The case for lower interest rates

Casey Fleming

Mortgage rates are about to take a nice little turn down.  You heard it here first.I am often asked how  mortgage interest rates are set.  I hear this question all the time, and you’d be quite surprised at the answer.  It turns out that there is a huge table with dozens of interest rates randomly written on it.  Each morning the Federal Reserve gives a mouse a cup of coffee, then releases it on the board.  The mouse runs around like a maniac until it passes out from exhaustion.  Wherever it lands, that’s the interest rate for the day.

OK, I made that up but it makes about as much sense as reality.  Let me explain.

If you look at figure one you’ll see that the mortgage market is a fairly complex system of getting your rich Uncle Bob and Aunt Sue to lend you money to buy a house.  There are several paths through the system, but they all amount to essentially the same thing.  Moving down the graphic and “up” the money chain it looks like this:

The Mortgage Market

You go to a mortgage loan originator (MLO for short) to get a mortgage.  The mortgage is approved by a mortgage banker, who may be a separate company from the MLO or not.  The mortgage banker underwrites and funds the loan, packages it with other loans, and sells it to a mortgage investor, such as Fannie Mae and Freddie Mac.  The mortgage banker often retains the servicing of the mortgage, meaning that you continue to make the payments to XYZ Mortgage even if Fannie Mae owns the loan.

The mortgage investor will then issue bonds called mortgage-backed securities, backed by a huge pool of mortgage loans, and use the payments received from you (the borrower) to pay back the bonds.  These bonds are then typically bought by large institutional investors who want to invest a portion of their portfolio in a fixed-income, guaranteed investment backed by real collateral.  These institutional investors usually have large mutual funds that they use to buy these bonds.  Those funds are purchased by their clients – your rich Uncle Bob and Aunt Sue.

You can see there are lots of middlemen and you suspect that none of them work for free.  You would be right.  They get paid in two ways: fees collected along the way, and a profit margin created when there is a difference between the interest rate you pay on your mortgage and the interest rate Uncle Bob and Aunt Sue earn on their investment.

Now we’re getting somewhere.  Uncle Bob and Aunt Sue need to earn a certain yield in order for them to choose to invest, so that’s where it all starts – what do Uncle Bob and Aunt Sue want to make on their investment?  In one way or another, a little bit has to be added to that yield by every middleman.

We can’t measure what everyone’s Uncle Bob and Aunt Sue want to make, but we can measure something called mortgage-backed security yields.  This is the current market yield, or interest rate, demanded by the buyers of the mortgage-backed securities.  (Two steps up from Bob and Sue.)   The yield (interest rate) on these securities has moved down unsteadily over the last 20 years.  In the last year it has been driven down even further primarily by the U.S. government, by way of the Federal Reserve, buying large quantities of MBS’s – currently about $45 billion per month.

By jumping in to compete with other investors, the Fed has driven down the yield on the securities, hoping to drive down mortgage rates.  By driving down mortgage rates the Fed hopes to free up cash flow for the average consumer, encourage spending, and stimulate the economy.  It’s a good plan.

So have mortgage rates moved down as a result?  Remember how we said that there is a spread between the yields on mortgage-backed securities and your mortgage rate?  The difference in this rate provides the profits for all the middlemen in the transaction.  If the yield on mortgage-backed securities goes down then the interest rates on mortgages should go down, too.  Right?

Here’s where the plan falls apart a bit.   Lenders – think all the middlemen – were told that business in 2012 would be down by 20% or so from 2011.  Consequently, they reduced staff.  Then the Feds started trying to prod the economy, interest rates went lower than expected, and lenders were swamped with loan applications.  If you were Macy’s, say, and there was a line outside your door of folks clamoring to get in to buy your stuff, would you put it on sale?

Of course not.

You would have your staff work very hard, and take the extra profit.  Why have a sale when you can’t handle the business you have?

Historic yield spread
Lenders are keeping the spread today

So how did this work out in the mortgage industry?   Well, historically the spread between the yields on mortgage-backed securities and mortgage rates was about 0.500%.  Wherever MBS yields were running, the mortgage interest rate you see should be about 0.500% higher.  Today, however, the spread has increased to over 1.000%.  So, while MBS yields are running in the low 2% range, mortgage interest rates are running in the low 3% range (for 30 year fixed, conforming loans.)  Lenders – all the middlemen – are making about twice what they would in a “normal” market.

Because business was so much greater than expected in 2012 there was no reason for all the middlemen to reduce their margins.  But with a small blip upward in rates starting at the beginning of the year applications have fallen off dramatically.  Lenders are catching up, and turn times are back to near normal.  If this holds – and most folks in the know think it will – competition should drive interest rates down very soon as the spread compresses.

Barring anything unusual happening in the international market, look for interest rates to drop by 0.250% or more in March.

If not, go talk to Uncle Bob and Aunt Sue.  Maybe you can cut out all the middlemen.

If anyone you know is looking to refinance or purchase a home, please pass this on.  If I’m right I’m brilliant and you should let them know.  If I’m wrong I don’t know anything and you should let them know.

I help families in California make informed decisions and get the best possible financing for their circumstances.  I am based in Silicon Valley.

Casey Fleming, Mortgage Advisor

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