As the US Federal Reserve pulls back from the mortgage market, will the government and its proxies, Fannie Mae and Freddie Mac, pick up the baton?
Many investors are looking to Fannie and Freddie to play an expanded role in the market for mortgage-backed securities (MBS) – helping to keep the market liquid and mortgage rates low – as the Fed completes its $1,250bn (£780bn) purchase programme.
This is mitigating concerns, expressed by some Fed officials in the minutes of the US central bank’s December 15-16 policy meeting released this week, that the scheduled winding down of Fed purchases of MBS by March 31 could “undercut” a fragile housing recovery. Since the Christmas eve announcement that the government was increasing the effective caps on the amount of assets Fannie and Freddie are allowed to hold, spreads on MBS have narrowed to record low levels.
However, the US Treasury officials say it is not their intention that Fannie and Freddie should become large net buyers of securities – rather, they want to ensure these enterprises are not forced sellers at a time when the Fed is pulling out.
Inside the Fed, policymakers disagree as to how big an impact the end to MBS purchases will have. This relates to longstanding arguments as to whether the stock or flow of purchases influences mortgage rates – and the extent to which Fed buying crowded out private activity. Fed doves want to ensure the central bank keeps open the option of expanding MBS purchases if the economic outlook deteriorates or mortgage rates spike. However, another group is keen for the government and its proxies to take on full responsibility for housing and mortgage-related issues. That would allow the central bank to focus exclusively on the general macroeconomic outlook, and increase MBS purchases only if that outlook deteriorated sharply.
The US administration’s decision to expand the portfolio caps gives Fannie and Freddie some additional headroom to buy MBS. Their debt funding costs are at record lows, making such purchases attractive to them. But Treasury officials say they do not expect Fannie and Freddie to expand their portfolios over the course of the year, though they acknowledge the enterprises will be able to buy opportunistically if spreads widen.
One top priority for the administration is loan modifications to reduce foreclosure, and there is a trade-off between using investment capacity to buyback modified loans and to buy newly issued MBS. Credit Suisse estimates that Fannie and Freddie will buy back some $175bn in modified and delinquent loans this year, leaving them with the capacity to buy about $80bn in newly issued MBS
Some analysts believe the Fed may not be able to rely exclusively on Fannie and Freddie to keep the mortgage market liquid and rates low. If rates do move up, one option floated at the last Fed meeting would be for the Fed to start reinvesting the reflows it gets as its giant portfolio matures or is paid down. This could provide roughly another $100bn over a year.
By the central bank’s own definition, reinvesting reflows would represent an easing of policy. The hurdle for this would presumably be quite high. At least in principle, however, policymakers could choose to offset additional easing via mortgage rates with tighter policy in short-term rates.
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