May 23rd, 2013 12:22 PM by Richard T. Cirelli
Why Did Mortgage Rates Spike Up?
On a day when rates were expected to fall, mortgage rates rose dramatically yesterday thanks to mixed signals from Fed Chairman Ben Bernanke. In a matter of moments, the stock market plunged 230 points and the price of Mortgage-Backed Securities shot up over 100 basis points which translates to about .25% in rate. Overnight, the overseas markets also fell hard. So, what happened, and why? And, how are mortgage rates affected?
How Rates are Determined
First of all, to understand the meaning, it’s important to first understand how mortgage rates are determined and why they have remained so low.
All lenders sell their conforming loan (loans less than $625,500 in high-priced markets such as Orange and LA counties) to the Federal Agencies known as Fannie Mae and Freddie Mac. These agencies then bundle the loans from various lenders creating Mortgage-Backed Securities (MBS). These MBS’s are then traded in the financial markets. As with any financial commodity, supply and demand dictate the price that an investor will pay.
When the financial collapsed several years ago, the Government needed to do something to restore stability to the mortgage and other financial markets. The private sector - hedge funds, pension funds, mutual funds and other entities that previous bought MBS’s – wouldn’t buy them anymore. MBS’s became practically worthless because the loans that comprised these MBS’s were not properly underwritten. The probability of default by the homeowners was high. At the same time, home values were dropping and many owners found themselves underwater.
QE1, QE2 & QE3:
In order to enable a mortgage market, the Federal Reserve created a program that came to be called “Quantitative Easing “ or “QE” to drive rates lower and enable homebuyers to finance and refinance homes. Essentially, the Government will buy as many MBS’s at whatever interest rate the market dictates and for as much supply as lenders can originate and sell. The program has worked well since implemented in December, 2008. In fact, it has been extended twice and we are now in third round known as QE3.
What Happens when the Program Ends?
The Fed has vowed to continue to the program until the economy improves. And, that’s exactly what is happening. When the Government stops buying MBS’s, the private sector will have to buy them again and to do so, the private sector will demand higher rates. So yesterday, Bernanke spoke and his mixed signals sent shockwaves through the markets as both Stocks and Bonds plunged. Mr. Bernanke's text read that QE will not be halted. But when the Q&A session began, he did say that if the economic environment improves, the MBS purchases could be tapered by the next Fed meeting. Although the Fed has a dual mandate of maximum employment and price stability - they have a responsibility to provide clarity, maintain calm and do their best not to roil the financial markets. Yesterday's mixed messages did not meet that goal - at all! The “Bernanke Effect” was felt around the world as global Stock markets plunged too. Essentially, the Fed ruined a perfectly good technical picture. Bernanke was unclear as to whether the Fed will or will not pare back purchases. Bond Traders sold into the confusion and as technical support levels were broken, programmed trading kicked in which further exasperated the selloff. As evidenced by the selloff in Stocks - nobody won on yesterday’s confusing Fed testimony.
Putting It All In Perspective:
· Rates are still historically near all-time lows and probably won’t rise much more from here. They actually hit this same level last year before retreating. A rise of .25% still keeps the conforming loan rate at around 3.75%.
· The Fed “could” come out and explain their intentions with more clarity to calm the markets but probably won’t. Volatility is nothing new to the financial markets.
· The rise in interest rates could slow the economy down thereby forcing the Fed to extend the time line for QE3 further which in turn would brings rates down again.
What To Do If Your Rate is Not Locked?
Don’t panic! Borrowers floating or just starting their loans have a choice: lock and remove fears of further losses, or float and hope the market comes back. While we're likely to recover at least some of the losses over the next week but it takes a steel constitution to float in this environment. In my opinion, yesterday’s negative reaction was overcooked. At the end of the day - if there is fear of tapering QE3, Stocks will have trouble moving higher, giving MBS’s some support. And when you consider all of the global landmines that exist - Europe and now Japan, these are fundamental reasons for relatively low rates.
It’s still a great time to buy a new home or to refinance with rates still under 4%.