WASHINGTON — The mortgage market could lose vital support from Fannie Mae and Freddie Mac early next year if the Federal Reserve Board goes forward with plans to stop buying government-sponsored enterprise securities and debt.
The Fed plans to stop purchasing debt and mortgage-backed securities from Fannie, Freddie and the Federal Home Loan banks on March 31, with the likely result of steeper funding costs for the government-sponsored enterprises and higher mortgage rates for consumers.
The Senate Banking Committee will meet today to discuss the future of the GSEs, and critical to that outlook is the role Fannie and Freddie will have in post-crisis mortgage markets. Until that role is settled, observers argue, the Fed should wait to withdraw its purchases.
"If they get out in the first quarter, it's a mistake," said Joe Murin, the managing director of the Collingwood Group and the former chief executive of the Government National Mortgage Association, or Ginnie Mae. "My concern would be the pricing of the securities is going to go up, which is going to drive interest rates up. I don't think that's a good thing at this time, when we're not back on our feet yet."
The Fed has committed to purchasing up to $1.25 trillion of MBS and $200 billion of debt from the GSEs. So far the central bank has bought $882.6 billion in MBS and $131.2 billion in debt.
The point of the Fed's purchases was to lower mortgage rates during the worst of the housing slump and lower funding costs at the GSEs, which were struggling with skittish investors in the private market. That plan has largely worked; rates for a 30-year fixed-rate loan have fallen to 5.11%, according to Bankrate.com, and GSE debt with five-year maturities traded at 30.5 basis points above Treasuries this week.
But most analysts are predicting those rates will rise by at least 50 basis points before the Fed stops buying and could rise even further afterward. That might not hurt as much on the MBS side, as long as investors have an appetite for mortgages, but could pose problems on the debt side if investors are worried about funding an institution that might not be around a few years down the road.
"It's a little uncertain," said Bose George, a mortgage equity analyst at KBW Inc. "Part of the sticking point for investors is the lack of clarity of the role of the GSEs and whether it has [the government's] full faith and credit. It's still not official government debt."
Observers are still debating the importance debt will play at the GSEs. Under the terms of the conservatorship, Fannie and Freddie are supposed to begin the gradual process of shrinking their mortgage portfolios in 2010. That would ease the need for the GSEs to sell debt to support the assets held in portfolio.
"In the long run, if the portfolio sizes are much smaller, then obviously the total debt sizes would be much smaller," said Vivek Sriram, an MBS and derivatives strategist at RBC Capital Markets Corp.
He added that Fannie and Freddie could issue shares of stock instead of selling debt, though that might be futile with GSE shares trading for less than $2.
Still, others pointed out that debt sales remain a crucial part of the funding strategy at the Home Loan banks and said they will continue to be part of the business at Fannie and Freddie.
"The mortgage portfolio is going to decline very gradually, so they will still have to continue to fund those assets," said Brian Harris, an analyst at Moody's Investors Service.
Moreover, with the Obama administration's reliance on Fannie and Freddie to conduct loan modifications, it is not clear that cutting the portfolios will be a near-term priority.
"These are entities that are providing a tremendous amount of support to the mortgage market," Harris said. "I would imagine any actions they take on their portfolio are secondary in nature. Their primary goal is to support the mortgage markets."
A key concern for both debt and MBS analysts is whether private investors, who have spent much of the financial crisis sinking their money into only the safest investments, will return to Fannie and Freddie once the Fed exits.
"The question is the extent to which the pool of investors will widen out," said Bert Ely, an independent consultant in Alexandria, Va. "The Fed can't pull back faster than that pool widens out."
Despite the Fed's planned withdrawal, Fannie and Freddie still have significant government support, including a $200 billion credit line for each GSE from the Treasury Department. But Fed officials are well aware of what is at stake.
In a speech last month, Donald Kohn, the Fed's vice chairman, suggested that spreads on MBS might not rise — and could in fact fall — if the central bank continues to hold those assets on its books.
"The effects of our holdings of mortgage-backed and agency securities on spreads nonetheless should decline even if they remain on our balance sheet," he said. The declines "may result from the flow of our purchases, as well as our stock of holdings. … As confidence returns, asset demands will become less focused on particular classes of highly safe and liquid assets and more sensitive to relative interest rates."
If spreads or interest rates buck the Fed's goals, Kohn held out the possibility of selling some of these assets.
For its part, the Federal Housing Finance Agency, which regulates the GSEs, says it is standing clear of whatever decision the Fed will make.
"The Federal Reserve is going to consider its purchase programs not just with respect to housing finance or mortgage rates, but in the context of its view of the economy," Ed DeMarco, the Finance Agency's interim director, said in an interview last month.
Of course, if the Fed remains worried about the housing market, it could extend its purchases into the second quarter. After all, the purchases were initially slated to expire at yearend.
"This is not an ironclad decision," Ely said. "I don't think we want to get hung up too much on the permanence of that date."
Another extension might soothe housing markets but would still reinforce the need for guidance from the government on just where Fannie and Freddie are heading. The Obama administration has said it will unveil its vision for the GSEs in February, and Sriram said that would be key.
"It's a game of mutual nudging," he said. "The administration has not been able to address the GSE issue yet, and given that they are expected to address it in February, the Fed scheduled its purchases to end in March. Now the ball is back in the administration's court."