Academic

Mortgage Rates

By Gordon Smith, Christine, Hurt, Vic Fleischer, Fred Tung, Lisa Fairfax, David Zaring

Mortgage rates just keep falling, but we could see bigger drops in the very near future. Here is the theory about why even the current low rates are higher than they could be in a few months:

When the equity markets are performing well, they create competition against mortgage backed securities and funds. Investors are always looking for the highest yield (return) possible, so when other options are available, they tell mortgage buyers Fannie and Freddie that unless they offer some higher-yield options, they are moving to bonds or stocks. So those mortgage buyers then require higher yield loans from the issuing banks and lenders (those who originally sold you the loan) and rates rise.

Conversely, when the market expects the Fed to lower rates, they start snatching up bonds quickly while higher interest rates are still available. That drives up demand and allows banks to lower rates. And if the stock market is performing poorly, investors look for mortgage backed investments as an alternative, again, pushing mortgage rates down.

What's happening now?

This is what should be happening now, right? The equities markets are uncertain and volatile, and the Fed continues to lower rates, driving up present demand for bonds and mortgage backed investments, thus pushing mortgage rates lower.

But it isn't happening the way it should. Investors are avoiding mortgage-backed investments and while are low, they certainly aren't as low as they should be considering the factors in the market and history.

There are many factors at play, but two are most obvious. The first is that there is a major black mark on mortgage investments right now. Even with equities sliding and fear of more Fed cuts, investors are putting a high risk premium on mortgage backed investments and won't invest unless the rates are higher. The banks won't lower the rates because their investors are basically saying they won't buy them. So rates stay higher to try to attract investors.

And the second factor only compounds the first, and that's that the lenders aren't opening the coffers. They got burned big-time on risky loans, and now they are being more selective, and are likely hoarding liquid assets, namely cash.

The Fed announced in November that it would buy up to $100 billion in debt issued by Fannie Mae, Freddie Mac and the Federal Home Loan Banks, but yesterday it said that it will attempt to buy $500 billion in mortgage-backed securities by the middle of 2009.

Yikes!

The aggressiveness of the Fed's action has some people thinking that rates in the middle of next year could be down in the 4.0-4.5 range. So here I sit, having started the process of refinancing my 6.25% mortgage two weeks ago and wondering if it's asking too much to hope for rates to dip down to the high 4s in the next two weeks ...

Full post as published by Conglomerate on December 31, 2008 (boomark / email).