What happens to house prices when the Fed stops buying MBS?

By Felix Salmon
February 26, 2010
Paul Smalera asks what's going to happen to mortgage rates after March 31, when the Fed has said that it will stop buying mortgage-backed securities. The answer, predictably, is that they're going up:

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Paul Smalera asks what’s going to happen to mortgage rates after March 31, when the Fed has said that it will stop buying mortgage-backed securities. The answer, predictably, is that they’re going up:

Lawrence Yun, chief economist for the National Association of Realtors (NAR), says 30-year fixed rates are “rock bottom” and simply cannot stay at 5 percent. That much, economists, analysts, and the Fed all agree on. But just how high they’ll get is another question.

Fed Vice Chairman Donald Kohn told a conference last month that any increase in rates is likely to be “modest” but added “that judgment is subject to considerable uncertainty.” Yun believes 30-year fixed rates will probably end up jumping to about 5.7 percent by year’s end. Freddie Mac, which issues many of the MBS being bought by the Fed, said in late December that rates would hit 6 percent by the end of 2010, sending a shock through the market… Bill Gross, head of Pimco, one of the largest and earliest private investors in mortgage-backed securities, believes that due to a rising interest rate environment in general, mortgage rates could settle anywhere between 6 to 6.5 percent, but admits at this point he’s simply making an educated guess.

What does this mean for house prices? Let’s say I have an $80,000 income and a $20,000 downpayment. According to this calculator, at 5% mortgage rates I can afford $279,075 of house. At 6%, that figure drops to $257,780 — a 7.6% fall. And at 6.5%, it’s $248,034 — a drop of more than 11%. And that’s assuming that I have no car or credit-card payments to make.

The government and the Federal Reserve can’t artificially prop up house prices indefinitely, of course. But it’s a fair guess, especially in light of this morning’s gruesome home-sales data, that a combination of falling demand and rising interest rates is going to translate into lower prices and even more negative equity than we have at the moment.

Throwing money at the problem will alter the amount of time it takes to finally arrive at a market-clearing, private-sector-generated level of house prices. But there’s little doubt that such a level is well below where we are right now. Which is yet another reason not to buy, at least for the time being.

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