A Primer on What Originators Should Know About the Fed

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Rob Chrisman's Perspectives
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A popular topic among investors, economists, and analysts is the Federal Reserve’s nearly daily purchases of assets, either through buying securities backed by U.S. Treasuries or securities backed by residential mortgages underwritten to Agency standards. The Fed’s activities, however, should also be of interest to every lender, its originators and borrower clients. Rates are low, in part, due to this constant buying. While owning securities is something that the Federal Reserve does now, at some point it will stop, and its balance sheet will decrease. How that happens, and when, is certainly of interest to lenders and borrowers.

Why should a typical mortgage company even care about these matters? Dallas Fed President Robert Kaplan, in speaking to the Wall Street Journal, thinks the daily purchases, which keep rates probably lower than where they would be ordinarily without the daily buying, are contributing to skyrocketing home prices.

First, a short history lesson. 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 $8 trillion in fixed-income securities. The Fed held $2.35 trillion in MBS in the week ending June 23, which means the Fed could be holding around a quarter of total MBS outstanding…the proverbial 800-pound gorilla in the MBS marketplace.

The Federal Reserve announced its Quantitative Easing program in late November of 2008. It had a very specific goal: support 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) MBS markets, and within a month, mortgage rates had fallen by almost one percentage point. 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.

The Fed’s purchases (though announced well in advance), that drive up security prices and drive down rates, at some point will taper off or stop entirely, depending on economic conditions. It is important for MLOs to remember 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 begins reducing its billions of daily and monthly bond purchases, thus driving up long-term rates, lenders will probably struggle to replace this income (when interest rates rise, banks holding the fixed portion of the contract lose money on a mark-to-market basis. In essence, a bank is receiving a lower rate than what the market is offering).

At a time when the Federal Reserve is purchasing $4-5 billion per day in Agency MBS to help reduce the cost of buying or refinancing a home and stimulate the broader economy, any action by the Government Sponsored Enterprises (GSEs) to raise borrowers’ costs contradicts and undermines Fed policy. We will see the direction in which the new FHFA Director Sandra Thompson takes the GSEs of Freddie Mac and Fannie Mae.

The Federal Reserve has been purchasing $40 billion in mortgage bonds and $80 billion in Treasury securities each month to augment a near-zero short-term interest-rate target range. Recently, Fed Governor Christopher Waller became the first board member to publicly say it might be time to taper purchases of mortgage-backed securities. Federal Reserve Bank of Philadelphia President Patrick Harker says he is ready for tapering but hopes for “a slow, methodical process” that treats Treasuries and MBS equally.

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, that will change easy-money policies. MLOs should be aware that many economists expect the Federal Reserve to begin lifting the target range for the federal funds rate in 2023 and to begin tapering long-term asset purchases in the first half of 2022.

It is important to understand the role that these instruments play in hedging, how the Federal Reserve is using a tool at its disposal to impact interest rates, and the role they play in continuing the acceptance of 30-year fixed rate mortgages. Yes, companies are focused on regulatory issues, margins, efficiency, and the Agencies. The Federal Reserve’s Quantitative Easing certainly impacted lending through its impact on interest rates, and for that, lenders are very thankful. When it slows or stops, mortgage rates very well may head higher. But the Central Bank of the U.S.’ focus is on helping the stability of our economy, and at some point, the Fed can reduce its role in that.

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