In January, the Mortgage Bankers Association (MBA) announced that US consumers applying for housing loans to buy a home or refinance rose to an 11-month high.

The MBA’s chief economist Mike Fratantoni said:

“Uncertainty regarding the government shutdown, slowing global growth, Brexit, a more patient Fed, and a volatile stock market continued to keep rates from increasing.”

This is important because higher rates will mean that mortgages become more unaffordable. Therefore, house prices will begin to fall as demand dries up.

We saw signs of this in 2018, as the rate of house price growth began to steadily slow down.

The Situation for Homebuyers

Business Insider ran an article that went through some examples of how rates would impact home-buyers on a limited budget.

Example 1: Household budget for mortgage payment is $1,200 a month. With a 30-year fixed rate mortgage:

  • At 3.5%, they can afford a $267,000 home.
  • At the current 4.86%, they have to slash their aspirations by $40,000 because the mortgage they can afford at a $1,200 payment drops to $227,000
  • At 6%, they have to climb down to a $200,000 home. They’re going from above the national median price ($250,000) to something at the lower end of the spectrum.

Example 2: Household budget for mortgage payment is $3,500 a month. With a 30-year fixed rate mortgage:

  • At 3.5%, they can afford a $779,000 home
  • At 4.86%, what they can afford drops by $117,000 to $662,000
  • At 6%, it drops by $195,000 from their original aspirations to $584,000.

Example 3, for cities like San Francisco, where this reflects the median home price: Household budget for mortgage payment is $6,000 a month. With a 30-year fixed rate mortgage:

  • At 3.5%, they can afford a $1.336 million home – a decent two-bedroom condo.
  • At 4.86%, they have to lower their aspirations by $200,000 to $1.136 million.
  • At 6%, they have to slash their original aspirations by $336,000 to $1.0 million.

Home owners are used to the ultra-low rates from the past decade, but if mortgage rates pushed to 5.5-6%, we may start to see house prices under pressure as people are priced out.

That’s why the applications number climbing is good news. But is that likely to continue?

To answer that, we need to dive into mortgage-backed securities and the Federal Reserve.

What is a Mortgage-Backed Security?

Mortgage-backed securities (MBS) are financial assets that are secured by a mortgage or a group of mortgages.

They can be packaged together by a bank or a government agency (such as Freddie Mac) and sold to investors, who make a profit on the interest rate.

To keep things basic, let’s say you take out a mortgage from a bank. The bank can then package your mortgage with a bunch of other mortgages and sell them on to an investor, with the bank acting as the middleman. The interest payments on the mortgage can then be passed onto the investor.

Prepayment Risk

One of the risks that are specific to mortgages is known as prepayment risk. This is because mortgage holders are allowed to pay off their mortgages early.

This tends to happen if interest rates fall, as people choose to refinance at a lower cost. This is what we’ve seen happening as rates have dropped, which is why mortgage applications have increased.

If a mortgage holder chooses to do this, it means the investor stops receiving their interest payments earlier than expected. Investors can hedge against this by using things like interest rate swaps, but this can intensify movements in long-term yields and create volatility.

On the flip-side to this, if interest rates go up then it means the mortgage holder is less likely to prepay. In this case, the investor is left with the same level of interest payments on the mortgage, while interest rates have actually gone up. This means the payments are of lower value in real terms.

With this in mind, investors demand a risk premium on top of the interest rates, which therefore means there are higher mortgage rates.

However, over the past decade, thanks to the Federal Reserve, this has not been the case.

The Federal Reserve’s use of MBS

Traditionally, the Federal Reserve will manage its monetary policy by changing the level of the Fed Funds Rate. This is the short-term interest rate that you are probably quite familiar with.

Changes in this rate would affect how households and firms allocate spending. A higher interest rate would encourage more saving and less borrowing, while lower interest rates would have the opposite effect.

Certain sectors in the economy will respond differently to these changes, such as the housing sector, which has historically been more responsive than the economy as a whole.

However, over the past decade, the Federal Reserve has used unconventional monetary policy and gone beyond simply moving interest rates.

One thing they have done is to purchase a huge amount of MBSs, worth almost $1.8 trillion (as of October 2017). This is equal to roughly 26% of all outstanding residential mortgage-backed securities.

During the 2008 financial crisis, the short-term Fed funds rate was dropped to 0.25%. By purchasing MBSs, they were also able to reduce longer-term interest rates, which would have an amplified effect.

As a result of this action, spending increased in the housing market and helped to prop it up when it was desperately needed.

The Federal Reserve intentionally targeted the housing market. They said:

“This action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.”

The Federal Reserve’s Impact on Mortgage Rates

Now, let’s go back to when we discussed the risk premium that investors need, which ultimately pushes up mortgage rates.

The Federal Reserve doesn’t actually need to hedge these risks. This means, since the Fed had been holding a substantial amount of MBSs, it had removed some of the prepayment risk premia from the market, along with the volatility.

Since then, the Fed has indicated that it will offload all the MBSs from their balance sheet, to avoid the central bank indirectly influencing the decisions of investors in the credit allocation process.

In November 2017, it began the process of unwinding its massive balance sheet, which at its peak was $4.5 trillion; a figure that had ballooned from roughly $800 billion before the 2008 financial crisis.

In one year, the Fed has shed $94 billion worth of MBSs from their balance sheet and, over the course of the next year, they could shed over double that number up to $220 billion.

Volatility and risk will be re-entering the market, with the risk premium pushing up mortgage rates.

For now, this all seems under control. However, if some of the factors mentioned in the MBA statement at the start of the article begin to reverse, we could see yields rising and mortgage rates rising with them. If those hit 5.5-6%, we could start to see homebuyers and home prices taking a hammering.