End of Fed Program Doesn't Necessarily Imply Trouble for Mortgages

The Federal Reserve has taken emergency measures to keep the recent financial crisis from spiraling out of control. One such measure, announced last March, was to purchase almost a trillion dollars worth of mortgage-backed securities from Fannie Mae and Freddie Mac. The financial crisis had severely impaired banks' capacity to provide credit, so the Fed stepped in to support the housing market.

The announced program of Fed purchases is almost complete, and is scheduled to end in March. The credit markets have stabilized over the past year, but housing market observers nevertheless are anxious about what will happen to mortgage rates when the Fed withdraws its support. The anxiety is understandable. The Fed purchased 73% of the mortgages that Fannie Mae and Freddie Mac turned into securities during 2009. Withdrawal of that kind of support seems likely to cause at least some disruption.

As I’ve pointed out in the past, mortgage rates are closely tied to Treasury rates. Take a look at the chart, below, which shows the interest rate spread between 30-year fixed-rate mortgages and 10-year Treasurys.


In the years leading up to the crisis, the mortgage spread remained close to its historical average of 1.6 percentage points. It rose dramatically as the crisis unfolded, but has since fallen to less than 1.3 percentage points. A casual analysis would therefore suggest that mortgage rates are likely to rise when the Fed program ends in March.

At least one major bond market player (PIMCO) is betting that mortgage rates will indeed increase soon. Bill Gross (PIMCO's managing partner) has an outstanding record of accurate interest rate forecasts. That's why PIMCO has become the world's largest bond fund manager; if you're looking for investment advice, take theirs. Before you decide that mortgage rates are headed for an abrupt increase, however, take a look at the chart, below, which shows a longer history of the mortgage spread.


Note: This chart uses annual averages, which smooth out some of the volatility that is evident in the monthly chart above. That’s why the maximum spread shown in this chart is lower than the maximum shown in the monthly chart.

The mortgage spread remained below 1.6 percentage points from 1991 to 1997. (It’s worth pointing out that this period coincided with the last significant housing market slowdown, and followed the S&L crisis of the late 1980’s.) The average spread during this period was 1.35 percentage points, which isn't far from the current spread. Perhaps PIMCO is correct about the likely course of mortgage rates, but I wouldn't look for a dramatic near-term increase.

(I’m not saying that you should wait to refinance. Today’s mortgage rates probably will look like a bargain a few years from now.)