What Happens when Uncle Sam stops buying mortgages???

Currently, 85% of new mortgages are guaranteed by Government backed entities( FHA, FNMA, GNMA, Freddie Mac) and the Fed buys 80% of the securities into which these government backed mortgages are packaged. This dominance of the Fed and the reliance upon the Government to fund mortgages can not last forever. The Federal Reserve’s $1.25 trillion special program to buy Fannie Mae and Freddie Mac securities is two-thirds complete and is scheduled to close at the end of the year. What happens then???

More than half of the country’s home mortgages are now being originated by only 3 banks; Wells Fargo, Banik of America, and J.P. Morgan Chase. The problem is that these banks are acting only as originators of mortgages, and immediately sell most of the mortgages that they create to Fannie Mae and Freddie Mac and hold very few of them on their own balance sheets. Combined, the 3 dominant banks actually held 3.5 % fewer mortgages on their balance sheets in the firs half of 2009. (note: the statistics for this post came from a wall street journal article U.S. Bets the House – WSJ.com )

This strategy of the banks to sell almost all of their mortgages has fed their bottom line with strong loan origination and mortgage servicing fees with very little risk. The fact that banks are unwilling to hold mortgages for their own investment demonstrates that the interest rates of these mortgages are artificially low , driven down by the government purchase of them, and the banks are thus unwilling to invest their own money in them.

When the government stops funding mortgages, where will the capital come from? In the recent past, capital for mortgages came from mortgage backed securities funded by investors through Wall Street. This type of security is now dead. Investment by private capital ( banks, individual investors, and pension funds ) will only happen if interest rates are allowed to increase to a level to compensate investors for the perceived risk in these investments.

Because of this, I believe that there is a very real risk of interest rates escalating substantially after the first of the year, especially if signs of inflation start to emerge as the economy strengthens. Because of this, I have been encouraging buyers to buy now, if they are buying a home for the long term, as this may be the best time in the foreseeable future to buy a home.