In case you missed it, the Federal Reserve just threw some gasoline on the housing inferno. This month, the Fed confirmed that it will no longer make open market purchases of mortgage backed securities after March 31st, and underwater homeowners are going to miss that money. This particular Fed program was one of a number of extraordinary, emergency measures meant to reverse the near meltdown of the U.S. financial system, and through it the Fed pumped nearly $1.25 trillion into the mortgage backed securities market over the past twelve months.
The program was officially intended to lower home-loan mortgage rates, and that’s exactly what it did. Brian Sack, head of the NY Fed’s money market desk, estimated that it lowered rates on agency mortgage backed securities by a full point, and that a separate program targeting government securities lowered rates on the 10 year Treasury by at least half a point. Home mortgage rates dutifully followed suit, dropping from almost 6% at the end of 2008 to below 4.5% today:
When this unprecedented government market manipulation comes to an end, and it is coming to an end now, single family mortgage rates will go right back to where they came from. As that happens home ownership will become even less affordable, and that means home prices are likely to drop even further.
But there’s much more….
As the Fed begins to unwind its historic intervention, it faces a second wave of toxic mortgage maturities that could be even more damaging than the last wave of subprime mortgages. These are the 3 and 5 year Option ARM mortgages, and they were the credit bubble’s absolute creme de la creme.
If you didn’t manage to get a piece of the action in Option ARMs, these were the mortgages given to credit-worthy borrowers who could not afford their monthly mortgage payment using a normal ARM (in other words, they paid too much for their home), and the Fed is waiving goodbye just as these Option ARMs get set to explode:
Not only did these loans require zero principal repayments, they also allowed borrowers the option of skipping scheduled interest payments altogether. As these loans reset in 2010 and 2011, that option goes away and principal amortization payments will kick in, adding hundreds of dollars to a borrower’s monthly mortgage nut.
And, with the Fed pulling the plug on its mortgage buying program, these loans will reset at rates that are far higher than the initial “teaser” rate. Sadly, this may spell doom for borrowers who used these loans to fund overpriced home purchases in 2006-2007, especially in high-priced markets along the coasts.
And there’s even more….
Terminating these programs are the Fed’s first tentative steps in a “tightening cycle like no other in its history”, according to Sacks. In a speech last week to the National Association for Business Economics, Sacks noted that the Fed faces “extraordinary challenge with this exit, given the historic steps that have been taken with the Fed’s balance sheet.”
He candidly admitted that the Federal Reserve’s largesse over the past two years has been so massive and so broad that tightening will need to be implemented on a scale that the Fed has “never before attempted”. He also said that the Fed will be operating in a framework that has not been fully tested in U.S. markets. What he did not say is that the Fed needs to take these steps, and fast, in order to prevent something even worse: inflation and yet another asset price bubble.
Unfortunately, there is no asset price bubble brewing in single family housing. Despite a glimmer of hope in the number of borrowers who had fallen behind in their payments in Q4, a record 15 percent of all homeowners with a mortgage had still missed at least one payment, and nearly half those borrowers were at least three months delinquent.
Three month’s delinquent is the point at which foreclosure proceedings commence, and this latter figure is more than double its typical level. The Fed has now run out of time, and its efforts to re-inflate housing are coming to an end in favor of fighting even more damaging inflation in the broader economy. This is not good news if you’re an underwater homeowner, and it looks house prices are going to get a lot worse before they get better.