Will Mortgage Rates Rise Because Of The $700b Bailout?

Today alone, economic reports showed record low consumer confidence and 20 consecutive months of home price declines. Couple this with 6.1% unemployment poised to jump higher when the October report comes out next Friday, and it’s easy to argue that mortgage rates have to come down. After all, the Fed has been cutting rates aggressively, so mortgage rates follow, right? Wrong.

Contrary to popular belief (inside and outside the mortgage industry), mortgage rates are are NOT tied to the Fed Funds Rate or the Discount Rate or the 10-year Treasury Note. Mortgage rates are tied to the prices of mortgage-backed bonds.

So the question is: what drives mortgage bond trading, and thus, mortgage rates? The mortgage bonds that rates are tied to are issued by Fannie Mae and Freddie Mac. Since the government took over Fannie & Freddie on September 7, these bonds are considered to be as safe as Treasuries because they have government backing. The phenomenon we’re experiencing now is that as government issues (and will continue to issue) massive new Treasury bonds to raise money for the $700b bank rescue, it dilutes pricing of Treasury bonds

“We are in a weak economy and the numbers will remain weak, but we may be yielding to supply in terms of actual yield levels,” said Paul Horrmann, a strategist in Jersey City, New Jersey, at ICAP Plc, the world’s largest inter-dealer broker.

…Anthony Ryan, acting Treasury undersecretary for domestic finance, said the U.S. may bring back the three-year note and sell more long-term debt to address “unprecedented” 2009 needs to finance a growing budget deficit and the $700 billion bank- rescue plan. He spoke in New York at the Securities Industry and Financial Markets Association conference.

…Long-term supply concerns will push Treasury yields higher as primary dealers, responsible for bidding on government securities at auctions, remain cautious about committing capital to the market, according to investors and strategists. Credit- market losses and writedowns of securities tied to U.S. subprime mortgages have reached $678 billion since the start of 2007.

When Treasury bond prices drop as supply dilutes pricing, bond yields (or rates) rise. But since we know that mortgage rates are not tied to Treasuries, no big deal right? Maybe right, maybe wrong.

Mortgage bonds are also now government securities. So the question is: do all government securities suffer as supply of Treasuries grows to raise money for the bailout? Or do mortgage bonds actually benefit as an alternative government-backed security? It’s difficult to determine how this will play out, and volatility will continue as markets are figuring all of this out. We can expect that mortgage rates will see some spikes like they have this week, and some really nice dips like last week.

Mortgage rates for conforming loans (up to $417k) and high-limit conforming loans (up to $729k) have been moving in a +/- 0.5% range. This can be gut wrenching, but for now it doesn’t look like we’re going to stick on highs … at least for awhile. So the opportunities to lock affordable rates will still be there for the next couple months. We will continue to monitor.