Fed Rate Cut - Good News?

WHY DON'T MORTGAGE RATES DROP WHEN THE FED CUTS?
This is a question I get time and time again. Clients will call our office excited about the recent rate cuts by the Fed only to find out that it had little to no impact on mortgage rates. In some cases, they are even surprised to learn that mortgage rates can actually increase when the Fed cuts rates. That's right, mortgage rates can and often do increase when the Fed makes a rate cut like those they have done recently.

To really understand how all of this plays out, take a few minutes to read this post. You may be surprised at the complexity of the financial markets and what role Wall Street plays in our everyday lives.

FED FUNDS RATE vs. MORTGAGE BACKED SECURITIES
It is important to realize that the Fed Funds rate and Mortgage Backed Securities are two totally different instruments. When the Fed cuts the Fed Funds rate they are essentially cutting the overnight lending rate that banks charge each other. This has absolutely nothing to do with home mortgage rates.

Home mortgage rates are set by the price Mortgage Backed Securities are able to get on Wall Street. In other words, Wall Street sells bonds to investors, the price investors are willing to pay for these bonds can fluctuate drastically like a stock price. The price investors pay will also dictate the required yield. In other words, the price an investor is willing to buy these bonds at will determine the rate you and I will pay for our mortgage. Again, this has nothing to do with the Fed funds rate.

SO WHAT DOES THE FED FUNDS RATE EFFECT?
The Fed Funds rate effects loans that are tied to a banks prime lending rate. As a banks cost of money decreases, so does the cost of money for it's customers who are borrowing under variable rate lending agreeements. The prime lending rate is often used for credit cards and home equity lines of credit. Clients with a home equity line of credit and/or credit card debt will notice that their interest rates will often times decrease with the prime lending rate. Clients with these types of debts will see an immediate impact from a Fed rate cut. Again, this has nothing to do with home mortgage rates.

DO MORTGAGE RATES DROP BEFORE A RATE CUT OR AFTER A RATE CUT?
The truth is that the market will trade in anticipation of what the market thinks the Fed is likely going to do with rates in general. Generally speaking, if the market feels that the economy is weak and that the Fed is likely to cut rates, we will see mortgage rates drift down in anticipation of a Fed rate cut. Not when the Fed cuts, but before it cuts.

Think of it this way, if you own stock in a company that is going to go bankrupt. Do you sell that stock before it announces it is going bankrupt or do you wait for them to go bankrupt? Like most people, you will sell before the news breaks. If you wait for them to go bankrupt, your investment is worth nothing. The same is true with bonds, should Wall Street expect a move down by the Fed, the market will price the likelihood of that move down into the rates and terms investors are willing to pay. In other words, the market prices based on what they anticipate happening.

In cases like today, the market for mortgage rates had already been moving down since the end of last week and the beginning of this week. When the Fed made it's announcement at 2:15 today, the market got a .75% rate cut when it was looking for a 1.0% rate cut. This was lower than what many had hoped for. Most importantly, the bond market stayed flat for around 30 minutes before bond yields (rates) shot up dramatically.

Mortgage rates started the day low. By 3pm, most lenders increased rates sharply due to the fact that Mortgage Backed Securities got hammered by afternoon selling. In other words, most lenders increased their mortgage rates by .25% in the course of less than 30 minutes after the Fed cut rates.

WHY DO MORTGAGE RATES GO UP AFTER A FED RATE CUT?
To answer that question today is simple, investors don't like the idea that inflation is still a factor. At the end of the day, inflation is bad for their bond investments and makes them worth even less. In those cases, investors pull back from mortgage bonds and the yield (rate) required to attract their money goes up. This means the rate you and I pay goes up as well.

SUPPLY AND DEMAND
The other area that has been a major issue for the market lately is supply vs. demand. There is a glut of mortgage paper on the market. There are few buyers of Mortgage Backed Securities as of recent. This has put supply and demand out of balance. Because investors are cautious about US Mortgage Backed Securities, they have been hesitant to invest in them. The best example of this is home prices.

In Michigan, we have seen home prices drop significantly. This has been the case as the number of buyers has decreased and the number of sellers has increased. This has caused prices to fall. The same is true with Mortgage Backed Securitites. Prices have fallen because the number of buyers is significantly lower than in the past. In order to attract bond buyers, the rates the bond pays must go up. This means the rate you and I pay must go up to attract the money.

SUMMARY
In the nearly 17 years I have done this for a living, I have never seen volatility in the market like we are seeing today. Mortgage rates saw a nice drop over the last two days only to rip saw back up by the end of the day today. We knew mortgage rates would see a short lived rally this morning and we were right on the money, it was indeed short lived.

It is important to understand that the Fed funds rate does not directly drive mortgage rates. More than one client has thought so, only to wait to lock their rate in and miss their window of opportunity all together. While I deal with mortgage backed securities on a daily basis and watch their prices in real time, even I would not begin to attempt to speculate on the direction of rates. Two things are for sure, rates will go up and they will go down. The question is when.

We will keep an eye on the market and post updates as warranted. We appreciate the support of all our clients. It is my hope that post such as these will help you to understand the complexity of the market.

One of America's Top 200 Lenders!

I wanted to take a moment to thank all of our clients and business partners for making me one of the Top 200 Mortgage Lenders in the US as ranked by Mortgage Originator Magazine. We were recognized for our market leading production for 2007 and this is the second time we have been featured on Mortgage Originator Magazine's Top 200 list.

I am grateful for your support and referrals that led to this honor. Without you our valued clients and business partners we never could have obtained such success.

Thank you for your support. I am grateful to serve such a wonderful group of people!