What the Fed’s action means for you
The Federal Reserve on Wednesday stepped up its program to ease the nation’s credit crunch, this time targeting long-term interest rates, such as on mortgages and corporate bonds. Here is a look at the Fed’s plans, what the central bank hopes to accomplish and what it could mean for home buyers and for homeowners looking to refinance.
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What did the Fed announce?
The central bank committed to pumping another $1 trillion into the financial system, specifically to try to push down long-term interest rates, including on mortgages.
The Fed boosted its program to buy mortgage-backed securities issued by government agencies to $1.25 trillion from a previous promise of $500 billion. It also said it would spend $300 billion to buy longer-term U.S. Treasury securities.
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How would these purchases help cut interest rates?
The idea is to try to push up the value of mortgage bonds and Treasuries in the marketplace. As bond prices rise, the effect is to lower their “yields” (interest payments as a percentage of the bonds’ value). That, in turn, should mean that newly issued bonds also can pay less and still lure investors.
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Will it work?
It could. The Fed began buying mortgage-backed bonds at the start of this year, and is credited with helping to keep downward pressure on loan rates. The average 30-year mortgage rate was 4.89% last week, compared with 6.5% last fall, according to the Mortgage Bankers Assn.
Direct purchases of Treasuries would add more firepower to the Fed’s efforts on interest rates, because Treasury bond yields are benchmarks for other long-term rates, including on corporate bonds.
What’s more, the Fed would be stepping into the Treasury market at a time when the government is borrowing record sums to fund the economic-stimulus program and the financial-system rescue. The Fed’s presence could help allay concerns that the Treasury could have trouble borrowing what it needs.
Still, the Fed can only influence longer-term rates, not control them. Investors have to play along.
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Is the Fed basically creating money out of thin air?
Yes. The Fed has virtually unlimited power to create credit in the financial system.
“It is in effect printing more money,” said Ethan Harris, an economist at Barclays Capital in New York.
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Is that risky?
In normal times, Harris said, using the Fed to buy the government’s own bonds “would be an abomination.” But in this deep recession, and with credit still tight as the banking system struggles with a mountain of bad loans, the Fed’s supporters say it is simply filling the gap left by private lenders and investors that have pulled back.
Longer-term, the risk is that the Fed is creating a massive amount of money in the financial system that could eventually flood into the real economy, fueling a surge in inflation -- a classic case of “too much money chasing too few goods or services.”
But Fed officials, including Chairman Ben S. Bernanke, have said they will be ready to drain money out of the system -- and thereby reduce the risk of higher inflation -- as soon as the economy is on solid footing.
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How did financial markets react to the Fed’s announcement?
The news had the desired effect: Treasury bond yields tumbled, with the yield on the 10-year Treasury note sliding to a seven-week low of 2.53% from 3% on Tuesday. Stocks rallied on optimism that the Fed’s programs could speed a recovery in the housing market and in the broader economy.
But worries about the long-term effect on inflation drove the dollar’s value lower against other currencies.
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What about the reaction in the mortgage market?
Some mortgage brokers were quoting 30-year loan rates in the 4.5% to 4.75% range after the Fed’s announcement, not including upfront fees, or “points.” Jeff Lazerson, head of mortgagegrader.com in Laguna Niguel, said he was able to offer a rate of 4.63%.
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How low could rates go?
Barclays’ Harris said his firm figures that the Fed’s new commitment to damping long-term rates could bring home loan rates down about a half-percentage-point in the next few weeks or so, compared with last week’s national average of 4.89%. That could mean rates below 4.5%.
Still, the Fed can only succeed in keeping rates down if investors are willing to buy mortgage and Treasury securities at the same yields the central bank is willing to accept.
“The risk in driving down [Treasury] yields is that investors might still choose not to buy riskier assets,” said Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, N.Y. “We simply don’t know how this will play out, because there is no prior experience to use as a route map.”
Also, one question is whether mortgage lenders will pass along the full effect of lower rates to borrowers -- as opposed to fattening their own profit by keeping rates elevated, particularly on loans that are too big to be sold to government agencies such as Fannie Mae and Freddie Mac.
“Lenders are making really big margins right now” on home loans, Lazerson said.
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What has been happening with refinancing activity?
Even before the Fed’s announcement Wednesday, more homeowners had been stepping up to refinance in recent weeks as mortgage rates have drifted lower.
The Mortgage Bankers Assn. said its index of refinancing activity nationwide jumped 30% last week from the previous week, to the highest level since mid-January.
As a share of total mortgage activity, refis accounted for 73% of loan applications last week, up from 68% the previous week.
Mortgage market experts warned that a new wave of refinancing activity could vex homeowners who are trying to get through to banks or mortgage brokers. The severe shrinkage of the mortgage industry over the last two years has left the business short of capacity to handle a crush of loan requests.
The Obama administration hopes to further stoke refinancing activity with its Making Home Affordable program. The plan will allow qualified homeowners to refi loans held by Fannie Mae or Freddie Mac for a maximum loan-to-value ratio of 105% -- in other words, for 5% more than their home is worth.
But lower mortgage rates won’t benefit homeowners whose current loans are so much larger than the value of their house that no lender will be willing to refinance them.
For the housing market, “that is the longer-term issue the government still has to address,” said Scott Simon, a bond fund manager at Pacific Investment Management Co., or Pimco, in Newport Beach.
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