When the Fed Stops Buying MBS, How Will Rates Be Affected?

The Federal Reserve’s purchase of Mortgage Backed Securities (MBS) is scheduled to end on March 31^st. A few weeks ago I wrote that there was some talk of extending this program. It seems as though most signs are pointing to the market stepping in and taking the place of the Fed in these purchases. The Fed is 98.4% complete with its planned $1.25trillion dollars of MBS purchases.

There was some buzz a few weeks back, particularly at the beginning of February with William Dudley, New York Federal Reserve Bank President, leaving the door open for a possible extension of the MBS purchase program. That chatter has all but dried up as the market is stepping in and buying these securities with demand picking up as banks shore up their balance sheets.

Real estate investors should pay attention to this secondary market because the interest rates directly affect the performance of their real estate assets. The Fed has been buying this $1.25trillion dollars worth of securities creating and artificial demand for them. That demand increases the price of the MBS and interest rates move in the opposite direction of the prices. Currently, rates have been hovering around 5% sparking significant refinance activity under 5%. Many have feared when the government intervention ends, we could see a spike of at least 1% in interest rates. For now that looks like it won’t happen as Fed purchases are winding down. I suspect any increases at this point in rates will be temporary and driven more on speculation.

I was having coffee on Friday here in New York with a client of mine who’s worked as a trader of Mortgage Backed Securities for 7 years. He was working for Lehman trading MBS at the time of their implosion and has since worked for Barclays doing the same. He felt that we are seeing no danger of rates rising because of significant demand for MBS from financial institutions. Also he informed me that most big banks have fat balance sheets right now and are frankly too scared to lend with the money. Why wouldn’t they purchase a Fannie Mae underwritten MBS? Apparently banks are looking for places to park their new found cash reserves and MBS is one of the primary places this money is going. Because of this the Fed will be able to back away without rates being significantly impacted. This demand has surged only recently.

I think it’s important to note the client I was referring to in the above paragraph found a lender online and locked in a 5% interest rate fixed for 10 years. He’s planning on holding for 5-7 years and exiting to a retail buyer at that time. Without sounding like I’m selling, it seems that with the expected 1.4million foreclosures in 2010 and the rates holding very low, we’ll look back on 2010 as the year where the stars aligned for investors on both price and rates. On the flip side, prices will likely remain low due to forecasted foreclosures in the next 3 years but will the interest rates?

The Fed ending the MBS program this month and the first-time buyer tax credit ending will leave much of the real estate market standing on its own by late spring and early summer. Of course that’s just in time for peak season which might make the real test of the recovery happening in the fall of this year. For now, I think we can bank on the Fed ending the MBS program as scheduled and the impact on interest rates to be limited. I’m looking for 25 bp increase in mortgage rates (30 yr fixed according to Freddie Mac) over the next 45-60 days ending May 15^th(today 4.95%).

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.