With the federal funds rate effectively at the zero lower bound, the Federal Reserve has used unconventional forms of monetary policy. Specifically, the central bank has issued forward guidance about the policy path and purchased large amounts of U.S. Treasury bonds and agency mortgage-backed securities (MBS) in an effort to lower long-term interest rates. In the case of agency MBS purchases, a goal was to stimulate the housing market by lowering mortgage rates. Two papers presented at the recent Atlanta Fed/University of North Carolina—Charlotte conference, "Government Involvement in Residential Mortgage Markets," examine the extent to which the Federal Reserve has been successful.
Unanticipated announcements of new large-scale asset purchase programs (LSAPs), or changes in these programs, should have an immediate impact on interest rates under the assumption that the total stock of purchases is what matters. On the other hand, the flow of purchases may independently influence markets through portfolio rebalancing—that is, investors reacting to the removal of duration and convexity from the market—and liquidity effects—that is, ease of reselling assets in the future. Diana Hancock and Wayne Passmore conduct an empirical analysis of the differing effects of the LSAPs in their paper, "How the Federal Reserve's Large-Scale Asset Purchases Influence MBS Yields and Mortgage Rates." Using weekly data from July 2000 to June 2013, the authors estimate a model of MBS yields that controls for market expectations about future interest rates and find that the Federal Reserve's market share of MBSs and Treasuries are negatively related to MBS yields. Under their model, the Fed's holdings of MBSs has lowered MBS yields by 54 basis points and the Treasury holdings have pushed down the MBS yields another 70 basis points. This finding is consistent with portfolio rebalancing and liquidity effects being important determinants of MBS yields.
The finding is important because it suggests that agency MBS yields and mortgage rates will rise when the Federal Reserve reduces its MBS purchases—even if the Fed successfully signals that it intends to keep rates low for an extended time. On the margin, this could serve to dampen housing market activity, including refinancing. Since the beginning of the third phase of quantitative easing (QE3), the Fed's MBS market share has grown from around 17 percent to nearly 24 percent. Given the estimate that each percentage point increase in market share pushes MBS yields down by 2.3 basis points, reducing the Fed’s MBS market share back to a pre-QE3 level would push MBS yields up by around 16 basis points, which is unlikely to be economically meaningful.
While the cost of mortgage refinancing is borne by MBS investors, most of the policy attention is placed on the benefit to borrowers through an increase in their disposable income. In cases where borrowers are underwater and having difficulty making mortgage payments, refinancing can ease borrowers’ financial distress. In "The Effect of Mortgage Payment Reduction on Default: Evidence from the Home Affordable Refinance Program," Jun Zhu, Jared Janowiak, Lu Ji, Kadiri Karamon, and Douglas McManus estimate that during the 2009 to 2012 period, a 10 percent reduction in monthly mortgage payments for participants in Freddie Mac’s Home Affordable Refinance Program (HARP) resulted in a 12 percent reduction in the monthly default hazard for 30-year fixed rate conventional-conforming mortgages. This likely helped slow the flow of mortgages entering the foreclosure pipeline and gave neighborhoods time to stabilize.
Government involvement in residential mortgage markets takes many forms (see the conference website for papers that examine other forms of intervention). Taken together, the papers discussed here provide evidence that the Federal Reserve's LSAPs and Freddie Mac's HARP did put downward pressure on longer-term interest rates and facilitated refinancing activity that helped to support housing and mortgage markets. The tapering of the MBS LSAPs should not be a cause for concern. The Fed’s strong forward guidance combined with the slow, judicious pace of the taper imply that stagnation of the housing market is unlikely.
By Carl Hudson, Director, Center for Real Estate Analytics in the Atlanta Fed's research department, and