Government Tries to Drive Down Mortgage Rates

Because investors are afraid to buy mortgage backed securities (MBS) or mortgage bonds, the Fed is using taxpayer money to buy large amounts of those financial instruments. By doing so, it hopes to lower the price of retail mortgage rates to help Americans buy or refinance homes.

The Federal Reserve recently continued its buying spree of mortgage backed securities or MBS products, purchasing another $30 billion worth. That was the biggest one-week MBS investment made by the Fed since it announced an emergency program of aggressively snapping up mortgage bonds in an effort to force mortgage rates to go down. Mortgage rates at the retail level-those that affect the monthly payments for homeowners wanting to buy a house or refinance an existing mortgage-are already historically low, but the threat of inflation could send them higher. By intervening as a major buyer at MBS auctions, the Fed is trying to prop up demand that sagged when most investors fled from the risky mortgage bond market.

Saving the MBS market

Securitized mortgages are divided up, packaged together, parceled out, and "sliced and diced" in almost countless ways. Then, they're sold to people around the globe who divide them up even more and sell them again. That makes them nearly impossible to accurately appraise, because nobody knows exactly what kinds of mortgages are contained within each diversified MBS bundle. As long as MBS investment products contain bad mortgages, their value remains questionable, and prudent investors shy away from them. Based on recent experience, these savvy investors know that many of these MBS investments are infected with so-called assets that turn out to be completely worthless. The MBS market, which was once frenzied with activity due to an insatiable global demand, is now so dead that the Fed has to prop it up by buying the bad apples that nobody else wants.

Will the Fed succeed?

Fed purchases so far have totaled $190 billion, or about one third of the $500 billion worth of mortgage bonds that it announced it will buy under an emergency plan launched in November 2008. A surge in home refinances would translate into early repayment of many of those mortgage bonds, which would bolster mortgage investor confidence. If the buyback succeeds in driving down rates, that will be good news for taxpayers, average consumers, institutional investors, mortgage lenders, and the Fed.

Currently, 30-year fixed mortgage rates are hovering around 5 percent, compared to levels of about 6.5 percent back in October, which was right before the Fed started its MBS buying spree. That's evidence that the strategy is working; but whether or not it's a sustainable plan remains to be seen. Eventually, private investors must return to play the vital role now being artificially occupied by the Fed. Otherwise, the forced demand generated by spending American tax dollars to buy mortgage bonds will have the negative effect of causing inflation, and that could send mortgage rates soaring into the stratosphere.