Fed Plan to Stop Buying Mortgages Feeds Recovery Worries

The Federal Reserve's pledge to stop buying mortgages by the end of March is sparking fears among home builders, mortgage investors and even some Fed officials that mortgage rates could rise and knock the fragile housing recovery off course.

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Bloomberg News

Home-mortgage rates have risen by about a quarter percentage point over the past month. Here, an unfinished home in Raleigh, N.C., in November.

Rates on 30-year fixed-rate mortgage have risen by a quarter of a percentage point in the past month to around 5.2%, according to HSH Associates, near their highest levels since September as the bond market has pushed up long-term interest rates amid signs of an improving economy.

The recent rise in mortgage rates could be a prelude to even bigger increases in coming months as the Fed steps away from support for the market. That prospect has some in the markets counting on the Fed to change course and keep buying past March, which many officials are reluctant to do.

When such a big investor stops buying, "that could lead to material increases in [interest] rates across the board," said Ronald Temple, portfolio manager at Lazard Asset Management. He sees mortgage rates rising by a percentage point when the Fed stops buying. A withdrawal of government support, combined with high unemployment and rising mortgage foreclosures, could push home prices down 20%, he said.

The Fed now holds $909 billion of mortgage-backed securities. In the past year it has purchased 73% of the mortgages that government-backed Fannie Mae, Freddie Mac and Ginnie Mae have turned into securities. Purchases by the Treasury pushed total government purchases above $1 trillion. The Fed says it plans to top off its purchases at $1.25 trillion by the end of March, but must decide in the months ahead whether the economy is strong enough to stick with that plan.

The urgency of sustaining the housing market has sparked a debate inside the Fed. Many Fed officials don't think ending the purchases will have a large effect.

If mortgage rates shoot up or the economy weakens, some Fed officials argue, the central bank might need to keep buying. But with the economy improving and the mortgage market already heavily dependent on government, other Fed officials are eager to get on with an exit.

"I think the economy is starting its recovery, and there's reason to be optimistic," Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, said Thursday.

Minutes from the Fed's December meeting, released this week, pointed to the Fed's internal debates.

Some Fed officials fretted that "mortgage markets could come under pressure as the Federal Reserve's agency MBS [mortgage-backed securities] purchases wind down." The bottom line, officials say privately, is that it would take a surprisingly sharp upturn in mortgage rates, or a worsening economic outlook, to prompt them to change their plans.

The government has already taken steps to reassure investors. In late December the Treasury Department said it would provide unlimited support to Fannie Mae and Freddie Mac, and wouldn't force them to sell securities they hold. That should soften the sting of the Fed's removal from the market.

"Now that the question of [Fannie and Freddie] selling is off the table, the market is less worried about the Fed's exit," said Mahesh Swaminathan, a mortgage strategist at Credit Suisse.

Nevertheless, home builders and others are hoping the Fed will flinch. Some market participants haven't reacted to the Fed's promises to exit, believing the central bank won't have the will to wind down its purchase program.

If the Fed stops buying, "it would be the beginning of a crisis again, and we haven't emerged from the last one," said Larry Sorsby, chief financial officer at home builder Hovnanian Enterprises Inc., which had a $250.8 million loss in its last quarter on a 39% drop in revenue.

Mr. Sorsby figures the Fed's withdrawal will prompt at least a one-percentage-point rise in mortgage rates, which he fears could squash recent glimmers of more demand for homes. He expects the Fed will, in fact, keep buying. "I doubt they'll just pull out," he said.

On a $250,000 conventional 30-year mortgage, a mortgage-rate increase from 5% to 6% would raise monthly payments by about $150 per month to $1,499.

"The Fed wants to keep mortgage rates low," said Mitch Flack, co-head of the mortgage group at TCW Group Inc., a money manager that hasn't been a big seller of mortgage securities. "It's very possible that they'll slow purchases now, but should mortgage rates rise significantly after the end of the program in March, they may decide to extend that purchase program further."

Many Fed insiders expect the end to their mortgage buying to have a mild effect on rates, a half-percentage-point increase or possibly much less. Mortgage rates didn't move up much when the Fed initially signaled in September that it intended to end the $1.25 trillion mortgage program by March.

One theory inside the Fed is that what matters for mortgage rates isn't the central bank's day-to-day purchases, but the magnitude of mortgages that it has taken from the private sector. According to this view, the impact of removing more than a trillion dollars of supply should help to keep rates low even after the Fed stops buying.

Fed officials take comfort that yields on Treasury bonds remained little changed during a stretch between August and November when the Fed was completing its $300 billion of Treasury purchases, meaning the Fed's exit from that program didn't severely disrupt that market.

The Fed's heavy buying last year drove yields on mortgage bonds to within 0.65 percentage point of comparable Treasury bonds, much lower than the traditional spread of 1.15 percentage points. Lower mortgage rates helped sustain the housing market, and housing prices recently appear to have stabilized. But a looming wave of foreclosures, still-high unemployment and other factors are clouding the housing outlook for this year.