The Federal Reserve’s thoughts and actions are in the financial news nearly every day, along with being discussed widely in mortgage banking circles and at conferences. The presidents of the various Fed Districts are constantly out speaking, opining about the economy and the direction of rates, and being asked to predict the future. The situation begs the question, “Why have the Fed’s decisions become so important to mortgage rates?”
We all talk about “the Fed,” but what is it? Founded by Congress in 1913, the Federal Reserve System is the central bank of the United States whose primary purpose is to enhance the stability of the American banking system. The Board of Governors of the Federal Reserve System was established as a federal government agency made up of seven members appointed by the President of the United States and confirmed by the U.S. Senate. The Chairman (Chair) and the Vice Chair of the Board are also appointed by the President and confirmed by the Senate.
The U.S. Central Bank carries out its mission through the actions of its Federal Open Market Committee (FOMC). The Federal Open Market Committee (FOMC) is made up of the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and presidents of four other Federal Reserve Banks, who serve on a rotating basis. It is the FOMC that makes financial news headlines. The FOMC does not set mortgage rates, but the same factors that influence its actions also influence mortgage rates, so as we move through 2024, it is good to know how the Fed operates and what the market is thinking about its actions. After all, its actions directly impact the interest rates that borrowers see.
For much of its history, the Federal Reserve was “in the background” in terms of its actions, who the chairman was, and the publicity it garnered. Some Fed Chairs have disappeared into obscurity. But others, especially those in recent years, such as Paul Volker, Alan Greenspan, Ben Bernanke, Janet Yellen, and Jay Powell, have received more notoriety through speeches and social media.
It is unquestionable that real estate, housing, and financing homes have been key components of the U.S. economy for hundreds of years. But it is helpful to go back 10-15 years to obtain a sense of how the Fed became the “go to” source of information and rate direction. The Federal Reserve announced QE1 in late November of 2008 with a specific goal: supporting the housing and financial markets by way of large-scale asset purchases. The announcement of the program set off widespread buying in the TBA (To Be Announced, where specific pool attributes aren’t known) markets, and within a month, mortgage rates had fallen by almost one percentage point.
Fast forward to early 2014. The “financial crisis,” or “great recession,” was fresh in everyone’s minds. The Fed, through the actions of its Federal Open Market Committee, had been purchasing $85 billion a month in bonds. The Fed was expected to “taper off” and begin reducing its purchases, thus driving up long-term rates and therefore reducing residential lenders’ volumes. Prices of securities are determined by supply and demand, and ratcheting up demand of securities directly impacts the price. Understandably, lenders were worried about replacing income caused by interest rates moving higher and volumes dropping due to the Fed’s activities. Specifically, the Quantitative Easing (QE) programs had a role in encouraging, or discouraging, the refinance market and the overall economic impact on the nation.
Fears of a recession prompted the Federal Reserve Open Market Committee to reverse its previous course of gradually raising interest rates and began lowering rates, causing the 30-year mortgage rate to drop from nearly 5.00% in November 2018 to 3.50% at the end of August 2019. Of course, the Fed helping determine interest rates, and therefore mortgage rates, is only part of the cost seen by consumers. Actions by Freddie Mac and Fannie Mae, or the U.S. Department of Housing and Urban Development (HUD), in terms of their costs can contradict or undermine Fed policy.
As the years went on, the financial markets grew accustomed to — and began relying upon — the Fed’s moves. And Fed officials seemed very open to “being on the stump” and speaking about the economy. This included the advent of the pandemic in the first and second quarters of 2020. The coronavirus crisis in the United States triggered a deep economic downturn as people “hunkered down” and increased the desire to hold deposits and only the most liquid assets. The Federal Reserve stepped in with a broad array of actions to keep credit flowing to limit the economic damage from the pandemic including large purchases of U.S. government and mortgage-backed securities and lending to support households, employers, financial market participants, and state and local governments through 2020 and into 2021. Lenders, of course, took note of the appetite of the Fed for mortgage-backed securities.
