Housing Finance at a Glance: Monthly Chartbooks
The April 2017 edition of At A Glance, the Housing Finance Policy Center’s reference guide for mortgage and housing market data, includes updated figures describing housing credit availability, agency and non-agency MBS issuance activities, and latest GSE risk-sharing transactions.Introduction:
The Unwinding of Fed’s MBS Holdings
The Federal Open Market Committee has long maintained that the wind down of the Fed’s agency MBS holdings, currently at $1.75 trillion, will not commence until the Fed begins increasing the federal funds rate. After holding the target rate in the 0.0 to 0.25% range for seven years from 2008 to 2015, the Fed announced its first rate increase in December 2015. The second hike came a year later in December 2016 and the third one, just a month ago in March.
Now that the Fed has in fact begun raising rates, questions surrounding the unwinding of its MBS portfolio are, not surprisingly, beginning to surface.
The Fed has a wide range of options to accomplish the ramp down. These include minimally disruptive strategies such as gradually phasing out reinvestments of principal pay downs (prepayments for example), or ceasing reinvestments altogether.
Once the Fed has ceased reinvestment, they will have the option of letting the securities run off over time (and due to prepayments, the average life of these mortgage investments is far shorter than their maturity) or selling in the open market. The latter is a very aggressive option, something the Fed has said it is not considering. In line with this, in a recent survey of market participants conducted by the Fed, a large majority expects the Fed to start by phasing out reinvestments.
But even at a slow pace, there is no question that unwinding will, over time, remove a major source of demand for agency mortgage-backed securities. The Fed currently owns 29.4 percent of all agency MBS outstanding. Therefore its withdrawal will surely put some upward pressure on MBS yields and on mortgage rates, although it will hardly be the only factor. Exactly how much impact is nearly impossible to predict and will depend not only on which of the above strategies the Fed chooses, but also on how it implements that strategy. For instance, under the most likely option of phasing out reinvestments, the Fed will still need to decide how much of the principal paid down should be reinvested, and the pace at which this number ought to be reduced over time.
Equally important, the Fed will need to decide how to allocate reinvestment reductions across agencies— should the reductions be pro-rata or should there be any skew? If reductions are skewed more toward conventional MBS (those backed by Fannie and Freddie), any increase in rates will be felt more by conventional borrowers. In contrast, if reductions are skewed more toward Ginnie Mae MBS, the potential impact will be felt more by first-time homebuyers, low- and moderate-income borrowers and veterans, who depend heavily on FHA and VA financing.
Indeed, how the Fed begins to unwind is crucial to housing affordability in the coming years. More so, because baseline interest rates are already on an upward trajectory and house prices in several geographies are already unaffordable and out of reach for many.
Fed’s wind down raises another important policy question relevant to the future of housing finance: The agency MBS market has for a long time relied on a backstop bid from the federal government during turbulent times. Prior to financial crisis, this bid was provided by Fannie Mae and Freddie Mac through their retained portfolios, but at a substantial risk and cost to the taxpayer. Currently, this bid is being provided by the Fed, although its rationale and mode of operation are very different from that of the GSEs. Therefore, as policymakers debate the future of housing finance, they will need to decide if there is any role for similar market intervention in the future, and if yes, the most appropriate structural framework for it.