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In a prior article, I described why I believe the Federal Reserve needs to begin tapering the MBS portion of QE. A significant number of economists and pundits are now claiming that tapering is imminent. Private sector lenders now appear to be more willing to step in and provide funding to maintain the mortgage market. It is important to keep in mind Bernanke's statement that Fed tapering will be reactive in nature, and the Case-Shiller home price index can be used as a predictor of what the Fed will do with the MBS side of the portfolio. Claims that MBS purchases have created a monster, and that we're headed for another real estate bubble are largely overblown.

The MBS portion of QE was intended to help revive the mortgage market in the U.S. Following the real estate melt-down, many investors were hesitant about purchasing Mortgage Backed Securities. This was problematic for mortgage originators because the lending system in the U.S. had evolved to one where mortgages were bundled and securitized, then sold to investors. Without buyers for mortgage backed investment products, banks were largely incapable of offering new mortgages, as many had already liquidated staff and resources necessary to hold and manage these assets. The MBS portion of QE increased liquidity in the mortgage market, making it easier for banks to originate new loans. As soon as it became apparent that home values had bottomed out in most markets, many REIT investors jumped into the market, eager to snap up low cost properties before all of the best deals had disappeared. This seems to have stabilized the residential home market, and - despite a recent sell-off in REIT shares - it appears overly pessimistic to assume that a pullback in Fed MBS purchases will spark a significant decline in home values. Private sector ventures such as a new lending arm created by Blackstone Investment Group will help to support real estate market liquidity needs as the Fed pulls back.

It is important to keep in mind Bernanke's statement that Fed policy will be data-driven, and reactive in nature. For the MBS portion of QE, one can look at the Case-Shiller Home Price Indices as a clue to what the Fed will do at its next meeting. The ideal outcome would be for banks that have deposits sitting at the Fed earning 0.25% interest should withdraw some of those funds and use them to purchase Mortgage Backed Securities. This will become more likely as mortgage interest rates rise, and they will rise somewhat, but that's okay as even with recent increases over fears of Fed tapering, 30-year fixed rates are still well below what they were in the 80s and 90s. In order to maintain sustainability the rate of increase in home prices will have to slow a bit, but not fall below a certain minimum threshold. It's likely the Fed will set a target similar to the 2% target it used for inflation, and that as long as the rate of increase in home values does not fall below that 2% target it can continue to taper the MBS portion of QE.

Home prices will never reach the ridiculous and unsustainable peaks seen during the real estate bubble. Many younger people feel the need to maintain geographic mobility for the sake of pursuing job prospects, and are not interested in tying themselves down to a single area. Corporate outsourcing policies mean that anyone who reaches the point where they can afford to buy a home also knows they've reached the point where they've become a prime target for corporate cost-cutting. Buying a home is seen by many as the height of foolishness for a younger person, and something that's only really practical once you're retired. This means that REITs play a larger role in home ownership in the U.S., and there will eventually come a point where a majority of the homes in the U.S. are owned by property management firms. REIT purchases are managed by Real Estate professionals who weigh every purchase against the potential for Return on Investment. This creates an upward cap on property values, which are directly tied to local rental rates, and rental rates will be determined by the ability of an area to provide jobs for young and middle-aged workers. As REIT ownership and management of properties grows, the potential for a disconnect between property values, and the earning potential of local residents diminishes.

Tapering of the MBS portion of QE appears imminent. The Fed stepped in with MBS purchases to try to revive the housing market, and to revive investors' taste in real estate, and that strategy appears to have worked. The Fed has assured the public that its policy will be data-driven and reactive in nature, and one should not be surprised if the Fed sets a target much like it does with inflation, and tapers MBS purchases so long as the rise in home values does not fall below that target figure. Fears of another real estate bubble related to Fed MBS purchases are not founded, due to a change in how young people view real estate, and the increased influence of REITs on the real estate market. Looking forward one should listen for suggestions from Fed chairmen regarding how a drawdown in QE will be managed, and keep an eye on the Case-Shiller home price index as a clue to what will happen to the MBS portion of QE.

Source: Case-Shiller May Cue Fed Tapering