In the summer of 2021, the Federal Reserve’s nearly daily purchase of assets, either through buying securities backed by U.S. Treasuries or securities backed by residential mortgages underwritten to Agency standards, had become the center of attention for investors. The Fed’s activities, however, were also of interest to every lender, its originators, and borrower clients. Mortgage rates were low, arguably unnaturally low, in part, due to this constant buying. While buying and owning securities was something that the Federal Reserve did then, there was a growing school of thought that at some point it would stop, and its balance sheet would decrease. Back then, given the impact of this move on mortgage rates, how that happened, and when, was certainly of interest to lenders and borrowers. After all, years’ worth of mortgage activity was being crammed into 2020 and 2021.
The Fed buying mortgage-backed securities had other implications that directly concerned mortgage companies. In 2021 Dallas Fed President Robert Kaplan, in speaking to the Wall Street Journal, thought the daily purchases, which kept rates probably lower than where they would have been ordinarily without the daily buying, contributed to skyrocketing home prices. Escalating home prices impacted underwriting, investor demand for mortgages, and borrower behavior.
As any mortgage loan officer (MLO) will tell a prospective borrower, a lower-rate mortgage increases the borrower’s disposable income and ability to buy a home. It is safe to assume that the increase in disposable income garnered by the mass refinancing wave also contributed as a stimulus to the overall economy.
Although it is a viable tool, the Federal Reserve has not always purchased billions of dollars of securities. Between mid-2007 and early 2015, it purchased approximately $3.7 trillion of Treasury and mortgage-backed securities (MBS). Purchases quieted down between mid-2017 and mid-2019, and then picked back up. Currently the Federal Reserve owns over $7 trillion in fixed-income securities, which, in terms of MBS, includes around a quarter of total MBS outstanding…the proverbial 800-pound gorilla in the MBS marketplace. Should the Fed decide to actively sell its holdings, the laws of supply and demand suggest that prices will drop, and mortgage rates will increase.
The Fed’s purchases (though announced well in advance), when it was actively buying securities, drove up security prices and drove down rates but tapered off entirely as economic conditions changed. MLOs should know that one of the purposes of the Central Bank of the U.S. is to increase the stability of our financial system. Sudden moves have the opposite impact. When the Federal Reserve began reducing its billions of daily and monthly bond purchases, long-term rates indeed rose, and lenders struggled to replace this income (when interest rates rise, banks holding the fixed portion of the contract lose money on a mark-to-market basis … a bank is receiving a lower rate than what the market is offering).
Investors and economists watch any speeches or policy statements from the Federal Reserve for any indication that recent data, including faster-than-expected inflation and slower job growth, will change easy-money policies. MLOs should be aware that many economists expect the Federal Reserve to begin reducing rates some time in 2024, but the Fed has made it clear that it is not in any great hurry. For lenders, the interest rate climate drives volumes and products for every lender. And as we’ve wrapped up the first quarter of 2024 and are moving through the second quarter, lenders everywhere know that the FOMC is in a holding pattern. Lenders watched 2023 pass with the Fed Chair and the Fed presidents underscoring that there is more work to be done. But in general investors expect the Federal Reserve to stay the course in its battle to tame inflation as recession worries subside.
The Fed is not only focused on interest rates. As a result of the Dodd-Frank Act, new compliance standards were put into place, such as the Qualified Residential Mortgage rule (QRM). The 689-page rule was written by a combined effort from the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve, Federal Deposit Insurance Corporation, Securities and Exchange Commission, Federal Housing Finance Agency, and the Department of Housing and Urban Development. This rule placed a greater burden on lenders to ensure tighter credit standards are met, resulting in less foreclosure risk and a firmer belief that borrowers who took out a mortgage had the ability to repay the loan. The objective of tighter underwriting approaches and enforcement of new regulations was to safeguard against another housing crash and promote stability within the industry.
The Fed is also good at analyzing data. The Federal Reserve system has over 20,000 employees, and a good portion of those are dedicated to mortgage research and data analysis. For example, 10 years ago it found (to no surprise of lenders) that a change in down payment requirements tends to have a large effect on housing demand (households’ willingness to pay for a given home) especially for current renters, whereas the effects of a change in the mortgage rate are modest.
We should keep in mind that the reasons that cause the Federal Reserve’s Open Market Committee to act are just as important, if not more so, than the actual actions of the FOMC. The markets look to the Fed as having the best research ability, the best sources of information, and the brightest minds in making decisions. Lenders and the markets using the Fed funds rate is a relatively simple gauge of economic strength or weakness, so although the Fed does not set mortgage rates, the information and logic it uses in determining its actions can also move interest rates.
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