggressive than in 2008. In effect, we became the ultimate and sole buyer of these securities. Agency MBS holdings increased by $1.3 trillion between 2020 and 2022. , the market for agency mortgage-backed securities increased by $1.5 trillion. The Federal Reserve currently holds over 40% of total agency MBS balances, or almost half of the market.
These actions are one of the big reasons why interest rates are so low. Mortgage interest rates are based on the 10-year bond rate plus a premium for associated additional risk. The size of that risk premium is primarily determined in the MBS market based on the liquidity and rate risk borne by the investor. The chart below shows the Bloomberg US MBS index minus the 10-year yield.
Spreads spiked at the start of the pandemic, but as the Fed continued to buy spreads fell to near zero and the housing market raged. Spreads began to rise again in June as the end of quantitative easing came into view, and in the fall of 2021 he saw the Fed begin to scale back purchases before halting in early 2022. did. Spreads are now higher than before the pandemic. .
Buying mortgage-backed securities in the spring of 2020 may make sense, but why the Fed hasn’t started contracting for 18 months despite the housing market clearly overheating? Not explained. Whether or not quantitative easing will actually help the economy remains a divisive topic among economists. Federal Reserve economists claim it helps, but academic economists are skeptical. There is evidence of a decline.
Even if the Fed ends QE, its role in stimulating the housing market could continue for the next decade. The Fed wants to reduce the size of its MBS portfolio. So far, we plan to do so by not reinvesting all our securities when the mortgage is paid off.
But higher interest rates mean fewer people refinancing or moving, so the mortgage portfolio won’t shrink as quickly as the Fed expects. There are rumors that the Fed has sold some of its mortgage-backed securities. In that case, Charles Schwab expects spreads on his MBS to be even wider, and mortgage rates are likely to be similarly wide.
There will also be an impact from very low interest rates in 2020 and 2021. Like many people, I purchased a home in the spring of 2021. The housing market may remain depressed and illiquid for an extended period of time.
The MBS market can also be illiquid. Their buyer usually assumes he won’t last 30 years because people move or refinance. But given that so many people bought artificially cheap mortgages before interest rates rose, their behavior and the duration of mortgage-backed securities will be less predictable. It becomes a riskier asset commanding larger spreads.
Recently, the Fed has received a lot of criticism for being too slow to raise interest rates in response to inflation. But another policy mistake could have been continuing to buy too many mortgage-backed securities in late 2020 and into 2021 when the housing market was on fire and interest rates continued to fall. I have.
A fixed rate of 2.6% on 30 year risky assets doesn’t make much sense. This suggests that something is off in the market due to some manipulation or mis-pricing of risk. The Federal Reserve would create huge distortions in the markets where many Americans hold the bulk of their wealth, and the effects could be felt for decades.
Details from the writers of Bloomberg Opinion:
• Unemployment is headed in the wrong direction for the Fed: Jonathan Levin
• ‘Jobful Vibecession’ keeps workers paid: Connor Sen
• The Inflation Beast Won’t Lie Quietly Again: Alison Schrager
This column does not necessarily reflect the opinions of the editorial board or Bloomberg LP and its owners.
Alison Schrager is a Bloomberg Opinion columnist for economics. A Senior Fellow of the Manhattan Institute, she is the author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understanding Risk.”
Other stories like this Bloomberg.com/opinion