Understanding the Effect of Ending the Fed’s Shopping Spree

Jessica Lanning

The Federal Open Market Committee is the group of folks who run the Federal Reserve Board.  The press often refers to this group of people as the “Fed.”  It is ultimately responsible for regulating the money supply in the United States.  When Fannie Mae and Freddie Mac (the two government sponsored entities, now government owned and run) started to report financial problems with their mortgage holdings, the Fed decided to buy their mortgage-backed securities.  This put money back into Fannie and Freddie so that they could function and continue doing loans.  This was done with the idea that it would support the American public.  The Fed has decided that on March 31, 2010 it would stop buying those securities.

What does this mean and why do you care?

Warning:  Remember, this is a blog.  The goal here is to present the big picture on sometimes complicated subjects. By design, I oversimplify.

First, it will likely mean higher rates.  Mortgage-backed securities have bond-like quality.  They sell with a price (what they cost) and a yield (what they earn).  The law of supply and demand drives price and yield.  Sorry to haunt you with Economics 101. If prices are high, the yield goes down (which generally drives people to sell).  If prices are low, yield is high (driving people to buy).  If the Fed stops buying those securities and there is no other buyer, prices will drop to attract those buyers, yields will go up as a result, and those yields are directly correlated to mortgage interest rates, which means—you guessed it—that interest rates on mortgages have to go up as well.  Got it?

Second, understand that just a few years ago, the Fed owned no MBSs.  None.  By March, it will own $1.5 trillion.  Trillion with a T.  This means that $1.5T is now in the marketplace.  Too much money in the marketplace can mean greater inflation (too much money chasing the same amount of goods).  Now, so far, we haven’t seen greater inflation.  It’s the Fed’s job to keep that in check.  Someone also has to pay for these purchases, meaning that the American taxpayer is likely going to have to pony up money to cover it.  That may mean higher taxes—higher income taxes, higher capital gains taxes, and the list goes on.

We can’t predict the future, but we can do our best to anticipate what might be coming around the blind curves in the road.  This might be a good time to consider refinancing into that 30-year fixed-rate loan if you haven’t already.  This might be a good time to consider a loan modification.  This might be a good time to consider retirements and education funding plans that provide a tax-free component.

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