If Fed Funds Are 0%, Why Are Mortgages 4%?

When I visit with mortgage folks around the country, I’m sometimes asked, “Hey, you with the corny jokes, if Fed Funds are 0%, why are 30-yr mortgage rates 4% or higher?” It’s a good question, and an answer starts with knowing how the Fed Funds rate is determined, if Fannie and Freddie are involved, and what is “effective Fed Funds?”

Fed Funds effective is the weighted average rate on overnight brokered fed funds transactions over the course of a business day. Currently these transactions fall into two types: a smaller volume of trades involving banks that occur at higher interest rates, and a larger volume of trades between Fannie and Freddie (the GSEs) and banks with strong balance sheets that tend to occur at lower rates since the GSEs are presented with few viable options for investing their cash given their daylight overdraft restrictions. It is this second type of trade that dominates averages given the sheer volume of GSE cash. Domestic banks that borrow in Fed Funds pay FDIC-insurance assessments for doing this trade because it grosses up the balance sheet, which is a key reason why the effective is so far below IOER (the Fed’s interest on excess reserves).

But before you ask, if you’ve read this far, “How might lowering the rates paid on excess reserves impact ‘FF effective’?” you should know that the GSEs are significant sellers of funds on a daily basis and yet are not legally eligible to earn interest on balances held with Reserve Banks. Those banks willing and able to borrow funds from GSEs have been able to pay them rates under the IOER that they earn. For example, banks receive 25bps IOER and pay GSEs something like 10bps. A small reduction in IOER might leave this arbitrage intact (and economically attractive to banks), although we would still expect banks to pass through this cost to the GSEs, which would push FF effective rates lower. At some point, though, these rates could get so low that the GSEs would prefer to just leave their funds at the Fed and earn nothing on them rather than be under-compensated for assuming the counterparty risk. Historically, the GSEs have been lenders of funds. The Home Loans have typically used this market as a liquid warehouse for cash to be drawn upon to meet unexpected borrowing demands from member banks. Freddie and Fannie have also been net sellers, using the Fed Fund market for short-term investments for cash earmarked for later principal and interest payments.

Right now, GSE transactions dominate Fed Fund transactions and while lower IOER forces lower the rates that banks are willing to pay GSEs for funds, there is little reason why the GSEs would pay banks for the opportunity to lend them cash – so don’t look for a negative interest rate. Fed funds have never traded at negative rates, even on quarter-end dates when repo and bills have traded negative. And probably the same with LIBOR, which, basically, represents the rate at which banks borrow unsecured funds from one another, there isn’t much reason why any bank would pay to assume counterparty risk and make an uncollateralized loan.