How Fed’s Latest Plan Lowers Mortgage Rates

Rates again hit record lows today as investors piled into mortgage and Treasury bonds/notes after the Fed confirmed Operation Twist and said they’d buy more mortgage bonds.

Below is an explanation of each strategy in simple terms.

Operation Twist is a Fed strategy where they shift their debt holdings to longer-term securities. Between now and June 30, 2012, the Fed will sell $400b of Treasury debt with durations of 3 years or less and reinvest the proceeds into durations of six to 30 years.

This helps lower rates on various forms of credit, including mortgage loans.

Lower rates cause more people to refinance mortgages and when a refi pays off an existing mortgage, a mortgage bondholder gets paid off.

The Fed is a huge mortgage bondholder—they bought $1.25 trillion of mortgage bonds from January 2009 through March 2010—so they collect principal balances as loans refinance, and they also get paid as homeowners make their mortgage payments.

The Fed also said today they’d use the money they collect from loan payoffs and payments to buy more mortgage bonds starting October 3. Previously this money was being use to buy Treasury securities.

This renewed Fed commitment to buy mortgage bonds caused a huge mortgage rally today (FNMA 30yr 3.5% coupon +134 basis points), and because yields (or rates) drop when bond prices rise, rates dropped to record lows.

Also today the 10yr Note hit a record low yield of 1.88%. Stocks closed down sharply: S&P 500 -35, Down -283.

This mortgage bond rally today is extreme. Mortgage bond prices were already hovering near record highs on U.S. weakness and the Eurozone debt crisis.

So if you’ve been rate shopping, be aware that today’s levels may correct in the coming days, and this is a very good time to lock.

But even if rates come up a bit as mortgage bond prices come off these nosebleed levels, the economic fundamentals noted/linked above still support very low rates.

The next FOMC meeting is November 1-2.

It should also be noted that Operation Twist isn’t quantitative easing because the latter means creating new money to buy bonds.

Operation Twist is just shifting from shorter to longer term debt, but today’s Fed statement indicated quantitative easing remains an option if needed.

Fed’s Operation Twist & Mortgage Buying Plan

Today’s Fed Statement