The Federal Reserve (the Fed) has taken aggressive steps during 2009 to drive mortgage rates down in order to encourage more people to buy homes and revive the real estate industry. The Fed lowers interest rates by purchasing large quantities of mortgage-backed bonds (MBBs) packaged and sold as investments by Freddie Mac and Fannie Mae (themselves taken over by the federal government in September 2008). This program, started last year, immediately pulled interest rates well below 6% and made highly advantageous financing available to well-qualified borrowers, spurring real estate activity. The steps coincided with massive buyer, builder and mortgage lender subsidies from the Treasury to clear out new homes and real estate owned (REO) inventory.

However, the Fed will start winding down its MBB purchase program early in 2010 by purchasing fewer of these MBBs. For the MBB market to continue to sell off its bonds, more private investors will need to re-enter the market since they have been largely absent due to the low rates set by the Fed purchases during 2009. The reason: private investors generally require a higher yield on their MBBs than the Fed set during 2009, which will necessarily require mortgage lenders to raise the interest rates they charge homebuyers.

An increase in interest rates will eliminate many potential homebuyers, unless sellers and their listing agents are willing to reduce the prices they demand to reflect the reduced borrowing power caused by an increase in interest rates.

first tuesday take: A quick review covering how the Fed is able to lower interest rates by purchasing MBBs may be helpful. Typically, both the Fed and private investors purchase MMBs. As the Fed temporarily purchases larger quantities of MBBs at ever lower interest rate yields (artificially creating greater demand for lenders to obtain funds for mortgage lending), the price of MBBs increases. In lock-step response to the rise in the price paid by the Fed for MBBs, yields (reflected in the form of mortgage interest rates) fall. Thus, price and yield (interest rates) always move diametrically, much like the opposing sides of a teeter-totter.

The Fed’s program to lower interest rates has been nothing but successful. However, it cannot go on indefinitely and the Fed must start easing back before consumer and asset (real estate) price inflation become a real threat. While some may object to the personal impact of increased interest rates, they should also take solace in the fact that the Fed concludes the economy will soon be healthy enough to live without life support.  [For more information regarding inflationary concerns in response to the Fed’s actions, see the November 2009 first tuesday blog, The Fed to the rescue – inflationary fears assuaged; see also the October 2009 first tuesday article, Fear mongers’ inflation prediction unjustifiable.]

A tip to first tuesday students: be sure to inform the buyers and prospective refinancers you represent that rates are expected to increase as soon as March 2010. Your clients would be wise to obtain financing now when rates are artificially low – before they begin their eventual upward ascent.

Re: “Freddie sees mortgage rates hitting 6% in 2010,” from the Washington Post

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