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One of the most common questions that I hear is: “Why are interest rates rising?” The companion question is: “Do you think they will go back down?”
Interest rates reflect the ‘cost of money.’ High interest rates curb inflation, but slow down the economy. Low interest rates stimulate the economy, but can lead to inflation. Interest rates on mortgages are determined by mortgage bonds or mortgage backed securities (MBS). Normally MBS fluctuate in tandem with Treasury Bills, Notes and Bond yields, referred to simply as ‘Treasuries.’
Treasuries are sold in public auction to finance U.S. debt. They are considered one of the most secure investments in the world. Auctions of these notes attract capital from around the world from individuals seeking a safe, secure investment. Treasury yields and prices are inversely proportional. Higher yields equate to lower prices and vice versa. The prices investors will pay for a bond varies based on interest rates and perceived risk.
All rates are determined relative to real risk free market interest rates, assuming no inflation is expected. However, most interest rates are not risk free. Mortgage bonds and mortgage backed securities were considered ‘safe’ investments prior to the market collapse. However, the increase in risk associated with mortgage bonds over the last couple of years has caused divergence from a ‘normal’ yield curve.
There are several variables that impact what the money you invest NOW will be worth in the future:
The Business Cycle: When times are good, companies spend money to buy equipment, raw materials, and build inventories. As borrowers compete for investment capital, they drive up the cost of money (i.e. interest rates). When demand for capital is strong, banks raise the interest rates. To compete, the U.S. Treasury rates must also increase to attract capital. Normally bond rate increases and decreases move in tandem to fluctuations in business activity, though not always.
Flow of Funds: How much capital is flowing (supply) and how much demand for capital (future borrowing). By analyzing supply and demand, it may be possible to predict future interest rates.
Inflation: Interest rates increase with inflation. If you invest $1 today and you expect the value of a dollar to be worth less tomorrow, then you will want to be compensated for the loss on your initial investment via a higher return (interest rate). As the cost of goods and services increase due to inflation, financial institutions will increase interest rates to offset the decline in purchasing power.
Other risk factors that determine interest rates are:
Default Risk: A default premium is factored into the interest rate. It is based on the possibility that the entity borrowing money will be unable to pay it back. U.S. Government bills, notes and bonds have a low default risk premium, because the Federal Reserve can print money to pay for them. Subprime loans have a high default risk premium, because there is a higher probability that those borrowers will default on their loan than borrowers with stronger credit profiles and stable income.
Liquidity: If an investment cannot be converted into cash quickly, then it is considered ‘illiquid.’ The liquidity premium is based on the market demand for the type of debt (bond) held or issued. There is a considerable demand for U.S. Debt (bills, notes and bonds). When an investor wants to sell holdings of these securities, it is easy to find a buyer. If a bond is backing the debt of a small company, it may be more difficult to find willing buyers. This is referred to as an ‘illiquid’ security. When it is difficult to find a buyer for a security, the price is reduced to attract buyers.
Maturity: This compensates an investor for how long their money will be tied up in an investment. The longer the length of the bond contract, the longer the exposure to changing market conditions. Inflationary expectations may change or the ability of the debt issuer to service their loan may change. This is why the yield curve of U.S. bills, bonds and notes generally slope upward. The clarity of economic expectations defines the maturity premium.
The vast majority of mortgages that are sold in the U.S. are securitized. They are grouped in big pools of loans with similar interest rates and loan characteristics. The loan pools have specific cash flows associated with them based on the coupon (average interest rate) of the mortgages that make up (the collateral) the pool. When investors buy from a pool of mortgages, they know how much they will be paid and when.
Every morning lenders publish rate sheets, which are distributed to lenders, who then offer you an interest rate based on your loan parameters. Depending on when these rate sheets are generated, rates will either be better or worse based on the price the MBS are trading at when the rate sheets are generated. If the MBS is in demand and the price is increasing, rates will likely be lower compared to the previous day. If MBS coupons are being sold, the rate you are quoted will be higher than the previous day.
When economic conditions change, or one of the aforementioned premiums change, the MBS either gain or lose value. When the value of the MBS changes, the interest rate offered to consumers on purchases and refinances is impacted. If MBS prices increase and remain stable at higher levels, mortgage interest rates will move lower. When rates move lower, there may be incentive for you to refinance your home. When you do this you are paying off your old mortgage in favor of a new one at a lower interest rate, which restarts the securitization process. The loan servicer, money market fund or bank that invested in the pool of MBS, that your loan partially backs, has lost the cash flow that you contributed when you made your monthly payment.
