THE LONG VIEW

Allison Schrager

The central bank created major distortions in a market where many Americans have most of their wealth . Why ?

ITH INTEREST RATES NOW HOVERING around 5 %, existing-home sales are down more than 14 % from last year . Some potential buyers are sitting on the sidelines until rates or prices or both decline , while sellers are hoping the market picks up again so they can get a higher price .

But don ’ t count on rates falling to those pandemic lows . They were the result of extraordinary market manipulation from the Fed . And unless this becomes a regular feature of monetary policy , rates are not going back to what they used to be .

The real estate market has been on a wild ride . House prices , measured by the Case-Shiller index , increased 30 % between March 2020 and December 2021 , a steeper rise than the lead-up to end the housing bubble in 2008 . This was in part because many people moved during the pandemic , but also because the 30-year mortgage rate was only 2.65 % in spring of 2021 .

The impact of the Fed ’ s interference may be felt for years . In the spring of 2020 , the Fed was desperate to avoid economic collapse , so it reverted to its 2008 playbook . It cut rates to zero and brought back quantitative easing , buying long-dated government bonds and mortgage-backed securities ( MBS ). Most residential mortgages are securitized by Fannie Mae or Freddie Mac , and resold in what is known as an agency MBS .

The Fed ' s Footprint

MBS Risk Premium

2.0

1.5

1.0

0.5

0.0

Source : Bloomberg

2018 2019 2020 2021 2022

In 2020 , the mortgage-backed security market was in trouble , and the Fed was even more aggressive than it was in 2008 . It effectively became the only ultimate buyer of these securities : Its holdings of agency MBS increased by $ 1.3 trillion between 2020 and 2022 , while the market for agency mortgage-backed securities grew by $ 1.5 trillion . The Federal Reserve now holds more than 40 % of the total outstanding amount of agency MBS , or nearly half the market .

These actions were one big reason rates fell so low . Your mortgage rate is based on the 10-year bond rate , plus a premium for the extra risk involved . The size of that risk premium is largely determined in the MBS market , based on the liquidity and rate risk the investor takes on . The figure below shows the Bloomberg U . S . MBS index minus the yield on 10-year bonds .

The spread spiked at the start of the pandemic , but then as the Fed kept buying it fell to nearly zero , and the housing market raged . The spread started rising again in June once the end of QE was in sight , and it rose further when the Fed started to taper its purchases in the fall of 2021 before stopping in early 2022 . The spread is now higher than it was before the pandemic .

Buying mortgage-backed securities may have made sense in spring 2020 , but why the Fed did not start tapering for 18 months , even as the housing mar-

SEPTEMBER 2022 | FINANCIAL ADVISOR MAGAZINE | 21