In its most recent statement, the FOMC affirmed that it intended both to complete its announced purchase of $1.25 trillion of agency-guaranteed mortgage-backed securities (MBS) and to slow its purchases, and that it anticipated ending the program by the close of the first quarter of 2010. This FOMC is distinct from a Board of Governors program and can be extended or curtailed without Treasury or other governmental approval.
In an interview yesterday on CNBC, Professor Robert Shiller, one of the principals behind the Case-Shiller Index of housing prices, responded to a question about the impact that the Fed’s termination of its MBS purchase program by saying he was uncertain as to the impacts it would have. But he clearly felt that there were significant downside risks to both the housing market and the recovery and that these risks would likely increase.
From the very beginning of its MBS purchase program, the Federal Reserve has been the most significant player in the GSEs’ MBS market. Over the period for which data are readily available, from January through January 2010, Fed purchases averaged nearly 70% of GSE MBS issuance. In some early months the Fed bought virtually all of the GSEs’ issuance, particularly in some segments like securities backed by fixed-rate obligations, and recently the Fed has averaged about 60% of the newly issued GSE MBS.
It is important to understand what the impact of the program has been; but also, as the question to Professor Shiller suggests, understanding the effects that the Fed’s withdrawal will have on mortgage rates, the housing market, and ultimately the economy is perhaps even more critical. Commentators on the program have differed widely on the impact it has had on mortgage rates. Estimates have ranged from 50 to 150 basis points in reductions in mortgage interest rates. The manager of the Federal Reserve’s Open Market Desk, Brian Sack, estimates that mortgage rates are about 100 basis points lower than they would have been without the program. At the same time, while there is consensus that the program has narrowed the spread between MBS rates and Treasuries significantly – perhaps on the order of 100 basis points – Stroebel and Taylor (see Stroebel and Taylor, Jan. 27, 2010: http://www.voxeu.org/index.php?q=node/4531) suggest that after controlling for prepayments that it is hard to identify more than a 30-basis-point impact of the program on spreads.
Two issues immediately arise in assessing the likely current and future impact upon mortgage rates. First, if the Fed jumped in and was the dominant player in the market, and felt that it was necessary to do so because the market had dried up and there were no other potential buyers, then the expected price impacts and interest-rate impacts would indeed be large. Hence the justification for the program. However, with only a 50-150 basis-point estimated impact on mortgage rates, rates must have been substantially more elastic than assumed. Furthermore, some Fed officials have suggested that mortgage rates would only increase by 50 to 75 basis points upon exit from its program. Again, if it is correct that the Fed’s exit from the market, where it was the dominant buyer, would only increase market rates by 50 to 75 basis points, then market demand must have been extremely elastic and there is little if any justification for having established the MBS program to begin with.
So we are faced with uncertainty as to what the impact of the Fed’s withdrawal from the market will be on mortgage rates, let alone the housing market or broader economy. However, it stretches credibility to assert that a huge subsidy program that required the expenditure of $1.25 trillion to support mortgage rates would have only a small impact upon mortgage rates upon its termination. What we expect is that toward the end of the first quarter political pressure on the Fed will increase from both the GSEs and Congress to temporarily extend the program because of the concern about hurting a still struggling housing and mortgage markets. But if this fails to persuade the FOMC to change its mind, the program stops, and interest rates jump up significantly, then the Fed itself will decide that the risks of another downturn are too great, and the program will be restarted. In either case, the most likely outcome is that there will be some form of extension of the MBS purchase program. We note that there is one more FOMC meeting before the end of the first quarter, so it is possible that we may have the answer as to whether the Fed will live up to its intention to stop the program from the deliberations at that meeting.