Last week The Fed unexpectedly dropped the discount rate by a full 3/4s of a point. Since then my phone has been ringing off the hook. The Fed is expected to cut rates again today, so my phone should keep ringing. This happens every time the Fed announces a rate cut. Most people assume that a change in the Fed rates will mean a change in the rates charged for mortgages. There is some truth to this, but it isn’t a direct connection. In fact, it’s not uncommon for mortgage rates to jump higher when the Fed lowers the rates. (Last week the market did both – dropping at the announcement, but moving sharply higher by the next day.)

So the question is, why does it work this way? The short answer is that the Fed (The Federal Open Market Committee) controls short term rates, and mortgages are priced based on the expectation of long term interest rates. The long answer is more complicated.

The Fed controls short term interest rates by setting the federal funds rate and the overnight lending rate. These set the rates that banks can borrow from the Federal Reserve Bank. The Fed uses these interest rates as a way to control the money supply, putting more money in circulation at lower rates when the economy is slowing down, and raising the rates to slow down the economy when it is growing too quickly. When the fed funds rate is lowered, this lowers the banks cost of funds, which quickly translates into their lowering the Prime Rate (the rate banks charge their “best customers” – it is set 3 points above the Fed Funds rate). So when the Fed cut rates last week, anyone who had a home equity loan just found a little more money in their pockets. The conventional wisdom is that the Fed will cut rates again today, so this will help even more.

These short term rates can stay the same for months at a time. By contrast, mortgage rates change every day, sometimes (like last week) they can change several times in the course of a single day. These rates are set more by supply and demand, the same way as the prices move up and down in the stock market. Traders buy and sell mortgaged backed securities, which are similar to long term bonds.

When a wholesale mortgage lender (the big banks we lock our loans with) locks in an interest rate, they hedge the lock by buying a future contract tied to that mortgage rate. By hedging they are locking in their profit. As long as the loan closes, it doesn’t matter if rates go up, or down, they are protected from loss. Most mortgage lenders price to the market, so interest rates for mortgages change based on what is happening in the market. The wholesale lenders send out their rates each morning. If the market changes by more than a minor amount, they will re-price, so anyone locking in their loan will be subject to the new pricing.

When traders buy or sell a mortgage backed security, they are looking into the future and trying to anticipate what is going to happen years down the road. Mortgages are usually based on a 30 year term, but the average loan will be paid off earlier as people either sell their homes or refinance. Traders are usually looking out 5-7 years in the future.

Mortgage rates are most affected by the threat of inflation and the strength of the economy overall. When inflation rises, prices are moving up so it takes more money to buy the same amount of a good or service. To a mortgage holder this means that the borrowers are paying them back in cheaper money. Because of this, they react strongly to any hint of inflation, sending mortgage rates higher.

When the economy is growing strongly, it is the Fed’s job to keep inflation under control. It does this by increasing short-term rates, which slow down demand and act as a brake on the economy. Generally when the economy is strong, prices tend to increase. So if there is good news for the economy, it is bad news for mortgage rates. On the other hand, bad economic news tends to make the rates go down.

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So back to where we are now. We’ve been hearing lots and lots of bad news about the economy over the last months. With the housing market down, consumers are strapped and less likely to spend. The credit crunch is not just with housing though, some of the biggest concerns are with the losses by the big banks and bond insurers, and that we still don’t know the full extent of the problem. On the other hand, inflation is still a problem. Oil is up close to $100 a barrel, and this affects the cost of everything. Lower rates can fuel inflation, which in turn causes the mortgage bond traders to worry about their positions. So mortgage rates have moved back and forth based on the perception of which is a worse problem now, inflation or recession. An added layer now, is whether the Fed knows something the rest of us don’t, and this is why they have been so aggressive, or if they are floundering with out a firm plan.

My experience is that, over time, mortgage rates move in the same direction as Fed policy. If the Fed is reacting to a true slow down, inflation isn’t as much of a concern. In a real slow down deflation is a bigger worry. Mortgage rates now are slightly higher than they were before the Fed cut rates last week, but for a short period rates dropped to their lowest point in years. Over the last week, with the announcement of the economic stimulus plan and a rescue plan for bond underwriters, we’ve had some news come out that moved mortgage rates higher.It may not last, but my guess is we will see some news break on the other side, and over the next few weeks I won’t be surprised if mortgage rates start falling again.

Illinois Mortgage Rates and News

Tags: how mortgage rates change, Illinois mortgage rates, mortgage backed securities

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