Dennis' Mortgage Blog

Question of the week:  It’s time for a refresher course for many of us, can you please explain how mortgage rates are determined?

Answer:  This is a good week for our refresher on how mortgage rates come about since we have seen from last Wednesday to close Thursday the largest one week jump in mortgage rates since the first week of October 2008, when TARP was announced and $750 billion pledged to save the credit markets (my weekly update for 10/10/08 here ).  What causes mortgage rates to go up and down?  It is a very complex and complicated market, I will try to strip it down to basic principals and give an overview rather than detailed commentary:

Short version:  How are mortgage rates determined? By supply and demand setting prices, the higher the prices the lower the rates; demand is determined by investors expectations of what will happen in the economy in the future.  If investors think there will be inflation they will require a higher rate of return, demand will shrink and rates will go up.

Longer version (for those interested in the nitty-gritty.  For those who are not skip down further for rates and update):   Mortgages are like any other commodity or service, their price depends on supply, demand and competition (I will leave government intervention out of the equation for ease of understanding—though it is significant).  When a mortgage is funded for a homeowner the lender has an investment, the value of the investment is determined by the rate of return, or interest, collected.  Lenders, for the most part, do not keep their mortgages but rather bundle them into huge pools of $25 million or $50 million worth of mortgages and sell them to Fannie Mae or Freddie Mac for conventional mortgages, or Ginnie Mae for FHA or VA mortgages.

By selling the mortgages the lender reloads on cash, which they then use to fund more mortgages.  Fannie/Freddie/Ginnie meanwhile take the bundled mortgages and invite investors to participate by selling what are known as Mortgage Backed Securities (MBS).  The MBS has a stated rate of return and investors purchase the securities as they would a stock or United States Treasury Bill.  The more investors that want to purchase MBS at a certain rate of return the higher the price for MBS, the fewer investors that want to purchase MBS the lower the price. 

It is important to note here that the higher the price on bond type investments which pay consistent rates of return in interest, like mortgages, the higher the price the lower the yield or interest rate; conversely lower prices mean higher rates.  Like any investment or commodity or service, low prices attract more buyers, more buyers means increased demand, increased demand leads to higher prices—higher prices mean lower rates.

Bond investors and MBS investors tend to be the same group looking for the same result: guaranteed rate of return fixed for a long period of time.  I invest $10 million today in a MBS with a rate of return of 5% for the next 30 years, granted most of that will be paid off as mortgages pay off, but I am committed to locking up my investment for a long period of time.  So to invest in bonds or mortgages one is looking for a steady long term return on the investment and the money is not subject to the daily ups and downs of the markets.

So what drives the demand for the MBS market? Like any other investment those putting in their money desire a return, they are willing to forego some profit for the stability of the investment, but like any investor they put their money in depending on their best guess as to what will happen in the future and how they can maximize their return. If you are convinced that Dennis Corp is going to lose its business in December you would not buy stock in October; conversely if you are convinced Dennis Corp is going to bust out with growth and income in January and the market for the stock has been flat you would buy up shares looking for a nice profit once the company does what you expect.  Bond investors look long term and try to determine what will be happening in the economy and therefore the returns they are getting for their investments.  Based on their estimates they determine how much they are willing to pay for MBS.

Bond investors hate inflation.  Inflation erodes the value of the dollar in the future, a dollar today is worth only ninety-five cents in one year if there is 5% inflation.  Inflation erodes the purchasing power of your paycheck and the purchasing power of your savings.  If you save $100 to purchase a Nintendo for your child at Christmas and inflation raises the price of the toy to $105 you do not have enough money saved due to inflation.

If you are invested in bonds with a 5% rate of return and inflation is at 5% your effective return on investment will be zero—the funds you earn will be worth less due to inflation eroding the purchasing power of the interest revenue.  So if a bond investor thinks there will be inflation in the future he will require a greater yield, or return, on the investment to ensure inflation will not wipe out his investment gains. 

This past week we had the head of the biggest investment company talking about inflation and degrading the bond ratings for U.S. Treasury bills, we had a major investor on Bloomberg saying he felt inflation in the United States would be “Zimbabwe-like” (over 200%), and we had the U.S. Government dumping several hundred billion dollars of treasury bonds onto the market.

The first two events created perception and anticipation of inflation, causing bond investors to demand a higher return on any investments—which pushes rates higher.  The third event by the Treasury flooding the market with bonds created an excess of supply to demand; whenever supply exceeds demand prices must drop; as stated at the beginning of this missive prices drop and rates go up.

Have a question for me?  Ask me!   

Against the backdrop of the four previous days of rising rates we have seen prices climb on MBS today—which you just learned means rates drop.  As I write this just before noon on Friday we have gained back almost three-quarters of Wednesday’s losses, a huge comeback in a short time frame. 

I rarely say this, given the technical aspects of the Mortgage Backed Securities market I look to float any locks into early next week to see if we can greater gains in rates.  We’ll see if last Wednesday signaled the end of the  bottom or if we will see rates get back down to below 4.75% on conventional mortgages.

Rates jumped this week—Wednesday was the biggest one day move in several months, and the four day trading period of last Thursday, Friday, Tuesday (market closed for Memorial Day Monday) and Wednesday was the biggest four day sell off I can remember.  It was nice to see some profit taking hit the market yesterday and more investing today in MBS.  Monday should be interesting!  If I had posted the rates for today on opening they would read a lot differently than they do now—good market day!

FIXED RATE MORTGAGES AT COST OF 1 POINT*

30 year conventional  5.00%                 UP 0.125%

30 year conforming-jumbo 5.5%                       UP 0.125%

30 year FHA    5.375%                                    UP 0.125%

30 year FHA jumbo 6.00%                              NEW Quote added!

Please note that rates quoted are based on average of several lenders for a purchase transaction with 20% down payment and a minimum FICO score of 740; APR is not quoted as it is dependent upon specific loan amounts, lenders and services selected.  Numbers provided are for comparative purposes only.

We are around all weekend doing normal activities, if you need my assistance please call and if you miss me I will get back to you as soon as I can.

Have a great weekend,

Dennis

Remember this update is posted weekly on My Blog at www.DennisCSmith.com ; feel free to forward the link to family and friends who may be interested in past commentaries.