It’s Possible That The Fed’s Missteps Will Have Long-Term Effects On The Housing Market
Since interest rates are now around 5%, sales of already-built homes are down more than 14% from this time last year. Some people who want to buy are waiting until rates or prices or both go down. People who want to sell are hoping the market will pick up again so they can get a higher price.
But don’t expect rates to go back down to those pandemic lows. They happened because of how much the Fed messed with the market. Rates won’t go back to what they used to be unless this is a regular part of monetary policy.
The real estate market has gone through a lot of ups and downs. Using the Case-Schiller index, we can see that house prices rose 30% between March 2020 and December 2021. This is a steeper rise than in the months before the housing bubble burst in 2008. This was partly because a lot of people moved during the pandemic, but it was also because the 30-year mortgage rate in the spring of 2021 was only 2.65%.
The Fed’s actions may have effects that last for years. In the spring of 2020, the Fed was desperate to keep the economy from falling apart, so it went back to what it had done in 2008. It brought back quantitative easing and lowered interest rates to zero. It also bought long-term government bonds and mortgage-backed securities (MBS). Most home mortgages are securitized by Fannie Mae or Freddie Mac and then sold again in what is called an agency MBS.
In 2020, the market for mortgage-backed securities was in trouble, and the Fed was even tougher than in 2008. It ended up being the only buyer of these securities in the end: Between 2020 and 2022, the amount of agency MBS it owned grew by $1.3 trillion, while the market for agency MBS grew by $1.5 trillion. The Federal Reserve now owns more than 40% of all agency MBS, which is almost half of the market.
This was a big reason why rates dropped so much. Your mortgage rate is based on the rate for a 10-year bond plus a premium to account for the extra risk. The MBS market, which is where investors buy and sell MBS, is where most of the decisions about the size of this risk premium are made. The graph below shows the Bloomberg U.S. MBS index minus the yield on 10-year bonds.
At the start of the pandemic, the spread went up, but as the Fed kept buying, it went down to almost zero, and the housing market went crazy. The spread started to go up again in June, when it became clear that QE was coming to an end. It went up even more when the Fed started to cut back on its purchases in the fall of 2021, and it kept going up until it stopped buying bonds in early 2022. Before the pandemic, the spread wasn’t as high as it is now.
Buying mortgage-backed securities might have made sense in the spring of 2020, but the Fed never explained why it didn’t start tapering for 18 months, even though the housing market was clearly too hot. Economists still disagree about whether or not quantitative easing helps the economy. Academic economists are less sure, but Fed economists say it does help. But there is evidence that when the Fed buys mortgage-backed securities, the MBS spreads and mortgage rates go down.
Even though QE is over, its effect on the messed-up housing market may last for the next 10 years. The Fed would like to cut down on the number of MBS it owns. So far, it plans to do this by not reinvesting all of the securities as mortgages are paid off.
But if rates go up, fewer people will refinance or move. This means that the Fed’s portfolio of mortgages won’t shrink as quickly as it had hoped. Some rumours say that the Fed might sell some of its mortgage-backed securities. If that happens, Charles Schwab thinks that the MBS spread will get even bigger, and it’s likely that your mortgage rates will too.
In 2020 and 2021, there will be a hangover from the very low rates. I bought a house in the spring of 2021, like a lot of other people. Now that rates are going up and the housing market is slowing down, I’m not sure if I can ever afford to move. For a long time, the housing market may be slower and less liquid.
The MBS market may also have less money in it. Most of the time, their buyers think that a lot of mortgages won’t last 30 years because people move or refinance. But since so many people got mortgages when rates were artificially low before they went up, their behaviour and the length of mortgage-backed securities will be much harder to predict. It will be a more risky asset with a wider spread.
The Fed has been getting a lot of bad press lately for raising interest rates too late in response to rising prices. But it might have been a mistake to keep buying so many mortgage-backed securities in late 2020 and most of 2021, when the housing market was booming and interest rates kept going down.
A fixed rate of 2.6% on a risky asset with a 30-year term has never made much sense. It shows that something is wrong with the market, either because it is being manipulated or because the price of risk is wrong. The Fed caused big problems in a market where many Americans have most of their wealth, and the effects may last for decades.
