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The Fed Exit Raises Interest… Literally

I have been reading some interesting things this week in regard to the effect of the Fed exiting from their program of buying mortgage backed securities (MBS) on March 31 this year as they announced they would last Wednesday. There seems to be some people who do not believe that the Fed’s exit will have much impact on 30 year home mortgage rates. You already know I believe the exit will have a major impact as I have posted on it before.

Today, I want to look at what the contrarians are saying, and how that compares to what they have said before. The ‘headline’ story I want to speak on as an example is the one that Market Watch (part of the Wall Street Journal’s digital network) published on January 29, 2010: Fed’s exit seen having minimal impact on mortgage rates. In this story they report.

For its part, Morgan Stanley predicts it will be much more muted — in the range of 0.1% to 0.15%. “The Fed’s exit is likely to be anticlimactic,” analysts led by Jim Caron, head of global interest-rate strategy, wrote in a research report issued Friday.

I found this very interesting for two reasons:

  1. Just two months prior Market Watch ran a story with the headline: Investors see mortgage rates rising as Fed wraps up buys.
  2. An article on Bloomberg.com just last month reported:

Yields on benchmark 10-year notes will climb about 40 percent to 5.5 percent, the biggest annual increase since 1999, according to David Greenlaw, chief fixed-income economist at Morgan Stanley in New York. The surge will push interest rates on 30-year fixed mortgages to 7.5 percent to 8 percent, almost the highest in a decade, Greenlaw said.

So there lies the confusion. Which side has the greatest chance of being correct?

Let’s not look at the headlines.  Let’s look at the facts.

The TARP Quarterly Report to Congress was released this past Saturday (Yes, I read all 224 pages over the weekend!).

What the graph from the report below shows is how the mortgage markets have been supported by federal intervention. The government came to the rescue when Wall Street immediately lost their taste for mortgage investing during the housing slowdown which started in 2007. Since then, the Fed has ‘owned’ the mortgage market.

A quote from the TARP report says it best:

The residential housing market is a huge part of our national economy, and problems in that market were a significant contributing factor to the current financial crisis. The Federal Government has long played an important role in financing residential housing, and that role has increased dramatically since the outset of the crisis — with the Federal Government and the organizations it backs now guaranteeing or insuring almost all net new borrowings for mortgages and mortgage backed securities (“MBS”). In other words, the Government has done more than simply support the mortgage market, in many ways it has become the mortgage market, with the taxpayer shouldering the risk that had once been borne by the private investor.

(P.S. The emphasis was theirs, not mine!)

So, as the Fed exits the market, will private investors step in? Yes, but I believe not at the same 5% mortgage rates the government accepted. There are many experts that are predicting rates will go to anywhere from 6-8% in 2010. Morgan Stanley is one of them!!

Why? Because the private investor will factor in the risk of lending mortgage money in today’s environment. Look at the graph of the delinquency rates of loans held by the Fed. As we can see the delinquency rates are skyrocketing. The private investor will play the game by the old axiom, “High-risk demands high-reward.” Therefore rates will go up in 2010. You can bet on it!

How will that affect the housing market? Tomorrow, we’ll spend some time on that.


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8 replies
  1. Dean Hartman
    Dean Hartman says:

    I think your analysis is “dead on”. My fear is that people, “hoping” that dramatic rate increases won’t happen, will miss out on quite possibly the lowest interest rate environment that we may see for the balance of our lifetimes.

    Reply
  2. Gerry 'RealtyMan' Bourgeois
    Gerry 'RealtyMan' Bourgeois says:

    I’ve been saying this for quite while now. I fear that many will have a rude awakening after the fundamentals of the mortgage market begin to ‘do it’s thing’ as a result of the Fed ceasing to subsidize this market. Not to mention the Home Buyer Tax Credit will be expiring shortly thereafter.

    Remember, small changes in interest rate can equal large changes in one’s payment. Now is not a bad time to buy. (Could be why I’m seeing a surge in activity in the ‘upper end’ of my market).

    -RealtyMan

    Reply
  3. Cary Blumenfeld
    Cary Blumenfeld says:

    I can definitely see the Fed letting interest rates increase dramatically, and dramatically to me means 1%-2%. The number one concern for the Fed right now is our unemployment. According to the Director, Dr. Doug Elmendorf, of the Congressional Budget office in Washington D.C., we will not see the natural rate of unemployment again (which happens to be 5% regularly) until 2014. This is a major problem, because currently in the United States, there is a fundamental disconnect between our tax revenues and debt. When people don’t work, they can’t buy homes and the government receives a much smaller amount of tax revenues, and without the taxes, the Fed has no ability to continue to support the housing market. A positive aspect is private lenders entering the market again, but they are still extremely cautious in lending, as they should be.

    Reply

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