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The questions are simple enough: What's going on with mortgage rates?
What makes them rise, or fall? Is it the Fed? The economy? Inflation?
The banks? The President? Fannie Mae or Freddie Mac? Is it a secret
conspiracy?
The answer is that rates are moved by a number of related factors, and
believe it or not, you -- Joe or Jane Consumer -- are one of those
factors.
Mortgage money can come from many sources, including deposits at banks
and brokerages, but most comes from investors through what is
collectively known as the "capital markets." This is where investors
interested in purchasing certain kinds of debt instruments -- bonds, in
this case -- come to buy these items.
In order to attract investors, sellers of bonds must compete with one
another to get their money. They do this by offering a variety of "
instruments" (also called "product") with differing structures of risk
and return over given periods of time. These offerings compete with
other investments which are reasonably similar in performance, such as
US Treasuries, corporate bonds, foreign bonds, and others.
Who are these investors, and why are they so fickle? Mostly, they're
people like you, and you want two opposing things: low payments on your
debt, especially your mortgage, and high returns on your investments.
You (or your investment advisors or fund managers) will only buy so many
low- yielding bonds (mortgage or otherwise), because you'll take your
money elsewhere if your returns are too low.
Investor demand for a given kind of investment plays a considerable role
in moving market yields, because investors have literally hundreds of
places to put their money. It's a crowded marketplace, with many sellers
of various product competing for those investor dollars. Investor demand
for specific product rises and falls with changes in investment
strategies; if demand falls enough, a change needs to be made to attract
investors again. How to attract them again? Usually, by raising interest
rates.
Of course, it's not as easy or simple as that. Mortgage market makers
serve not one client, but two: investors, who want the highest possible
return on their investments, and the homeowner or homebuyer, who wants
the lowest possible interest rate. Simultaneously, rates need to be high
enough to attract investors but low enough to attract borrowers. It's
quite a complex dance; investors, though, make the music.
As interest rates (yields) decline, investment customers can become more
or less interested, depending upon the direction of economic growth,
inflation, appetite for the given product, and several other factors.
Typically, though, the lower those rates get, the fewer investors are
interested in putting them on their books.
In the case of financial instruments like bonds, things get a little
more complicated. Bonds have an interest rate (yield), a dollar amount
(face) and a current price (price).
A very simple explanation -- which leaves out a number of very important
factors -- would be as follows:
Let's say, for example, that you want to sell a $1,000 (face) bond with
a yield of 6%. And let's say that it's a good deal, so ten investors
start offering you more than the $1,000 you want. They bid the price up
to $1,010 -- $1,020 -- $1,030. In effect, that increase in price is
actually borrowing from the interest which the bond will return. Because
some of the interest is gone, the actual return to the investor is no
longer 6%, but something less than that. When demand for a given bond is
strong, prices rise to the seller, and the return to the investor
(yield) declines.
Conversely, when demand for a given bond is weak, the price falls. For
example, you might have to sell that $1,000 for only $980; and the
return to the investor (yield) rises, since the buyer not only gets all
the interest on $1,000, but also got a discount on his purchase price.
The principle to remember is this: as a bond price rises, its yield
falls, and vice-versa.
Relationships to Other Investments
Mortgages are priced for sale to attract investors who seek fixed income
investments. There are many kinds of bonds available, and mortgage rates
(yields) rise and fall with those competing investments to a greater or
lesser degree.
But how to price them? Fixed mortgage rates, like other bonds, track US
Treasury bonds quite well. Since Treasury obligations are backed by the
"full faith and credit" of the United States, they are the benchmark for
many other bonds.
There is no specific "lockstep" relationship between Treasuries of any
term and fixed mortgage rates. Given enough data points, a relationship
could be established against many different financial instruments.
However, as a 30-year fixed rate mortgage rarely lasts longer than about
10 years before being paid off or refinanced, the closest instrument
which has similar (though lesser) risks is the ten-year Treasury
Constant Maturity. Because of this, the ten-year year Treasury makes an
excellent tool to track mortgage rates.
Here's an oversimplification of the relationships of mortgages to
Treasuries:
As we mentioned, intermediate term bonds and long-term mortgages (more
properly, Mortgage-Backed Securities, or MBS) compete for the same
fixed-income investor dollar. Treasury issues are 100% guaranteed to be
repaid, but mortgages are not; therefore mortgages carry more risk of
default or early repayment, which could potentially disturb the return
on the investment. Therefore, mortgage rates must be priced higher to
compensate for that risk.
But how much higher are mortgages priced? In a normal market, the
average "spread" or markup above the 100% secured Treasury is about 170
basis points, or 1.7%. That markup -- the spread relationship -- widens
and contracts with a range of market conditions, investor appetites and
supply of available product -- as well as the presence of competing
investment opportunities, like corporate bonds or domestic (or foreign)
equity markets. Professional money managers, and investment and
retirement funds constantly strive to obtain high-yielding instruments
at a given level of risk. Money shuffles from place to place in search
of this -- from bond to bond, and market to market.
As we mentioned, the relationship isn't a fixed one, but one that
changes with market conditions. Recently, for example, ten-year
Treasuries rose from of 3.30% to 3.94% over a period of a few months --
about 64 basis points, altogether. At the same time, the the average
overall 30-year fixed mortgage rate rose from about 5.29% to 5.41%, a
rise of only 12 basis points. Over time, there are any number of
examples where Treasury yields have risen faster than mortgage rates, as
well as times when mortgage rates rose faster than Treasury yields.
