An economics textbook might define a free market economy as one that relies on individual choice and market forces, rather than government planning, to guide industry.

No developed Western economies fit this definition, no matter their stated aspirations. Some sectors within these economies may behave more free-spiritedly, but the U.S. housing finance system is not one of those sectors.

Through various methods, the federal government backstops much of the risk embedded in secondary mortgage markets that facilitate about two-thirds of U.S. home purchases in any given year.

Historically, when the risk premium investors demand to buy agency mortgage-backed securities (MBS) in the secondary market pushes credit spreads wider than certain thresholds, government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac or the Federal Reserve have directly purchased agency MBS to halt spread widening, holding the purchased MBS on their balance sheets.

Shifting demand for mortgage bonds due to changes in monetary policy means no “buyer of last resort” has been positioned to play that stabilizer role in nearly four years, according to a joint analysis published Monday by the Urban Institute, a housing policy nonprofit.

It is unlikely that a government entity can effectively fill that stabilizer function for agency MBS markets in the near term, the analysis concludes, raising essential questions for the mortgage industry about the extent to which the government should intervene in agency MBS markets at all.

“Do we want government-backed entities to intervene in markets like this, outside of a clear economic crisis?” posits Mark McArdle, head of regulatory affairs and public policy at Newrez, a large mortgage lender and servicer, in a note to Scotsman Guide. “Does it create unintended consequences or future expectations that can’t be met?”

“Did the Fed’s actions help contribute to the lock-in effects we are still dealing with today, by artificially pushing rates down farther than they perhaps should have gone?” McArdle asks.

What is agency MBS?

For all intents and purchases, all mortgage loans begin in the secondary market. Aggregators and issuers set underwriting and quality assurance guidelines for loans they are comfortable purchasing from mortgage lenders (or other aggregators), then pool the loans they purchase into securities.

Roughly two-thirds of first-lien purchase loans originated in 2024 were securitized by the government-run aggregators and issuers Fannie Mae, Freddie Mac and Ginnie Mae — collectively, the “agencies” that represent the qualifying mortgage (QM) market. Agency first-lien securitization share shrank to 63.1% in the third quarter of 2025, the continuation of a trend toward smaller agency market share post-pandemic.

In the secondary market, investors buy access to interest-bearing cash flows generated by mortgage borrowers repaying their home loans. Fannie, Freddie, Ginnie and private issuers sell access to different “shelves” of cash flows offering higher or lower yields, accounting for collateral risk, loss protection and investor risk tolerances.

Investors charge a risk premium that reflects the perceived risk of agency MBS relative to yields on 10-year U.S. Treasury bonds. That so-called “primary spread” was 2.1%, according to Urban Institute, on Nov. 7, 2025.

What the borrower sees, shopping lenders for an agency-eligible mortgage, is the mortgage rate — the primary spread plus lender markups. What they don’t see, however, is how their mortgage rate is a function of supply-demand dynamics in the secondary market for agency MBS, because without secondary buyers, mortgage lenders are largely illiquid.

When spreads have widened rapidly in response to broader economic crises, like the COVID-19 pandemic or 2008 financial crisis, reflecting falling demand or rising risk premiums for mortgage bonds, the Federal Reserve has purchased MBS to ensure that liquidity continues to flow to mortgage lenders, effectively subsidizing mortgage rates. If the Fed did not step in, mortgage spreads would widen until private buyers returned.

Demand for MBS has fallen sharply since mid-2022, however, as demand for MBS has fallen with the exit of one of the MBS market’s major recent buyers.

Shifting agency MBS demand

In March 2022, the Federal Reserve pivoted from a policy stance of quantitative tightening to quantitative easing as it hiked its benchmark borrowing rate and commenced an inflation-fighting campaign.

The pivot marked an end to its COVID-era purchases of trillions of dollars of MBS, while the Fed also allowed existing MBS to run off its books at maturity. Stability through government intervention in agency MBS markets during the pandemic came at a cost, however.

Federal Reserve Chairman Jerome Powell said in an October speech that the Fed’s COVID-era asset purchases “perhaps should have been stopped sooner,” a concession that foregrounds criticisms of entrenched housing market distortions in subsequent years — high home prices, stubborn lock-in effects — born of over-stimulative monetary policy.

“The Fed appears to be a willing backstop for the MBS market in times of significant economic stress,” said Mark Zandi, chief economist at Moody’s Analytics, in an emailed remark to Scotsman Guide. “Except during those periods, the costs of the Fed or GSEs intervening in the market outweigh any benefits.”

Before the GSEs landed in federal conservatorship due to their financial malfeasance in the runup to the 2008 financial crisis, prompting the Federal Reserve to step into the “buyer of last resort” role, Fannie and Freddie purchased their own MBS during market disruptions, profiting from wider spreads relative to their low cost of capital.

This strategy effectively halted spread widening, helping to restore investor confidence in agency MBS markets.

But the U.S. Treasury Department’s bailout agreements with the GSEs required them to shrink their portfolios while under conservatorship to a combined cap of $450 billion, says the Urban Institute, as the Trump administration’s concerted effort to reprivatize the GSEs complicates the manner in which they might return to providing a stabilization function.

“Until we know which path it will be for the GSEs — profit-seeking enterprises or mission-focused utilities — the risk of giving them this market-stabilizing role simply outweighs the cost of forgoing a market stabilizer altogether,” wrote Laurie Goodman, founder of Urban Institute’s Housing Policy Center, and Jim Parrott, Urban Institute fellow and former senior housing adviser to the White House National Economic Council under President Barack Obama.

Rising MBS volatility over time

The current $72 billion of agency MBS on Fannie’s and Freddie’s portfolios, according to Urban Institute figures, is roughly 8% of the $900 billion they held in 2003. Goodman and Parrott believe the incentive for the GSEs to use their role as an MBS market stabilizer to maximize returns to investors “would simply be too strong,” if left to their own devices.

“Ultimately, we conclude that neither the Federal Reserve nor the GSEs are well positioned to return to the role and that the agency MBS market may have to get comfortable operating without a net,” they wrote.

The GSEs cautiously began to increase their MBS purchases in the latter half of 2025, narrowing mortgage spreads slightly. But the impact of a long-term shift is potentially profound, says the Urban Institute, given the assumption of government intervention baked into secondary market stability.

Seth Sprague, director of mortgage banking for Richey May, a tax audit and advisory firm, says mortgage borrowers see lower and more consistent mortgage rates “when demand for MBS is strong and the pool of buyers is deep.”

“The longer end of the curve is controlled by the bond investors, and lack of demand from buyers for MBS results in higher mortgage rates,” Sprague wrote to Scotsman Guide. “The lack of a backstop buyer such as the Federal Reserve or the agencies can result in greater volatility of mortgage rates and potentially higher mortgage rates for consumers.”

On a fundamental level, the lack of an MBS market stabilizer would raise costs for mortgage borrowers across economic cycles, hurting already strained affordability.

By letting risk and return set their own table during periods of market stress, private MBS investors could allow spreads to drift wider than the GSEs or Federal Reserve would allow, pushing mortgage rates higher and eroding home-purchase affordability. Spreads could be wider during calm periods as investors price increased MBS volatility.

“If policymakers ultimately decide to turn the GSEs into utilities, it will be worth expanding that [stabilizer] role to reducing this costly volatility,” Goodman and Parrott concluded.