The Fed's Mortgage Muddle

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The Fed could rein in yields with any indication that it plans to take a lot more Treasury paper out of the system via debt purchases, but that's not likely, says Kim Rupert, managing director of fixed-income analysis at Action Economics. It's very difficult for the central bank to keep a handle on long-term interest rates since they're determined by other factors besides the amount of Treasury debt the Fed is buying.

Refinancing Activity Takes a Hit

Even if there weren't other factors, "it's a losing proposition for the Fed to try to fight an upsurge in yields via Treasury purchases" since its purchases can't keep pace with the $30 billion to $40 billion in new paper the Treasury is issuing each month to pay for the economic stimulus, Rupert says. The ultimate impact of all the stimulus is a very large inflation threat, she adds.

Although over the long run the Fed certainly wants to reduce the mortgage market's reliance on the Fed's purchasing of mortgages, in the near term it can afford to increase its mortgage purchases in order to keep rates from going higher, says Zelman.

One worrisome sign, notes Zelman: She's heard the hike in the 30-year fixed-rate mortgage to 5.50% has crippled refinancing activity. Deterioration in home values has caused many owners to lose equity to the point where they would only have positive equity in their homes if they got a rate between 4.5% or 4.875%. Rising rates appear to have boosted new home purchases, however, by pulling in people who were sitting on the fence since they're increasingly afraid of missing the window of opportunity to secure a relatively low rate.

Fannie Mae and Freddie Mac have been watching mortgages on their books decline in recent months to a combined balance of around $800 billion. Since their combined ceiling is $900 billion, the government-sponsored enterprises have the capacity to buy up to $100 billion in additional mortgage securities, which would help lower mortgage rates, says Zelman.

Persisting Depreciation, Foreclosure Worries

There are also ways to bring the effective mortgage rate down, such as the Obama Administration's tax credit of up to $8,000 for first-time home buyers, says Zandi. Anyone who hasn't owned a home in the past three years is eligible for the credit as long as their income isn't above a certain threshold. While the tax credit is slated to expire on Dec. 1, there are efforts to raise the limit to $15,000 and make it available to all home buyers, he says.

Higher mortgage rates in general are likely to exacerbate depreciation in home values, says Matthew Howlett, an analyst who covers the mortgage insurers at Fox-Pitt, Kelton Cochran Carolia Waller in New York. He expects home prices to fall an additional 15% to 20% over the next 18 months based on current mortgage rates and thinks they'll probably decline further if rates go up, causing more people to default on their mortgages.

Mortgage rates would also rise for people who can't afford to make at least a 20% down payment on homes they're buying if companies such as PMI Group (PMI) and MGIC Investment Corp. (MTG), which provide mortgage insurance, were to fail. While rising default rates and claims are making it more difficult for mortgage insurers to maintain adequate levels of capital and liquidity, Howlett doesn't believe any of them are in imminent danger of failing.

The insurers are depending on the moderate success of the mortgage modifications the Obama Administration is subsidizing in order to keep people in their homes. The Administration is targeting the prevention of 3 million to 4 million foreclosures. Any further downtrend in housing prices would hurt the chances of those modifications, says Howlett.

Mounting delinquencies of Alt-A mortgages—which are riskier than prime mortgages—will likely turn into defaults, creating a "tsunami of foreclosures" that will put the housing market under even more pressure, says Zelman. And it will be much harder to get those mortgages modified since they've been securitized and are in the hands of investors instead of the banks, she adds.

That Feedback Loop Again

Right now, the fear in the bond market is that even though the federal budget deficit is likely to moderate as the economy revives, the budget gap might stay around $800 billion for the next decade, says Rupert at Action Economics. The faster the economy can grow, the more the government will be able to boost tax revenues, and the lower the deficit will be. "For the moment, the working assumption is massive deficits as far as the eye can see, and I think that's going to be a problem for the bond market," she says.

And in classic feedback loop fashion, additional problems for the bond market will spell even more pain for the mortgage market.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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