Fear of COVID-19 has gripped everyone across the globe. All we hear around us are dire predictions of the time to come, especially in the near-term. With us being in the middle of a crisis, optimistic stories are hard to come by.
The truth is that we are in uncharted territory. Never before in the history of the modern world has the economy come to a sudden standstill like this — as if someone just slammed the brakes on the free-flowing world economy. All of a sudden, people are not going to work, not buying much, not traveling much. Not doing much of anything. Except, stay at home and wait-and-watch on what health practitioners and the policy makers advise them to do next.
Are things that bad?
We do not know how this crisis will pan out over time. This one seems more than a minor bump in the grand scheme of things, especially because there is little precedent of something like this. Unlike the economic crisis of the past few decades, which were borne out of greed and irrationality, this one’s a result of something that wasn’t really something we as humans were in control of altogether. But given how resilient mankind has been in all its history, there is enough reason to believe that we’ll come out of this fine. In other words, there is reason to stay optimistic.
What about the stock and the bond markets?
Not for the faint-of-the-heart, we would say. With many businesses having come to a stand-still all of a sudden, there is wide-spread panic. People are selling everything because the value of stocks and bonds on any given day is based on their promise of being able to generate cash-flows in the future. But all of a sudden, that future isn’t very certain and there is little clarity on what’s going to happen, at least in the short-term. That is leading to heavy losses in those markets. Not even assets such as gold and government bonds, which people flock to in times of a crisis, are being spared. ‘Red’ is all you see when you go to any finance website.
Why are the US government bonds, deemed as one of the safest assets, losing value?
US government bonds are losing value not because the government doesn’t have the ability to pay the money back to its bond-holders. Through the Federal Reserve Bank, also known as The Fed, the government can just print money at any time and pay off their debt. Instead, the primary reason they are losing value is because the Congress is trying to pass a big spending bill whereby it’ll use all its power to help businesses and individuals during this time of grave economic stress – Lend money to businesses and send money to people directly to help them survive the crisis period. For that, they need that money first. The government will go out and borrow first by issuing bonds and then use that borrowed money to help businesses and citizens. The problem is that this large issuance of bonds will increase the supply of government bonds in the market significantly, thereby causing a fall in prices in anticipation of that issuance that’s forthcoming.
What is the role of the Federal Reserve in times like this?
The goal of the Fed is to maintain employment, keep the economic machinery intact (as much as possible) and to support the financial system at large. With such a large supply of government bonds coming up and investors rushing for exits, there will be far fewer buyers of these bonds than usual. So who will lend the money to the government? Well, that’s where the Fed comes in. Fed can just print dollars and buy up these bonds. The government can then take this money and help anyone they plan to, through loans and direct remittances.The goal of the Fed is to maintain employment, keep the economic machinery intact (as much as possible) and to support the financial system at large Click To Tweet
What’s going on in the Mortgage Market?
With widespread unemployment expected in the next few months, more and more people are expected to not be able to make their monthly mortgage payments. With a higher rate of default expected, at least in the near-term, banks and other investors aren’t willing to lend money to people at the same rates as were before the crisis hit. The risk they take when lending money today has gone up, so they are asking people to pay a higher interest rate in times like these to help them cover their risk. That has led the mortgage rates higher in the last couple of weeks to levels not seen in a few years.
Why are higher Mortgage rates a cause for concern?
The real estate industry comprises over 13% of the US GDP. With such a large fraction of the economy dependent on housing, if rates rise, people will buy less due to in-affordability, leading to substantial job loss in real estate that employs over 1.5 million people – from material manufacturers to suppliers and from construction workers to brokers. To keep those jobs intact, the Fed wants to ensure that mortgage rates remain in control and low enough so people can continue to afford homes and the real estate industry stays afloat.
The way the mortgage market works is that once a bank makes a loan to an individual to buy a home, the bank sells off the loan to Government Sponsored Enterprises (GSEs) such as Fannie Mae and Freddie Mac. The GSEs then package these loans into a large pool of say, a thousand mortgages each, and sell them off as Mortgage-Backed-Securities (MBS) to investors who have large sums of money. The money that homebuyers pay every month ultimately flows to these investors and that’s how the banks can constantly make new loans without running out of money.
In a crisis like the one at hand, the prices of these MBS securities have also gone down significantly, just like government bonds. Why? Because there are fewer investors out there who have the ability to take excessive risk, esp. at a time when delinquencies are expected to go up. If investors stop buying these, the price of the MBS will be in free-fall and rates will climb rapidly because investors will demand more compensation for that additional risk.
How can the Fed play a role in the mortgage market?
To prevent massive job losses in the real estate industry, the Fed can stabilize the prices of the MBS. If MBS prices stabilize, investors will be willing to buy new mortgages because they know that the Fed will do anything to keep the prices of these securities afloat. That way, investors are less worried about losing significant money in their MBS investment and hence be willing to accept a lower rate of return for their investment. That way the mortgage rates can remain low enough for people to afford buying a home and keep many of the real estate jobs intact.If the Fed buys Mortgaged-Backed-Securities (MBS), they can support the functioning of the real estate sector and save a lot of jobs. And that is exactly what they are planning to do. Click To Tweet
To summarize, if the Fed buys MBS securities, they can save a lot of jobs. And that is exactly what they are planning to do. The Fed announced last week that they’ll be buying hundreds of billions of dollars worth of MBS in the coming weeks to bring the price of MBS back up so as to keep the mortgage origination going, thereby preventing excessive job loss.
What happens if and when mortgage rates go back down?
The goal of the Fed is to keep the real estate industry and related jobs afloat. The main effect of that is that new home buyers can continue to be able to afford to buy homes. An important side-effect of that turns out to be a blessing for existing home-buyers as well, those that have costlier mortgages where the rate of interest is high. It might be a great opportunity for such people to look into a possible refinance by lock in a lower rate today.
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