Are Higher Rates on the Horizon?

"What goes up must come down...," the song goes. In the world of interest rates gravity works both ways, and so the reverse "What goes down must come up..." also applies.

Federal Reserve MBS Purchases

There is some concern that 2010 will mark higher rates than in 2009. That shouldn't be a surprise. The Federal Reserve kept rates down last year to try and stabilize the economy. Not only has the Fed Funds (short term) rate been at near zero, the Federal Reserve helped to keep mortgage rates low with a massive spending spree for mortgage backed securities. The fact that it is a "spree" implies it cannot last forever, and it won't.

The Fed now holds $909 billion in mortgage backed securities. It sounds like a big number, and it is. Last year, the Fed and Treasury combined to purchase 73% of all Fannie Mae, Freddie Mac, and Ginnie Mae mortgage backed securities. The Fed's spending spree, when completed in March will result in $1.25 trillion in MBS purchases. Unless you are a politician, $1.25 trillion is a lot of money.

Effect on Interest Rates

Those purchases had a big impact on mortgage rates, and therefore on housing affordability. Home prices are based on what potential buyers are willing to pay, and what they can afford. Rising rates will result in higher monthly payments on new mortgages. That means for someone to be able to afford the same payment with a higher rate, the loan amount (and the sales price) must go down. The bottom line, higher rates equals further declines in home values. Further declines in home values equals more foreclosures. Therefore higher interest rates equals more foreclosures. Here are the equations for any math nerds that are reading this.

Higher Rates = Lower Home Values;
Lower Home Values = More Foreclosures;
Higher Rates = More Foreclosures.

With continued falling home values, and rising foreclosures, will the Fed really stop the MBS purchase program. They recently warned banks to be prepared for "instantaneous and significant changes in rates, substantial changes in rates over times, changes in the relationships between key market rates (mortgages versus Treasuries?) and changes in the slope and shape of the yield curve."

Prediction or Regulation?

Was that a warning from the Fed as to what is to come? Or are they just trying to be a better regulator since they did an obscenely poor job leading up to the recession? What about the President and Congress; will they let allow rising rates to beat down an already bloody housing market? Reeling from worse than expected unemployment numbers for December, there is political pressure to continue to stimulate the housing market.

Knowing that the Fed is ending its MBS purchase program in March, the Treasury's announcement of "unlimited support" for Fannie Mae and Freddie Mac makes sense. Perhaps they will pick up where the Fed is leaving off in the purchase of mortgage backed securities. If not, the absence of such a large buyer will drive up mortgage rates as yields must be bid up to attract new investors.

The Bottom Line

There is great pressure on the government to continue stimulating housing. One way or another they should keeps rates low (continue Fed MBS purchase plan, or use Fannie & Freddie). We are still in the midst of a housing crisis, so it is undesirable to intentionally trigger another one. Eventionally the housing market must be weaned off the stimulants, but this market is not yet ready for that.