The full impact of the Federal Reserve’s eventual pullback from the mortgage-backed securities market will depend largely on how and at what pace the Fed decides to wind down, according to a blog published by the Urban Institute’s Housing Finance Policy Center on Thursday.
In their blog post, “What Will Happen When the Fed Starts Unwinding its $1.75 Trillion Mortgage Portfolio,” HFPC Co-director Laurie Goodman and Research Associate Karan Kaul analyzed several different options the Fed has for winding down its hold on the MBS market.
The Fed began buying MBS eight years ago when the housing market was in crisis. It currently owns about 30 percent of the market. Now that the economy and housing markets are seemingly on the up-and-up, it is widely thought that the Fed will start pulling out of the MBS scene in late 2017 or early 2018.
According to Goodman and Kaul, the Fed has a few options in doing so.
“The Fed has a range of options,” they wrote. “A minimally disruptive strategy would be to gradually phase out reinvestments of principal pay-downs (prepayments, for example). A more aggressive option would be to cease reinvestments entirely. Once the Fed has ceased reinvestments, it could let the securities run off over time (because of prepayments, the average life of these securities is far shorter than their maturity) or sell them in the open market—the most aggressive option and something the Fed has said it is not considering.”
If the Fed goes with option No. 1—phasing out reinvestments—Goodman and Kaul said it will also need to decide how much should be invested, at what pace that amount should be reduced, and how to allocate the reinvestment reductions across all the government agencies.
“If reductions focus on conventional MBS (those backed by Fannie and Freddie), any impact will be felt more by conventional borrowers,” Goodman and Kaul wrote. “In contrast, if reductions focus more on MBS backed by Ginnie Mae, any impact will be felt more by first-time homebuyers, low- and moderate-income borrowers, and veterans, who depend heavily on FHA and VA loans (which are exclusively pooled into Ginnie Mae securities).”
No matter which option the Fed chooses, their pullback from the MBS market will likely influence the mortgage rates of the future, Goodman and Kaul wrote.
“But even at a slow pace, unwinding will, over time, undoubtedly reduce a major source of demand for agency MBS,” they wrote. “Therefore the Fed’s withdrawal will surely put some upward pressure on mortgage rates, although it will hardly be the only factor.”