Fed Attacks Mortgage Rates: 4 Things to Know

New program aims to make home loans cheaper for prospective buyers.

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The Federal Reserve on Tuesday announced a new approach to stabilizing the housing market: driving down mortgage rates.

The effort is based on a two-pronged program that involves buying up to $100 billion in debt of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, while at the same time purchasing up to $500 billion of mortgage-backed securities backed by Fannie, Freddie and Ginnie Mae.

The initiative is intended to lower Fannie and Freddie’s financing costs, which will enable the government-controlled, mortgage-finance giants to pass along those savings to consumers in the form of lower interest rates.

Here’s what you need to know:

1. Wide Spreads With home prices continuing to decline and investors unsure as to the extent of the government’s support of Fannie and Freddie’s obligations, the mortgage finance giants have had to pay higher premiums on their debt. This increases their cost of funding and translates into more expensive interest rates for consumers. “Spreads of rates on GSE debt and on GSE-guaranteed mortgages have widened appreciably of late,” the Fed said in a statement announcing the initiative. “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.”

2. Half Point Cut So what will the actions mean for mortgage rates? Keith Gumbinger, of HSH Associates, says that the moves could bring fixed mortgage rates down by as much as a half point. “Having someone with hundreds of billions of dollars to buy these things--fresh money in the market--means rates should go down,” Gumbinger says. “It’s a direct pass through [to consumers], if their cost of funds goes down, down goes the cost of mortgage credit on the other side.”

3. Necessary, But Not Sufficient In a smoothly functioning housing market, such a significant drop in mortgage rates would have a profound impact on housing demand: more buyers would enter the market to take advantage of the lower rates, says Susan Wachter, a professor of real estate at the University of Pennsylvania's Wharton School of Business. But with home prices already having dropped more than 20 percent from their peaks and facing additional declines due to a weakening economy, higher job losses and fresh foreclosures, the results of this program may be more modest. ”The responsiveness that one would expect may very well not be there because the magnitude of the driving factors that are pulling the market down [is] just so large,” Wachter says.

4. Explicit Guarantee? Richard Moody, chief economist at Mission Residential, argues that the Fed’s actions aren’t the best way to stabilize Fannie and Freddie’s funding costs. Instead of relying on the government to purchase such assets, he argues that Uncle Sam should explicitly back Fannie and Freddie’s debt. “That way [the Fed is] not on the hook for these purchases like they are now,” he says. This step would reduce the risk of buying Fannie and Freddie’s debt and lower their costs of funding, Moody says.

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