Every major sector of the US economy will feel the effects of "Brexit,” Great Britain’s shocking vote to exit the European Union. The housing finance system is no exception, but the nature and strength of its impact here will depend largely on what comes next: Will the transition be orderly or chaotic? Will the impact be limited to the United Kingdom or spill over into the rest of Europe? How these variables play out will determine whether the effect on the housing market is modest and fleeting or disruptive and enduring. Either way, we can already see the factors most likely to drive its impact on housing.

Falling interest rates

The flight of capital to the relative safety of US Treasuries has already driven down the rates that investors are able to demand for these investments, from a 10-year rate of 1.74 percent on June 23, the day before the Brexit vote, to 1.46 percent on June 28. Mortgage rates are based in significant part on Treasury rates and thus have undergone a similar drop. This flight to safety will continue to push rates lower as long as investors see heightened uncertainty and turmoil in worldwide markets.

The drop in mortgage rates will have a number of noteworthy effects on the market.

First, there will be a surge in refinancing. As 30-year mortgage rates trend below 3.5 percent, most borrowers who last financed their home before 2013 will be able to lower their rate with a new mortgage. Not all of these borrowers will refinance: some are moving too soon for the benefits of lower rates to outweigh the fees associated with taking out a new loan; some are unable to qualify for a new mortgage; and others simply won’t recognize the opportunity. But many no doubt will refinance, leading to a boom that may rival that seen from 2008 to 2014, when roughly 25 million families refinanced their mortgages. 

The surge in refinancing will increase prepay speeds for the securities backed by these mortgages (MBS), shortening the term of the investment and reducing the return. This will drive losses for investors with unhedged MBS positions. Similarly, servicers will see the revenue streams from their mortgage servicing rights (MSRs) dry up as borrowers refinance out of the loans they are servicing. Those servicers that have not hedged these revenue streams and are unable to mitigate their losses with new MSRs will also see significant losses.

Finally, the drop in mortgage rates may force Freddie Mac into the red for the quarter. The way in which Freddie hedges against interest rate risk requires it to mark to market its hedges each quarter. As it does not mark to market the positions that it is hedging, this leaves it exposed to accounting losses as interest rates move in the course of a quarter. In the first quarter of this year, 10-year Treasury rates dropped 48 basis points and Freddie reported accounting losses of $1.4 billion related to their hedging of interest rate risk, leading to overall losses of $354 million. The 10-year rate has fallen by about half that thus far this quarter, possibly triggering another round of accounting-driven losses.

It is worth noting that this period of low interest rates is likely to be protracted, as the Brexit will almost certainly forestall the Federal Reserve’s move to raise its benchmark interest rate. Not only will uncertainty over the macro impacts of Brexit give them pause to raise rates, but the stronger dollar also mitigates the need to check inflation with higher rates anytime soon.  

Overall impact on demand mixed

While lower interest rates will no doubt help drive demand for homebuying, this impact will be offset by some decrease in consumer wealth and confidence.

As stock markets fall in the United States and elsewhere, the savings and wealth of innumerable possible homebuyers will suffer, along with their purchasing power and confidence. Moreover, a much stronger dollar makes purchasing property in the United States a good deal more expensive for Brits and somewhat more expensive for other Europeans. All of this will create some downward pressure on demand for new purchases, particularly in markets heavily dependent on second home purchases and foreign investors. 

How much of all this will affect the housing market depends on how the rest of Brexit actually plays out. If it is relatively orderly, with minimal spillover effects in Europe or elsewhere, then its lingering impact on the US housing finance system will likewise be modest, limited to the effect of lower rates and possibly mildly depressed consumer confidence. But if the transition triggers a dramatic movement of capital and a broader loosening of the ties of Europe, then the effect on the housing market will no doubt be more significant, possibly depressing demand enough to stall the recovery. While the odds of the latter appear lower for the moment, there are too many unknowns to provide much comfort.