Fed's Next Move to Hit Housing, Mortgage Rates

Even though signs of a housing recovery are uneven at best, the Federal Reserve is about to take off the training wheels it has had in place for more than a year to help the battered market. The Fed has been buying mortgage-backed securities, the bundling of home loans that are used to fund mortgage lending, since late 2008. But next month it plans to complete its purchase of $1.25 trillion in mortgages That could be bad news. There is wide agreement that the removal of this support will mean higher mortgage rates, which could hit housing prices and sales hard. Some even worry that this could cause the broader economic recovery to stall. The program was the largest single injection of cash into the economy by the Fed during the financial crisis, and it will be the longest-lasting source of funds as well. Even though the Fed intends to stop buying mortgages, few expect the central bank will start selling them to private investors any time in the next few years. Higher rates on the way. But even if the Fed holds onto the mortgages it has already purchased, the act of no longer buying additional mortgages is likely to raise mortgage rates in the coming weeks. Experts say a jump of at least a quarter to a half percentage point is likely. San Francisco Federal Reserve President Janet Yellen warned of higher rates in a speech Monday. Fed Chairman Ben Bernanke is likely to take questions about the Fed's mortgage program when he testifies about economic conditions on Capitol Hill Wednesday and Thursday. The spread between the interest on 30-year fixed rate mortgages and the benchmark 10-year Treasury note now stands at about 1.2 percentage points. Before the financial crisis, this spread was typically closer to 1.5 percentage points. The worry is that high foreclosure rates and a still struggling economy will make investors demand a bigger spread than "normal", since mortgages carry far greater risk in the current market. Before the Fed started buying mortgages, the spread had climbed to about 2.5 percentage points. A return to that spread is unlikely, but there is uncertainty about how high it could go. Paul Kasriel, director of economic research at Northern Trust, said he "wouldn't be surprised" if the spread widened by half a percentage point from current levels. That can have a significant impact on prices by limiting what a buyer can pay for a home. Take the $178,000 median home price of existing homes sold in January. A buyer with a 20% down payment will pay just over $750 a month in mortgage payments for a 30-year fixed loan at today's rate. Raise that rate by a half point, and the same buyer will only be able to afford a home worth $170,000 to keep payments near the $750 a month level. The other concern is that even if the spread doesn't increase that much, mortgage rates could still shoot up simply if Treasury yields start to rise. That's possible if the debt problems in Greece and other weaker European countries is resolved in the new few months and investors who moved to U.S. government debt in a flight to quality move out of Treasurys. End of tax credit to add to problems. The worries about the Fed pulling back support for housing are compounded by the end of up to $8,000 in tax credits for home buyers. To qualify, buyers face an April 30 deadline to sign a sales contract. Dean Baker, co-director of the Center for Economic and Policy Research, argues that the Fed's program and tax credit for home buyers "ended the free fall in home prices." But he thinks that the removal of this support could mean that home prices could start to drop by as much as 1% a month again. He also thinks mortgage rates could climb by as much as a percentage point in the coming months. Jay Brinkman, chief economist for the Mortgage Bankers Association, said even if there isn't a big impact on home sales and prices, higher rates will lead to a plunge in mortgage refinancings. The MBA now forecasts refinancings will fall to a range of $500 billion to $600 billion this year from $1.4 trillion last year. That will mean even less cash available for homeowners to spend on other goods or to reduce debt. But Brinkman said the Fed is right to do what it is doing, even if the housing market is still in tenuous condition. "It's kind of like a pain killer. If you stay on it too long, the withdrawal pains may be worse than the pain you were trying to deal with," he said. But David Wyss, chief economist with Standard & Poor's, said he isn't sure that the Fed will even follow through and stop buying mortgages. If home sales and prices start to tumble sharply once again, the central bank could be back buying mortgages fairly quickly. "It's like the parent who is teaching a child to ride a bike who carefully lets go while running along side," he said. "The Fed thinks the child is able to balance by himself at this point, but it's still going to be running alongside the bike, just in case." CNN Money Article by: Chris Isidore