Fed Exits Market: What it Means For Mortgage Rates and Your Mortgage Application

April 08th, 2010

The several days of trading following the exit of the Federal Reserve from the mortgage markets saw mortgage rates jump. Purchase and refinance mortgage applications were affected and will continue to be impacted by the Fed’s most recent and future actions.

Why and how are the moves by the Federal Reserve having such a large impact on your mortgage rate and mortgage application?

At the end of March, the Federal Reserve closed its $1.25 trillion mortgage purchasing program, and on the first day of trading after this program closure, mortgage rates jumped. In the three days following the Fed’s exit from the mortgage markets, rates climbed from 0.25% to 0.375%, depending on the type of mortgage.

Mortgage Rates and the Fed’s MBS Purchase Program

Why did the Fed’s exit lead to such a big jump?

From January 2009 through March 2010, the Fed was the primary purchaser of mortgages on the secondary market, essentially creating more demand for funded mortgages being sold by Fannie Mae, Freddie Mac, and Ginnie Mae.

When you complete your refinance mortgage or purchase mortgage for a conventional or government mortgage, your mortgage lender will sell the mortgage to Fannie Mae, Freddie Mac, or Ginnie Mae–called GSEs, or Government Sponsored Entities. The GSEs then package tens of millions of dollars of mortgages together and sell what are known as mortgage-backed securities (MBS).

Like the stock markets or other bond markets, the MBS market trades daily, and prices go up and down. In MBS markets, as prices go up with greater demand, the effective mortgage rate goes down. The opposite is also true: as MBS prices go down, mortgage rates go up. When the Fed purchased $1.25 trillion in MBS over a 15-month period, it added extra demand to the MBS market, driving prices up and mortgage rates down. Rates stayed at historic lows for the period that the Federal Reserve continued to buy MBS.

If demand goes away for a product and the supply stays the same, then the price of that product drops until there is demand and buyers come to market. With the Fed leaving the market with its $83 billion monthly purchase of mortgages, a huge void in demand was created. In the initial days of trading without the Fed, prices on MBS fell 125 basis points, their biggest three-day drop since mid-December 2009.

Mortgage Shoppers Looking Ahead

In the coming days and weeks, the MBS markets will find the true market level of demand, with implications for refinance mortgage or purchase mortgage rates.

It’s worth noting that the Federal Reserve is not quite through with its participation in the mortgage markets. The Fed has stopped purchasing new MBS, but it now owns $1.25 trillion of residential mortgages. Holding assets like MBS is not part of the Federal Reserve’s charter nor purpose–so expect it to dispose of it holdings at some point. When that happens, it will mean an even greater supply of MBS on the market for less demand.

Refinancing and Purchase Mortgage Rates Expected to Rise More

What will happen when the Fed begins to auction its huge portfolio of mortgages? If you said, “create an oversupply of mortgages and lower prices which will increase mortgage rates,” then pat yourself on the back. That is exactly what most analysts expect will occur.

When and how the Federal Reserve decides to sell its MBS assets will have a major impact on mortgage rates for your refinance mortgage or purchase mortgage–and the real questions now are how high and how fast mortgage rates will climb.

Posted By :
Dennis C. Smith is co-owner and broker of record for Stratis Financial in southern California. He has over twenty years' experience in the mortgage industry.

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