The economic impact of the Federal Reserve’s mortgage-backed securities (MBS) holdings are comparable to its Treasury securities holdings, except for one main difference. MBS, unlike Treasury securities, are subject to prepayment risk. For this reason, the Fed “can lower the amount of such risk that the market must hold, which could lower the cost of housing, favoring that sector of the economy,” according to a post on the Federal Reserve Bank of New York’s blog.
Titled, “How Do the Fed’s MBS Holdings Affect the Economy,” the post said that in general, the Federal Reserve affects the economy by driving certain behaviors through interest rates. “Higher interest rates motivate more saving and less borrowing and consumption today, while lower interest rates have the opposite effect,” explained Antoine Martin, an SVP of research and statistics, and Sam Schulhover-Wohl, a Senior Economist and Research Advisor at the New York Fed.
The authors pointed out that the housing sector is particularly susceptible to changes in interest rates, more so than much of the larger economy. “A cut in interest rates tends to shift the mix of aggregate spending toward housing, while a rise in rates tends to shift the mix of spending away from housing,” they wrote.
When it comes to MBS purchases, the impact overall is often to lower longer-term interest rates, especially when short-term rates are already low. “This impact is generally like the impact of holding longer-term Treasury securities,” according to the blog post.
However, the Fed did use MBS purchases specifically to support and stimulate the housing market after the housing crisis in 2008.
Some may view the Fed’s actions in the market negatively, perhaps as “distortions away from an efficient, ‘laissez-faire’ allocation,” but Martin and Schulhofer-Wohl defended the Fed’s post-crisis actions saying, “But cross-sectional effects are not always bad; if the market is already distorted by liquidity constraints, information asymmetries, and other frictions, then the cross-sectional effects of policy could help remedy those distortions and improve overall outcomes.”
MBS purchases offer a more direct stimulus to the housing market than the broader economy because of prepayment risk, the blog post explained. While investors, of course, “demand a risk premium” to compensate for prepayment risks, the Fed researchers explained that “when the Fed holds MBS, it removes some prepayment risk from the market, reducing the prepayment risk premium.” In other words, mortgage rates, and thus the cost of owning a home, will go down.