Fed Pulls Plug; World Does Not End

Fed Pulls PlugTomorrow is the big day – the day the Federal Reserve pulls the plug on its purchases of mortgage-backed securities. Since December 2008, the Fed has kept the mortgage-backed securities market going by buying $1.25 trillion in securities issued by Fannie Mae, Freddie Mac and Ginnie Mae that no one else wanted. The massive program has helped keep home loan interest rates low during the financial crisis.

The securities -- comprised of residential mortgages bundled to diversify risk -- have long greased the wheels of the housing market. But after the subprime meltdown, investors viewed mortgage securities as unacceptably risky.

Starting tomorrow, private investors have to step back up to the plate to buy up the $1.5 trillion in mortgage-backed securities likely to be produced this year. Will they? Or will the government withdrawal leave a vacuum in the housing market that could push interest rates higher, as some fear?
"We will be watching the end of the Fed program very closely," said Mark Fogarty, editor of National Mortgage News. "We have heard predictions both ways -- that the end of the program will cause a big bump in interest rates and that it will have little effect at all."

So far, investors seem to be warming up to the idea of putting their money into mortgages again. Strict screening of borrowers and cautious lending under Fannie, Freddie and Ginnie means that mortgage pools are once again safe bets, and private investors are currently buying more than two-thirds of the securities. Prices of short-term securities are competitive with other investments, and have stabilized since the Fed started its buying program, a sign that investors now trust them.

And the federal wind-down has been orderly. It has signaled its intent to end the program, and has been steadily reducing its purchases since the beginning of the year.

As a result, the market has not been jolted, says Fogarty. Private bond investors seem to be picking up the slack for the Fed. Average interest rates for 30-year home loans have stayed under 5 percent, near its historic low point recorded at the end of last year, according to the Freddie Mac Primary Mortgage Market Survey for March 25.

"There has been a relatively liquid and stable market for Freddie Mac securities throughout the capital crisis," says Freddie Mac spokesman Michael Cosgrove. "What's important is that there is liquidity in the market and there have been investors that have been stepping up to buy."

There's still unfinished business to deal with, however. The Fed still has that $1.25 trillion in securities on its balance sheet – far more than it spent bailing out AIG and other credit insurers. One-fourth of all Fannie and Freddie securities are now the Fed's property. (Fannie and Freddie themselves hold another 25 percent.) Some conservative economists have expressed concern that when the Fed tries to unload all that debt, it risks increasing inflation. (For a paper by Stanford University economist and monetary policy expert John B. Taylor on the topic, check out this pdf).

But overall it's pretty hard to find the bad news here. Interest rates are likely to go up a quarter of a percent at most, much lower than many had predicted. The Fed has been generating tens of billions in income off these investments. And while inflation poses all kinds of problems for an economy, it also has a silver lining, because mortgage payments may end up taking less of a bite out of a household's income.

Bendix Anderson contributed reporting to this story.
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