Mortgage rates play a key role in making houses affordable for would-be homebuyers, as the lower mortgage rates are, the lower monthly payments will be on any loan amount. Yet as the Federal Reserve has continued along its yearlong path of winding down the amount of mortgage-backed securities it buys on the open market, financial analysts have been confounded regarding why mortgage rates haven't risen in response. Moderation in mortgage rates has been beneficial to the Dow Jones Industrials (DJINDICES:^DJI) and to financial institutions, especially Dow component JPMorgan Chase (NYSE:JPM) and other major mortgage lenders.
The fears of investors in JPMorgan and in other banks outside the Dow Jones Industrials are fairly easy to understand. Throughout 2013, the Federal Reserve spent $85 billion each month to buy bonds, including $40 billion specifically aimed at the mortgage-backed securities market. By focusing buying activity on mortgage-backed securities (unlike previous quantitative easing programs), the Fed believed that it could keep mortgage rates down more effectively than by counting on market mechanisms to restrain them.
As buying activity helped keep mortgage rates down, it was natural for investors to assume that taking away those purchases would allow mortgage rates to rise again. Indeed, about a year ago, just the hint that the Fed might taper its bond purchases in the future sent mortgage rates soaring, creating problems for financial stocks both inside and outside of the Dow as mortgage-lending activity dried up and bond prices started falling to earth.
Since the end of last year, the Fed has reduced that $40 billion monthly amount toward mortgage-backed securities purchases by $5 billion each meeting, with the latest pronouncement Wednesday cutting the total to just $15 billion per month. At this rate, the Fed will stop buying mortgage-backed bonds entirely by the end of 2014.
The other side of the equation
But looking only at demand for mortgage-backed securities gives you only half of the story. Interestingly, the supply of mortgage-backed securities has also fallen lately. Data from the Securities Industry and Financial Markets Association show that Fannie Mae (NASDAQOTH:FNMA) and Freddie Mac (NASDAQOTH:FMCC) have both dramatically reduced the amount of mortgage-backed debt they have outstanding, likely as part of their ongoing process of winding down in conservatorship.
Even as Fannie Mae and Freddie Mac see their outstanding debt levels shrink, even the modest uptick in mortgage rates has already had a big impact on activity in the market. Most people had already refinanced their mortgages at the lowest rates possible, and so refinancing activity will be much lower going forward than seen in the past. That will reduce the turnover in existing mortgage-backed securities and eliminate the need for as many newly issued securities to come out.
Of course, the Federal Reserve has started signaling that short-term interest rates will also eventually start making their way back up. Once monetary policy starts tightening more aggressively, it would be much harder to see mortgage rates sustain their current levels. For now, though, mortgage rates have held their own, and that has been a boon for the big mortgage banks and for the Dow Jones Industrials in general.
Dan Caplinger owns warrants on JPMorgan Chase. The Motley Fool owns shares of JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.