This is the main difference between mortgages and other types of bonds, like the 10 year U.S. Treasury. An MBS investor knows how much cash flow they will receive and when they will receive it. They don't know how long the cash flow will last, because individuals have the ability to refinance their loan at any time. This option to refinance is called an ‘embedded call option.’ This additional risk associated with mortgages is referred to as prepayment risk. Prepayment risk creates uncertainty for MBS investors. It inhibits the ability of funds managers to accurately determine the present value of future income streams that are generated from pools of mortgages.
When interest rates are expected to decline, the pools of mortgages (MBS) that are backed by loans with higher rates will begin to lose value as rates decrease and borrowers refinance their loans. When a consumer refinances their loan, MBS investors lose the income stream they were anticipating. MBS investors are compelled to find a way to replace the lost future cash flow. If a group of MBS investors believes rates will go lower, then they may sell a portion of their higher interest rate MBS holdings in favor of lower rate pools to compensate for lost income. Investors believe they will receive stable cash flows for a longer period of time at the lower rate.
When lenders say prices of mortgage backed securities (MBS) are going up, it means the rate you are offered as a borrower will go down. In times of economic instability, forecasting the interest rate environment becomes challenging. The models used to determine the future value of cash flows generated by a pool of mortgages become inaccurate. This creates a volatile interest rate market.
When the Federal Reserve cuts the rates, consumers assume that mortgage rates will fall. However, the short-term discount rate has little impact on long-term mortgage rates. Why? The Feds lower the short-term discount rate to stimulate consumer spending on short-term credit, which affects credit card rates, some car loans and lines of credit. When investors spot a short-term investment opportunity, they bail out of the safe haven of bonds (or mortgage backed securities) and move their money into stocks. When this happens, it spurs a rally in the stock market and a sell-off of mortgage backed securities, both of which cause interest rates to rise.
Historically, when the Feds have made dramatic rate cuts, interest rates remain virtually unchanged. The Fed’s moves do have an indirect impact on home loan rates, but it is a delayed impact. When the Fed changes the Fed Funds rate, it can take 12-18 months for the effect of the change to permeate the economy. When interest rates increase, banks lend less and businesses delay expansion. The stock market vigilantly watches the monthly FOMC meetings looking for clues about future moves. A .25 point decrease in the rate will immediately send the market higher in jubilation, because it stimulates the economy. On the other hand, a .25 increase in the rate can send the market down, because it does not bode well for growth. Stock analysts pore over every word uttered by anyone in the Fed to try to ascertain what the Fed will do in the future. Currently rates are going up due to the massive federal deficit, the perception that the economy is stabilizing and fear of inflation. The market is anticipating imminent Fed increases to the short term rates.
The Fed has indicated that they intend to keep rates where they are for now. The housing market is still flailing. The Fed has frequently cited stabilization of the housing market as the key to economic recovery. The next Feds meeting is on June 23-24. To bring rates back down, the Fed would have to make an effort to purchase more treasuries, notes and bonds. That would add to the deficit and increase inflationary concerns.
I cannot predict interest rates. If I could, I would be having wine and tapas somewhere in Spain rather than writing this blog. Demand for lending has been high due to the lower rates, but tighter lending guidelines have constricted the flow of capital. With the prime set so low, inflationary pressures are likely to increase significantly in the coming months. I anticipate higher interest rates in response to inflationary pressure. Business activity is beginning to show signs of recovery, but Geithner is anticipating more job losses in the imminent future. Though interest rates may improve marginally from one day to the next, I am not an advocate of ‘floating’ rates at the moment. Interest rates will not go up every single day for the next three months. The market ebbs and flows. However any decrease, or lull, will be temporary. Interest rates under 5% are not sustainable.
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Comments
Mr. President why are the banking,and loan company not making loans as you promised they would do for the american people we are all hurting and not getting any help. Time for them to answer to you for not helping us the little people that keep them in business, maybe we should boycott their business. Check www.obamamortgage2009.blogspot.com/2009/03/obamas-mortgage-modification-do-you.html#comments
I own a condo and have an outstanding balance of $140k, consisting of $104k primary and $36k secondary. I took the home equity to consolidate debts. At the time the property was valued at $163k but now it is valued at $134k. I'm looking to sell because i am engaged and will be moving into my fiancee's home. Check www.obamamortgage2009.blogspot.com/2009/03/obamas-mortgage-modification-do-you.html If I have a buyer who offers me within say $5-7k of the outstanding, can i agree to assume a loan on the residual and pay the bank the difference over time with interest? The same bank holds both mortgages.
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