For the traders in the mortgage backed securities markets yesterday, it had to feel like the sky was falling. Mortgage backed securities lost over 200 ticks  today – a huge and ugly move – and over 300 points in the last week. Mortgage rates move up and down based on what is happening in the mortgage backed securities markets, so when mortgage bonds get blasted like they did today, mortgage rates pop up, too. Rates have risen sharply in the last week, and are now about ¾ of a point higher in rate then they were last week. So what happened to rile the market so much? Is the sky really falling and are the low mortgage rates gone for good?

For most of this year mortgage rates have been in a low, low range. There has been some volatility, but most of this year has been stable to the point of being predictable. The reason for the predictability is because the Federal reserve has made it their mission to drive mortgage rates down and keep them low. They initially committed $500 billion to buying mortgage backed securities, but when the market started to look past the Fed buying and worrying about what would happen when they left the market (after they had spent a fraction of what they had committed at the time) the Fed stepped in and raised the limit, throwing an additional $750 billion into the pot (for a total of $1.25 Trillion). The Fed has been the big gorilla in the market, and over the last months the market has been nearly as calm as glass. So what changed over the last week? Two things. Investors started worrying about all the debt that the country was taking on to pay for all the new spending, and bond guru Bill Gross, the head of bond giant Pimco, said that it was likely the US would be downgraded from its AAA credit rating.

Since Gross made this comment last Thursday, the markets have seen nothing but pain. But this was the same person who just a few months back was predicting that mortgage rates were headed down to 4.0% (the market liked those comments) and his firm is working with the government to make a market for some of the toxic mortgage bonds taken on as a result of bank bailouts. As Pimco has huge positions in bonds of all types, you wonder how his comments effected his own bottom line? This prediction is basically saying that the United States is now insolvent, so it doesn’t matter how much the Fed is willing to spend to keep rates low, because the Fed, and the US government, is now irrelevant and won’t be able to keep rates low no matter how much they try. Just the thought of this is scary and bond traders have responded with outright panic. Our financial picture does look grim, but I think it may be a little early to be writing any obituaries for the financial power of the United States (or for low mortgage rates for that matter).

The bond holders (mortgage backed securities are a type of bond) worry isn’t that the US won’t be able to pay the debts. The government has a printing press they can crank up at any time, so they will be able to pay. But if they print more money to do so that means the dollars are worth less (inflation) so the return goes down. We are taking on debt at an alarming rate, and inflation is a worry. But in the past, the times we’ve had the most inflation problems were boom times, when values were moving up. Right now we’ve had a huge loss of value in everything from home values to the stock market to most commodities. Unemployment is growing and according to the last Fed minutes, deflation is still a possibility. Foreign countries (think China) own a big part of our national debt, and if they see us as insolvent they are likely to pull their money out and invest elsewhere. But where else can they go? Europe is in worse shape than we are, and as bad a hit as we have taken, the United States is still the largest economy in the world by a big margin. Our economy is also the biggest consumer for Chinese goods, so as much as they might like to disengage and pull away from us with their debt, this would cost their economy more. There is an old saying that if you owe the bank a few thousand dollars you have a problem; if you owe them a million dollars, the bank has a problem. Add a whole lot more zeros to that and you have the Chinese (and other foreign investors) view of our current situation. We are all intertwined, and like it or not, they have a vested interest in our success.

We’ve seen meltdowns like this in the past, and after the initial panic buyers start coming back in to the market. The Fed still has a lot of money to invest in mortgage bonds, and their goal is still to keep rates low. With most of the sellers already out of the market, their buying will have a bigger impact. The Fed, and the Obama administration, will have to address the investor’s fears in some way and I would guess that there are high level meetings about this going on now. No one knows what will happen in the future, but I wouldn’t be surprised to see rates drop back down close to their prior range over the next few weeks. If you didn’t pull the trigger on a refinance, the best rates are now gone. But you may still get another crack at them later. If rates drop again, be prepared to act.

(Update: As I am finishing this post, mortgage bonds are already starting to rally and making up some of yesterday’s losses.)

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