- The Washington Times - Friday, March 19, 2010

Q. I have been reading about the Federal Reserve Board’s decision to stop buying mortgage-backed securities at the end of this month. I understand this will cause mortgage rates to rise.

We are hoping to sell our house and buy a new one later this spring. Why would the Fed want to raise rates when the economy and the real estate market are still suffering?

A. Yours is a very good question. Let me quickly summarize what’s been happening.

Long-term interest rates, such as those for Treasury bonds and 30-year fixed-rate mortgages are controlled by market forces. Individual and institutional investors purchase these instruments and create the demand that keeps rates down.

The subprime mortgage meltdown caused investors to avoid investing in mortgage-backed securities, creating a colossal credit crunch. To create a demand for these securities in hopes of loosening the credit markets, the Fed adopted a policy to purchase up to $1.25 trillion in mortgage-backed securities. This demand supposedly is keeping mortgage rates low, which helps the ailing housing market.

While this policy may indeed be keeping rates down, it runs the risk of creating inflation, which could result in an even bigger problem. Jeffrey Lacker, president of the Richmond Federal Reserve Bank recently said that only a “cataclysmic” event would keep the Fed from halting its purchases of mortgage-backed securities at the end of March as scheduled.

Such a statement should be worrisome to anyone in the mortgage business. If the Fed is artificially creating a demand for mortgage investments through its purchase program and thus artificially keeping rates down, it must hope that the private sector will fill its shoes and have a healthy appetite for those investments.

This is the question no one can answer for sure: When the Fed stops buying mortgage-backed securities, will there be enough demand for these instruments to keep rates stable?

I don’t know the answer. On the one hand, I can tell you from hands-on experience that the mortgage market is tight. Purchase and refinance loans are getting done, but borrowers must be prepared to provide a lot more paperwork than in the recent past. If your credit score isn’t near perfect, expect to pay a slightly higher interest rate.

On the other hand, the tightening of underwriting rules is sure to result in a much more desirable mortgage pool. This may attract investors who previously got burned by purchasing mortgage-backed securities compiled from lesser-quality loans. If there is renewed investor interest in mortgage-backed securities, rates could stay low.

Assuming Mr. Lacker is correct and the Fed jumps out of the mortgage-investment business, I will be reporting on this subject again in a few weeks.

Henry Savage is president of PMC Mortgage in Alexandria, Va. Reach him at [email protected]

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