Bernie Germani posted this on WannaNetwork.com, and I thought that is was well written and extremely informative. It goes hand in hand with the Mortgage Pricing Updates that I write on here every day. Take a look, and let me know what you think:
I received this from a friend today. I tweaked it tad bit
This is a very simplified discussion of a very complex topic. Discussion of the intricate relationships involved, and many important factors market structures, hedging, advance commitments, and others are not here.What makes rates rise, or fall? Is it the Fed? The economy? Inflation? The banks? The President? Fannie Mae or Freddie Mac? Is it a secret conspiracy?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 advisor’s 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.
If 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 home-buyer, 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.
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 as 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.
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 the current 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 a low of 4.22% to 5.01% over a three-week period — about 80 basis points, altogether. At the same time, the average 30-year fixed mortgage rate rose from about 6.59% to 7.21%, a rise of only 62 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.
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.
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.
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.
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 can indeed have indirect effects.
Contrary to popular myth, the Fed doesn’t control mortgage rates. 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 & a fixed-rate mortgage is all the way at the other end of the scale, a loan that lasts as long as 30 years.
The Fed raises or lowers interest rates to help address increases or decreases in economic activity. Lower rates can help banks to make certain kinds of loans more cheaply, especially for business and certain kinds of consumer lending, and that can help to generate greater economic growth. Higher rates can cool demand, helping to keep inflationary pressures from forming.
In some ways, expectations of what the Fed might do can be more important than what the Fed actually does, as their actions or inactions can help to confirm or deny what investors believe.
You may also have noticed that sometimes the Fed cuts interest rates — and fixed mortgage rates actually rise as a result. Why? If the Fed is taking steps to address economic weakness by lowering rates, that likely means that a return to faster growth & possible higher inflation, as well is coming sooner, rather than later.
So what moves mortgage rates? Supply. Demand. Competition for money. Inflation. The Economy. Expectations. And you, of course.
I hope that this helps you understand a little better how the whole thing works. Or you might say wow I’m totally confused now….hahaha I know I was for quite a long time. I would suggest to get a grasp on this, is to listen to Barry Habib speak, get all the material you can from him, and this will help improve your fiscal literacy.
Again, I hope that this helps people better understand that measures and suggestions that I provide throughout the day. If you have questions or comments, please post them! I look forward to it!
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