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Residential Department: BackSpace: September 2017



Fed’s tapering plan seeks to ease the economy forward

The Federal Reserve, following a two-day meeting of its Federal Open Market Committee this past June, announced that it plans to begin unwinding, or tapering, its mega-portfolio of mortgage-backed securities (MBS) and Treasury holdings. The Fed will approach the tapering cautiously, using a measured approach of slowly reducing the level of new asset purchases as existing securities mature and run off its balance sheet.

Still, the enormity of the Fed’s asset holdings is staggering, representing the equivalent of nearly a quarter of the U.S. economy. Consequently, the Fed’s recently announced tapering plan, which is expected to launch as early as this month, has enormous consequences for the economy, and the housing industry in particular. As demand for MBS decreases with the Fed pullback from the market, there will be upward pressure placed on mortgage rates to entice more MBS buyers. That’s how supply and demand works.

“The Fed’s portfolio pre-crisis [prior to 2009] was less than $900 billion, and almost entirely Treasurys,” says Mike Fratantoni, chief economist for the Mortgage Bankers Association (MBA). “That portfolio is now at almost $4.5 trillion, and $1.8 trillion of that is MBS, making the Fed the largest single investor in the world in mortgage-backed securities, and they have a much larger Treasury portfolio.”

Fratantoni says varying opinions exist as to how much the Fed expects to shrink its balance sheet, but he says a reasonable estimate is in the range of $2 trillion to $2.5 trillion, representing about half of its existing portfolio. That would be accomplished over the course of the next five years or so, according to a Goldman Sachs analysis.

“The primary effect of Fed actions for all homebuyers will be the very gradual edging up of interest rates as some liquidity leaves the secondary market, which will affect affordability to some extent,” says Texas-based economist M. Ray Perryman, president of The Perryman Group. “… Of course, this effect could be offset by increased private-investor interest.”

Ken Fears, housing-finance economist at the National Association of Realtors, says analysis of the interest rate effect during the buildup of the Fed balance sheet, a buying spree dubbed “quantitative easing,” shows that it helped to reduce long-term mortgage rates by 20 to 40 basis points.

“It’s not clear we’ll have a similar effect on the way out [with the shrinking of the Fed’s balance sheet] because of the very slow tapering — and it’s a different market,” Fears says. “But if we see an increase of 20 to 40 basis points [in long-term mortgage rates as a consequence], that would put us right back at where we were [late last year], in terms of mortgage rates in the wake of the election and the strong rates, so we’ve been there.”

Fratantoni adds that the MBA expects interest rates, with the effects of tapering included, to be around 4.5 percent by the end of the year and in the range of 5 percent by the end of 2018. “So it’s a fairly modest increase, even with these changes [the tapering],” he says.

You have this countervailing force that’s helping to close that gap between how much the Fed pulls back and how much the private sector needs to come in.
Ken Fears, housing-finance economist, National Association of Realtors

The long-term consequences of failing to pursue a Fed balance-sheet reduction, however, could be far worse for the economy than the modest upward push the tapering plan is expected to have on mortgage rates.

“The buying [of the MBS and Treasury securities] was done in response to a crisis,” says Laurie Goodman, co-director of the Housing Finance Policy Center at the Urban Institute. “When we’re not in a crisis situation, you want to wind down the portfolio. You want ammunition should you need it later on.”

Goodman says as rates bump up, housing does become less affordable, but she says the market can cope with the modest rate impact tapering is expected to produce at this point.

“It’s important to realize that housing is still relatively affordable in a historical context nationwide,” she says. “That’s not the case in all areas, but for the nation overall its relatively affordable.”

Fratantoni adds that the Fed’s pullback from the MBS market could open up more space for private-sector players to enter that market. “I think it will be healthier for the market in the long term to have these [MBS] assets in private hands, rather than the central bank’s portfolio,” he says. “But it’s just a question of whether we’re going to hit some air pockets as we move from one situation to the next, and we have a period where the market is a little unsettled.”

Fears adds that rising interest rates should diminish the supply of MBS, which will have a mitigating effect on the upward pressure on rates sparked by the Fed’s tapering program. “Rising rates means refinances will tail off, and that means less new MBS issuance,” he explains. “So you have this countervailing force that’s helping to close that gap between how much the Fed pulls back and how much the private sector needs to come in [to balance out the Fed’s reduced demand].”

The key to all of this is the Fed’s handling of the tapering. If it moves too fast to shrink its balance sheet, or fails to give the market enough forewarning, it could spark a panic that spikes interest rates. That’s precisely what happened in 2013 with the so-called taper tantrum. In that case, then-Fed Chairman Ben Bernanke merely signaled a future plan to begin tapering bond purchases, and it prompted a spike in 10-year Treasury yields.

“I think the taper tantrum in 2013 was a valuable lesson for them in terms of moving too quickly and not adequately telegraphing,” Goodman says. She adds that the tapering plan now in place addresses that concern because it is being spelled out well in advance of the action and calls for “gradually phasing out reinvestment … and allowing the securities to run off over time.”


Bill Conroy is editor in chief of Scotsman Guide Media. Reach him at (800) 297-6061 or

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