Consequently, the spread between the two expands and narrows
appreciably, which is why you can't simply take the ten-year yield, add
1.7% to it and know exactly what today's rate is. It goes without saying
that these 'spread' relationships vary by mortgage product and also by
whether a loan will be held in a lender's portfolio or sold to other
entities.
An update, in light of more recent market events
All of the above text assumes for the most part that we are in a fairly
normal marketplace. It goes without saying that mortgage and bond
markets have been far from normal in recent years.
It may be some time until we return to normal mortgage markets, fully
free of extraordinary efforts by government, and where private-market
investor needs shape the marketplace. That said, we are starting to move
in that direction again.
A large influencing force in the mortgage market came to an end in April
2010, as the Federal Reserve finished its program of purchasing $1.25
Trillion in Mortgage-Backed Securities. Since the Fed not only bought
new production from Fannie Mae, Freddie Mac and Ginnie Mae (FHA-backed
loans) but also certain existing "agency" stock from investors, there
remains in the market some momentum from the program, as investors look
to re-fill holes in their portfolios with newly-issues, often better-
quality mortgage investments.
At the same time, some additional holes in investor portfolios were
created when Fannie Mae and Freddie Mac decided to re-acquire up to $200
Billion of previously-securitized-but-now-failing loans from investors,
an occurrence allowed under the terms of the guarantees which accompany
the MBS issued by these entities. Like a portion of the Fed program
above, retiring these holdings means that at least some new private-
market demand for newly-issues MBS should occur.
This increase in demand by investors for new MBS means that prices for
those MBS should remain fairly firm for a while, which in turn means
that low yields -- low mortgage rates -- should be with us for at least
a little while, too.
So there should be at least some demand for new securities. What about
supply... will new supply overwhelm the demand in the market? Probably
not, at least for a while. With home sales well below peak levels, and
even small flares in interest rates making sizable dents in the
refinance market, the number of new loans coming into these security
machines isn't all that strong, so there shouldn't need to be a cascade
of supply into the market. Better still, even if demand for MBS doesn't
remain constant, Fannie and Freddie have considerable space to balloon
their portfolios of loans (upstream of turning them into securities) and
so can release new MBS supply into the market at a measured pace, which
should also serve to stabilize prices, keeping rates level.
In a nutshell, the Fed may have stepped away from the mortgage market,
but there are now different mechanisms in place which should have much
of the same effect of keeping rates fairly low and steady, at least for
a time.
Other Factors
Then, there's the "unknown supply stream", aka "volume". Unlike many
other investment opportunities, no one really knows how many mortgages
will be originated, then made available for sale (as bonds) in a given
period of time. Recently, a quick drop in interest rates produced a
large buildup of loans to be sold to investors as homeowners rushed to
refinance. This made way too much bond supply available in too short a
time, and investors simply couldn't absorb it all at once. Too much
supply, not enough demand; prices had to go down, and yields had to go
up to attract investors.
Delays, Delays
There's also a time-lag for mortgage pricing. Though shorter than in
years past, it takes anywhere from several hours to several days for
increase or decreases to get from capital markets to wholesalers to
retailers to "the street" where loan originators are working with you.
Not all increases or decreases are passed along, either. Depending upon
the size of the change, rates may stay the same (but fees, such as
points, may change). Sometimes, a minor increase in bond yields in the
morning is followed by a minor decrease in the afternoon, while mortgage
rates remain the same all day.
Other Risks
There's also the impact of inflation, which affects both Treasury,
mortgage and other fixed-income investments. Rising inflation reduces
the actual return on a fixed interest rate investment, so with 2%
inflation, that 6% mortgage note returns only 4% "real" interest.
If inflation is expected to decline for the foreseeable future, you can
bet that mortgage rates have some room to fall. Conversely, an outlook
which suggests higher inflation ahead will see mortgage rates rise,
sometimes very quickly.
Also, a poor economic climate affects mortgages much more profoundly
than Treasuries. After all, the US government isn't likely to lose its
job and suddenly stop making payments, but it's a safe bet that a
percentage of homeowners will, even in good economic times.
There's much more to the structure or bond, mortgage and capital
markets, including government influences and overseas relationships to
our capital markets which can also have an effect, but the above should
be enough to give you a modest working knowledge of the market. You'll
notice that so far, we didn't mention the Fed at all. Fed moves have no
direct effect on fixed rate mortgage pricing, but their action or
inaction (and expectations thereof) can indeed have indirect effects.
The Fed's Role
Contrary to popular myth, the Fed (more properly, the Federal Reserve)
doesn't control mortgage rates. (For more on this, click here.) In fact,
their most well-known policy tool -- the Federal Funds rate -- is the
overnight interest rate which banks charge each other when a bank needs
to borrow money to meet end- of-day reserve requirements. Simply, those
rules say that a bank must have so much cash on hand when the books
close at the end of the day, and those funds can be borrowed from
another bank at this interest rate. You should know that the Fed merely
"suggests" what that rate should be, which is why it's called a "target"
rate; the actual rate is negotiated between the borrower bank and the
lender bank.
A good way to keep a handle on the Fed is to remember that the Fed Funds
rate is the shortest of short-term rates -- literally, an overnight loan |
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