Fed Losing Battle to keep Mortgage Rates Low?

Mortgage rates spike almost 1% in just over two weeks, what’s going on?

June 6, 2009 -- DETROIT, MI – One of the government’s stated goals this year is to stabilize the housing market. The thinking is that a long as home values continue to fall, homeowners will lack confidence in the economy and in response, won’t spend money.

To stop home values from falling, the number of foreclosures must be curtailed. One of the ways the government has been trying to curtail foreclosures is by keeping mortgage rates low. Low rates allows homeowners to refinance and lower their payments, so they don’t let their homes go to foreclosure and makes buying homes more affordable, so it increases homes sales to absorb the homes that have been foreclosed on.

Recent events might have put a damper on those plans. The chart below shows the price of Mortgage Backed Securities (MBS) over the last three months. Keep in mind that the price is the opposite, or inverse, of interest rates. The higher the price of the MBS, the lower the corresponding interest rate. To keep it simple, “green” is a good day for mortgage rates on the chart and “red” is a bad day. (MBS are sold by FNMA and FHLMC to fund their purchases of mortgages from banks and brokers)

Starting May 21st the chart shows four bad days in a row, culminating in one of the worst days for mortgage rates ever on May 26th. Intermixed with attempts to rally, mortgage rates have continued to worsen since then. Rates haven’t been this high since late November 2008.


What caused the sudden spike in mortgage rates?

To answer that, we have to go back a bit to look at why they were so low to begin with.

At the end of 2008, there was a lot of doom and gloom on Wall Street about the economy due to the bankruptcy of Lehman Brothers, the forced sale of Merrill Lynch, and the federal bailouts of AIG, Goldman Sachs, Morgan Stanley and a slew of banks deemed too big to fail.

In response, money flowed away from high-risk to low-risk investments. U.S. Treasuries and MBS are considered fairly low-risk, so prices on them were bid up, lowering interest rates.

On top of that, the Federal Reserve announced in early December that it was buying up to $500 billion in MBS over the next several months to lower mortgage rates even further. In mid March this figure was increased to $1.25 trillion.

The result of these two factors was the lowest mortgage rates in over 50 years.


Nothing Lasts Forever

Recent positive news on the economy now has Wall Street investors thinking that the worst recession in memory, may be ending. Over the last two weeks, economic reports are showing signs that unemployment, housing and consumer confidence may be stabilizing. The key word there is, “may”. The stock markets though, have responded to this news by increasing, pulling money away from the MBS market and causing rates to rise.

So, has the government’s stimulus working to lift us out of the recession? Will a turn around in the economy lead to lower unemployment, higher wages and housing prices, making rising mortgage rates a minor issue?

The chart below compares several recessions to our current one. The chart shows that historically, recessions tend to last around 30 months, a tad longer than the 20 months we’ve experienced in the current one.


The term, “Bear Market Rally, is used on Wall Street to describe a false rally in the stock markets, that’s followed by further downturn. The chart below shows that during the Great Depression, there were six bear market rally’s that were followed by the market dropping to new lows.


Is the current stock market rally something similar and we have several months to go until we see a true end to the recession?

What about the Fed’s $1.25 trillion allocated to buy MBS to keep mortgage rates low? So far, they’ve only used about $370 billion of that total, so there’s a lot left that could be used to attempt to drive mortgage rates back down. The problem is, that may not work much longer.

The game only works to lower mortgage rates when Wall Street investors play along. There’s growing concern on Wall Street that the amount of borrowing by the federal government to fund all the economic plans, including the Federal Reserve, is simply becoming a game of “borrowing from Peter to pay Paul” and vice versa.

Figure 2 shows that when the federal government borrowers too much to fund its stimulus packages, the effect of the stimulus funds loses steam. So, throwing more money at the economy doesn’t help.


Our concern is that the same rules may apply to the Federal Reserve’s game on mortgage rates. The markets may have arrived at the point where even if the Federal Reserve increases its purchases of MBS, mortgage rates may not respond and go lower.


Summary

I wish I had a crystal ball and could accurately predict what mortgage rates are going to do. We’re in this economic mess because people way smarter than I, thought they had a good grasp on the financial markets.

It is my opinion (only) that we’ll soon find out if this is all a bear market rally or not. If it is, we’ll see the stock market drop and rates will improve. I don’t think we’ll see the same recent lows though, unless there’s major bad news on the horizon.

On the other hand, if this is the end of the current recession, than better days are ahead for the economy and all of us. Higher interest rates won’t be that big of an issue when sanity returns to the housing market and unemployment drops.