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Federal Economic Policy Could Push Housing Market to ‘Extremes’

home, house, housing, key, movingThe seeming disconnect between the economic tumult created by the COVID-19 pandemic and the record-high levels for the Dow Jones Industrial Average and the S&P 500 Index can be explained when held up against the performance of the mortgage market, according to an op-ed piece authored by Brian Chappatta, a columnist with Bloomberg.

Chappatta observed that 30-year mortgage rates “slowly but surely dropped to record lows throughout the pandemic, touching 2.78% earlier this month, according to Freddie Mac data.” As a result, an increasing number of homeowners sought to refinance their mortgages, with the goal of either lowering their monthly payments or tapping into their property’s equity. Former Federal Reserve Chairwoman Janet Yellen referred to this as a “savings glut” and Chappatta noted this helps mitigate much of the financial trauma fueled by the pandemic.

“With more cash in their pockets, these people have kept spending levels relatively steady while also socking money away or investing in stocks or other assets,” he said.

Simultaneously, Chappatta continued, was the Federal Reserve’s efforts to bolster the economy in what he dubbed “pushing the $6.8 trillion mortgage-backed securities market to extremes.” He also warned that the Fed will create even greater problems for the economy if it steps away from this strategy.

“As it stands, the Fed has bought more than $1 trillion of mortgage bonds since March, a record pace, and now holds $2 trillion of the securities on its balance sheet,” he explained. “That easily eclipses the previous high during the last economic recovery. Central bankers have pledged repeatedly to keep adding bonds each month ‘at least at the current pace,’ which is often quoted as $40 billion. But that’s actually a net figure: Total monthly purchases tend to be closer to $100 billion because borrowers’ principal repayments take out some debt already on the Fed’s balance sheet.”

Chappatta highlighted the central bank’s decision on Oct. 29 of purchasing conventional 30-year securities with a 1.5% coupon, a historic low percentage. Because of this action, Chappatta theorized the Fed will not raise interest rates in the coming years – which, he argued, creates another problem.

“All of this serves to squeeze mortgage-bond investors in higher-rate securities,” he stated. “Most of them bought the debt at a premium, and the constant reduction in lending rates leaves them vulnerable to prepayment risk as homeowners refinance and pay off their existing obligations at par. But it would be arguably even more painful if investors are herded into ultra-low coupon MBS, only to see rates rise.”

Chappatta cited the threat of extension risk, where “fund managers left holding 1.5% or 2% MBS could be saddled with huge losses if longer-term interest rates start to increase next year as the U.S. economy rebounds and inflation starts to pick up on the back of a COVID-19 vaccine.”

As for the homeowners taking advantage of ultra-low mortgage rates, Chappatta cautioned that a rapid economic recovery in 2021 will cause spikes in longer-term Treasury yields and the benchmark 30-year mortgage rate, which would disrupt the advantages that homeowners are currently enjoying – which Chappatta predicted would create “at least a hiccup in the U.S. housing market and an implosion at worst.”

“If there’s a modest correction in housing prices, that shouldn’t be too disruptive for the economy as a whole,” he said. “Rather, it’s the second-order effects of higher mortgage rates that should concern investors … The refinancing boom the central bank engineered has helped countless Americans get through the pandemic. But it can’t afford to see it go bust. Most likely, the Fed won’t be able to extricate itself from buying mortgage bonds for at least the next several years, and possibly longer, or else risk toppling the entire house of cards it built.”

About Author: Bruce Phillips

Bruce Phillips
Bruce Phillips is SVP and Chief Information Security Officer for WFG National Title Insurance Co., a provider of title, escrow, closing, and settlement services for mortgage lenders. He can be reached at Bruce. Phillips@WillistonFinancial.com.
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