With US interest rates hovering around 5%, current-home sales are down more than 14% over the past year. Some potential buyers are sitting on the sidelines until rates or prices drop, or both, while sellers are hoping the market will rise again to get a higher price. But don’t count on rates falling to those pandemic levels. They were the result of extraordinary market manipulation from the Fed. And unless this becomes a regular feature of monetary policy, rates are not going back to the way they were before.
The real estate market is on a wild ride. House prices, as measured by the Case-Shiller Index, rose 30% between March 2020 and December 2021, a sharp increase compared to when the housing bubble ended in 2008. This was partly because many people moved during the pandemic, but also because the 30-year mortgage rate was only 2.65% in the spring of 2021.
The effects of the Fed’s intervention can be felt for years. In the spring of 2020, the Fed was desperate to avoid an economic collapse, so it reverted to its 2008 playbook. It brought rates back to zero and brought back quantitative easing, buying long-term government bonds and mortgage-backed securities (MBS). Most residential mortgages are secured by Fannie Mae or Freddie Mac, and an agency known as MBS.
In 2020, the mortgage-backed security market was in crisis, and the Fed was even more aggressive than it was in 2008. It effectively became the sole eventual buyer of these securities: its holdings of agency MBS grew by $1.3 trillion between 2020 and 2022. , while the agency mortgage-backed securities market grew by $1.5 trillion. The Fed now has 40%, or nearly half, of the total outstanding balance of agency MBS in the market.
These actions were a big reason why rates came down so low. Your mortgage rate is based on the 10-year bond rate, plus the premium for the added risk. That risk premium is largely determined in the MBS market, depending on the liquidity and rate risk investors take.
The spread peaked at the start of the pandemic, but then dropped to almost zero as the Fed kept buying it, and the housing market was in turmoil. The spread began to rise again in June after the end of QE, and was further exacerbated when the Fed began reducing its purchases in the fall of 2021 before halting in early 2022. The spread is now higher than before the pandemic. ,
Buying mortgage-backed securities may have made sense in the spring of 2020, but why the Fed didn’t begin tapering off 18 months, even though the housing market was apparently heating up, was never explained. Whether quantitative easing (QE) really helps the US economy remains a divisive topic among economists. Fed economists insist it helps, while academic economists are more skeptical. But there is evidence that when the Fed buys mortgage-backed securities, it brings down the MBS spread and mortgage rate.
Even if the Fed ends QE, its role in fueling a poor housing market could last for the next decade. The Fed wants to shrink the size of its MBS portfolio. So far it plans to do this by not reinvesting all the securities as the mortgage is paid off.
But higher rates mean fewer people will refinance or move, so mortgage portfolios won’t shrink as fast as the Fed might anticipate. There is some whispering about the Fed selling some of its mortgage-backed securities. If that’s the case, Charles Schwab expects the MBS spread to get even bigger, and your mortgage rates likely to be as well.
There will also be hangovers in 2020 and 2021 at very low rates. Like many people, I bought a house in the spring of 2021. Now between rising rates and a slowing housing market, I’m not sure I can ever move . The housing market may be slower and less liquid in the long run.
The MBS market can also be less liquid. Their buyers generally assume that a large number of mortgages will not last 30 years as people move or refinance. But given that so many people got artificially cheap mortgages before rates went up, that means their behavior, and the duration of mortgage-backed securities, will be much less predictable. This would be a risky asset that commands a large spread.
The Fed has been heavily criticized recently for being too late to raise rates in response to inflation. But another policy error could be that it continued to buy so many mortgage-backed securities later in 2020 and 2021 when the housing market was on fire and rates kept falling.
Fixed rate of 2.6% on risky assets of 30 years never meant much. It suggests that there is something wrong with the market, either through some manipulation or incorrect pricing of risk. The Fed created major distortions in a key market where many Americans own most of their wealth, and its effects can be felt for decades.
Allison Schrager is a Bloomberg Opinion columnist covering economics.
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