The Case for Stabilizing Housing Markets: Why the Fed Should Halt Mortgage-Backed Security Run-Offs

The U.S. housing market, a cornerstone of macroeconomic stability, faces a quiet but profound threat: the accelerating run-off of mortgage-backed securities (MBS). Over the past five years, as interest rates have fluctuated and prepayment behaviors shifted, the Federal Reserve's ability to manage this dynamic has become increasingly critical. The Fed's policy toolkit, once calibrated to address liquidity crises and inflationary pressures, now must contend with a structural challenge that could undermine housing affordability and broader financial stability.

The Mechanics of MBS Run-Offs and Their Macroeconomic Risks

Mortgage-backed securities, which pool thousands of home loans into tradable assets, remain central to the U.S. housing finance system. Over 60% of U.S. mortgages are repackaged as MBS, with agency-backed securities (Fannie Mae, Freddie Mac, and Ginnie Mae) dominating the marketMBS Dashboard - MBS Prices, Treasuries and Analysis^[1]. These instruments provide liquidity to lenders, enabling them to originate new mortgages while offering investors a steady stream of income. However, when homeowners refinance or sell properties—triggering principal repayments—investors face a “run-off” of capital. This process, while normal in a healthy market, becomes destabilizing when it accelerates rapidly.

The 2007–2008 financial crisis demonstrated the catastrophic risks of poorly underwritten MBS. Today's market, though regulated more stringently, remains vulnerable to systemic shocks. For instance, a surge in prepayments can reduce the supply of new MBS, tightening credit availability and driving up mortgage rates. This dynamic creates a feedback loop: higher rates discourage refinancing, slowing run-offs but also deterring home purchases, which could depress housing prices and trigger defaults. The Fed's ability to counteract these effects hinges on its capacity to manage MBS flows—a task it has historically addressed through quantitative easing (QE).

The Fed's Role in Stabilizing MBS Markets

During the 2008 crisis and the 2020 pandemic, the Fed injected trillions into the economy by purchasing MBS, ensuring liquidity and suppressing mortgage rates. These interventions stabilized the housing market but also created a dependency: investors now expect the Fed to act as a backstop during periods of stress. However, in the 2020s, the Fed has shifted toward tightening monetary policy, raising rates to combat inflation. This shift has led to a paradox: while higher rates reduce prepayment speeds, they also increase the risk of a sudden run-off if rates fall again.

The Fed's current strategy, which prioritizes inflation control over housing stability, overlooks a critical asymmetry. A rapid run-off of MBS could force investors to seek alternative fixed-income assets, driving up yields and pushing mortgage rates higher. This scenario would exacerbate housing affordability challenges, particularly for first-time buyers, and could reignite inflation by boosting construction costs. According to data from Mortgage News Daily, MBS prices have already shown volatility in response to prepayment forecasts, signaling investor uncertaintyMBS Dashboard - MBS Prices, Treasuries and Analysis^[1].

A Policy Framework for Stabilization

To mitigate these risks, the Fed should adopt a proactive approach to managing MBS run-offs. Three measures warrant consideration:

1. Targeted MBS Purchases: The Fed could resume limited QE-style purchases of agency MBS during periods of rapid run-off. This would stabilize investor demand, prevent a spike in mortgage rates, and ensure continued credit availability for homebuyers.

2. Prepayment Risk Hedging: The Fed could collaborate with GSEs to develop hedging mechanisms that offset the impact of prepayment volatility on MBS investors. Such tools would reduce the need for emergency interventions and enhance market resilience.

3. Forward Guidance on MBS Policy: Clear communication about the Fed's willingness to act as a buyer of last resort for MBS would anchor investor expectations, reducing panic-driven sell-offs and stabilizing the housing market.

These steps align with the Fed's dual mandate of price stability and maximum employment. A destabilized housing market risks spillovers into the broader economy, from reduced consumer spending to higher unemployment in construction and related sectors. By stabilizing MBS flows, the Fed can preserve housing affordability while maintaining its inflation-fighting credibility.

Conclusion

The housing market is not an isolated sector but a linchpin of macroeconomic health. Mortgage-backed securities, though often overlooked, are a critical conduit for liquidity and stability. The Fed's current focus on inflation, while necessary, must not come at the expense of long-term housing market resilience. Halting destabilizing MBS run-offs is not a policy of complacency but of foresight—a recognition that the tools of the past remain relevant in an uncertain future.