In 24 hours, the Federal Reserve will stop buying mortgage-backed securities. When it does, there's a good chance the economy will shift in big ways.
Here's the deal: In late 2008, the Fed announced plans to buy up $500 billion worth of mortgage-backed securities issued or backed by Fannie Mae
The impact has been twofold. First, buying mortgage-backed securities lowered interest rates on home mortgages. Second, it pumped $1.25 trillion of newly minted cash into the economy. This is where you often hear about "quantitative easing" -- aka firing up the printing press.
But with its $1.25 trillion mission nearly completed, the Fed will cease buying mortgage-backed securities tomorrow, March 31. The big question is what impact that'll have on housing going forward.
The honest answer is that no one really knows. Measuring the impact the purchases had in the first place is imprecise at best, and pondering life once they stop is even more so.
There are some reasonable assumptions, though, so we'll work from there.
Stimulus on steroids
First, how big is $1.25 trillion? Really freakin' big is the right answer, but in perspective:
- The value of all U.S. mortgages is roughly $12 trillion.
- Fannie and Freddie own or guarantee more than $5 trillion of mortgages.
- The value of all mortgage-related securities issuance in 2008 was $1.3 trillion.
- For $1.25 trillion, you could buy all of Coca-Cola
(NYSE: KO), Boeing (NYSE: BA), Apple (NYSE: AAPL)and ExxonMobil (NYSE: XOM)and still have enough left over to write a check for $1,820 to every man, woman, and child in America.
So the Fed clearly wasn't messing around here. This was, by any measure, the largest single stimulus package of the past two years. Or in history, for that matter.
Just after the buying began, Fed Chairman Ben Bernanke boasted that "mortgage rates dropped significantly on the announcement of this program and have fallen further since it went into operation."
By how much? The Fed estimates the program lowered mortgage rates by between 25 and 100 basis points (100 basis points is 1 percentage point).
When the program ends, one Fed official estimates that mortgage rates will rise by 50 to 75 basis points. Private estimates call for anything between 50 basis points to as much as 200 basis points.
Again, no one really knows for sure. But we can take these estimates and guess what impact they might have on housing prices.
Show me the money
When purchasing a house, buyers don't necessarily care about sticker price; what they care about is how much house they can buy at a given monthly payment. If someone can afford a $1,500 monthly mortgage, and $1,500 will finance a $300,000 house, then that's the person's market. If, thanks to low interest rates and financial chicanery, $1,500 can finance a $700,000 house (as it likely could have in 2005), then that's the person's new price range. In either case, home prices are linked to what borrowers can buy at a given budgeted monthly payment. Many other factors are involved here, like, say, consumers' mood, the outlook for price appreciation, and the ability to refinance. But the amount of house you can buy at a given monthly payment is a pretty good foundation to measure price sensitivity.
So let's say that, after the Fed stops buying mortgage-backed securities tomorrow, 30-year, fixed-rate mortgages jump 50 basis points from 5% (where they are now) to 5.5%. Or how about to 6%, or 7%. What could happen to home prices?
Assuming a 30-year, fixed-rate mortgage at today's 5% and a 20% down payment, a $1,500 mortgage payment will buy you $350,000 worth of house. If rates jump to 5.5%, $1,500 a month gets you $331,000. At 6%, $1,500 buys you $313,000, and at 7%, just $283,000. Compared with what you can buy today, that's a decline of 5.4%, 10.6%, and 19.1%, respectively.
Again, other factors are involved here. But is it possible that the end of buying mortgage-backed securities could hammer national housing prices by 5%, 10%, maybe even 20% more, all else being equal? Unless something else immediately takes its place, then yes. And it's not just possible, but quite likely.
As terrible as this financial crisis has been, it's been in an environment of falling interest rates that have significantly softened the blow. Starting tomorrow, we could get our first taste of what happens when the tide turns and interest rates really start to rise. And it could be ugly.