So many parts of the American dream depend on a strong credit system. The average U.S. citizen relies on a functioning credit system to approve loans for important milestones like their first car or home. Someone familiar with economics or building an investment portfolio might have an idea about how it all works. But, likely, most of the people who depend on a stable lending environment don’t really understand what goes into it.
There are various factors that play into how the U.S. economy and credit system function, but one of the best places to start is the Federal Reserve and mortgage interest rates.
What Is The Fed And Does It Set Mortgage Interest Rates?
While it has a long title, the Federal Reserve System is simply the name for the central bank of the United States. It’s heavily involved in how our economy functions. By monitoring financial institutions and implementing certain measures, it protects our financial system’s general stability. “The Fed” makes decisions that influence important credit markets, like mortgages and auto loans; however, it can’t dictate the loans that your lender or bank charge you.
What Is The Federal Reserve?
The Federal Reserve’s overall purpose is to help the U.S. economy run smoothly and protect public interest. Sometimes referred to as “the Fed,” it can be broken down into three entities: The Federal Reserve Board of Governors, 12 regional banks, and the Federal Open Market Committee (FOMC).
What Is Interest?
When you take out a loan for things like a car or a house, you owe your lender for using their money to make that purchase. Interest is a percentage of the principal balance you borrowed, and you pay it back, along with that original amount, over a period of time. How high that percentage is and how often you pay it depends on the agreement you made with your lender.
How Does The Fed Influence Interest Rates?
Through the FOMC, the U.S. government is able to influence interest rates, but it can’t directly control them. This hybrid system is unique to the U.S. and sways consumer interest rates like those for credit cards or deposits.
What Tools Does The Fed Use To Affect Interest Rates?
The Fed has two main tools at its disposal: The Fed funds rate and quantitative easing (QE). The Fed is currently interested in stabilizing the job market.
The Fed Funds Rate
The Fed funds rate, also known as the federal funds rate, federal interest rate, and the federal reserve rate, is the interest banks are charged when borrowing unsecured loans overnight. Its goal is to help control inflation, support high employment, and moderate interest rates.
The second tool is quantitative easing (QE), which essentially describes the Fed’s move into the bond market when it buys securities and assets to help maintain credit at low-interest rates. Buying those securities puts money back into the economy as well.
What Is Agency MBS?
Agency MBS, or mortgage-backed securities, are bundles of mortgages packaged together and sold as a single security. They are sold by either the Government National Mortgage Association (GNMA or Ginnie Mae), Federal National Mortgage (FNMA or Fannie Mae), or Federal Home Loan Mortgage Corp. (Freddie Mac). The Fed uses them as an intervention measure, helping rates stay low and keep credit flowing.
The GSEs: Meet Fannie Mae And Freddie Mac
GSEs are government-sponsored enterprises that are privately held, and they’re financial service corporations made by the U.S. Congress. Fannie Mae and Freddie Mac are two of these entities. Their overall purpose is to buy mortgages from lenders, which ensures liquidity.
Fannie Mae was founded in 1938 to improve the housing market’s flow of credit. To do this, it buys loans from large commercial banks. Then they turn it into an MBS to sell to mortgage investors.
Freddie Mac was founded in 1970 with the same intent. However, while it purchases loans from banks, it only buys from smaller lenders.
Why Is Liquidity Important To The Mortgage Industry?
Owning a home is an important pillar of the American dream. That fact reflects in the culture and the U.S.’s annual GDP. According to the National Association of Home Builders (NAHB), the housing industry’s combined contribution to the GDP averages between 15% – 18%. That includes residential investment, which is construction, remodeling, building homes, and brokers’ fees, and consumption spending. Consumption spending contributes more to the GDP at 12% –13% (versus residential investment’s 3% – 5%) and entails the utility payments of both renters and owners, as well as their respective gross and imputed rents.
The residential investment area provides widespread employment for many individuals. Those involved in construction, design, brokerages, and other elements of the housing sphere all contribute to it.
What Do GSEs Do With Our Mortgages?
GSE’s do not provide loans to the public directly. Instead, each GSE guarantees to purchases a specific type of loan in certain amounts, which in this case is qualified mortgages. They then bundle those mortgages together and sell them back as mortgage-backed securities (MBS) to other investors on the secondary market, commonly referred to as the “stock market.” This helps provide money to the lenders the mortgages were bought from, who can then use those funds to provide credit.
How Does The Fed Shore Up Agency MBS?
After the 2008 recession, the Fed stepped in to mitigate the effects of the financial crisis. To do so, it created a $1.25 trillion program which allowed it to buy agency MBS, beginning in 2009 and ending the year after in 2010. Its goal was to flood the financial system with liquidity using qualitative easing (QE), supporting the banks and GSEs themselves.
Recently, the Fed has once again been purchasing $40 billion worth of agency MBS to help the economy and the housing market in particular. It’s had to take up the practice as a result of COVID-19’s influence on the market. In effect, the measure helps the market maintain low rates and affordable housing.
One of the Fed’s target areas is the bond market. By buying up a lot of any bond, the yield or rate of return drops in response since it doesn’t need to attract a new buyer. Someone is already invested in purchasing it.
How Does The Bond Market Affect Your Mortgage?
The Fed has to help support the housing sector since it’s a significant contributor to the economy. So, it employs its quantitative easing measure wherein it enters the bond market as a buyer.
What Is The Bond Market?
Broadly speaking, the bond market is a marketplace for investors to investors to buy and sell debt securities, notably bonds. Corporations or governments may issue these bonds. They can influence the economy by shifting interest and mortgage rates.
Who Buys Bonds?
Two groups purchase bonds: risk-averse investors and the U.S. government. Certain bonds, particularly government bonds, are low-risk since they’re highly rated, which appeals to cautious investors. In contrast, the U.S. government buys them to add money into the economy and influence interest rates.
The Secret Life Of Mortgages
It is all these moving parts that help individuals purchase homes and those buying any MBS. The interest rates you see are the result of a complicated process on the Fed’s part that involves prediction and action. Without the Fed’s promise to protect lenders during the pandemic, any individual home buyer might not have access to mortgage financing in 2020.
More than that, protecting the ability to purchase MBS ensures supplementary, secure income to bond holders, often retirees.
The Bottom Line: All The Pieces Matter
Overall, the Federal Reserve is fundamental to how the U.S. and its markets function. It’s one of the strongest tools in America’s kit to help manage inflation, stabilize a volatile economy, and support those in need of loans. Rather than giving credit where it’s due, it’s more important to walk away understanding the system that influences some of your biggest milestones. You can keep learning about the mortgage market to better prepare yourself for whatever the future may bring.