What Happens to Mortgage Rates When the Fed Changes Rates? Part 3

We have now covered in some detail the data showing that mortgage rates are NOT correlated with the Discount Rate that is set by the Fed. Now we’re going to look at what mortgage rates are correlated with. I hope you will find it interesting to understand the data. That way you can act knowing your actions are grounded in fact.

The mortgage market is made up of two parts, the Primary Market and Secondary Market. The primary market is that which exists between borrowers and lenders. The Secondary Market is that in which lenders sell loans they have originated to various investors. The largest players in that market are FannieMae, FreddieMac, and a number of investment brokerage firms on Wall Street.

All of us know about the stock market. It receives a lot of publicity every day. Every major newspaper has a Business section that focuses on what the stock market did the day before. However, there is also another market: the market for fixed income securities. This one is a lot larger than the stock market, but it doesn’t get as much publicity because the average person does not invest in that market.  The actions of buyers and sellers in that market determine the yield on long-term Treasury bonds. Indirectly, that market also determines mortgage rates . Here’s why…

Mortgages are combined into large pools and the pools, rather than individual loans, are sold to investors like large pension plans. The managers look at mortgage-backed securities as alternatives to Treasury bonds or corporate bonds. So when an investment manager wants to buy some fixed income securities, he looks at a full spectrum of opportunities. Obviously he could buy nothing but risk-free Treasury bonds. Those are very safe but the yield is low. As he looks at other choices of what to buy, his decision would include an assessment of the yield or return that he would get adjusted with the risk factor.

The highest quality mortgage backed securities have always been those offered by FannieMae and FreddieMac. As Government Sponsored Enterprises, their securities are considered to have the lowest risk. The loans are always less than 80% loan-to-value or have carried PMI (Private Mortgage Insurance). They have also been underwritten to strict standards.  In fact, the default rate on those loans has typically been around 1%. That’s darn good. 

The yield on those securities is about 2% higher than Treasury bonds, so most investment managers would be willing to purchase some mortgage backed securities. But you can also see that what they would be willing to pay for those securities would be based upon the yield for Treasury bonds on the same day. Let’s now look at the interest rate data for the past eight years to see what correlation we find. 

In the chart below, I have taken data from the Federal Reserve Board for the Treasury Bond that matures in 10 years. If you wonder about the 10-year versus 30-year mortgage comparison, the fact is the majority of mortgages are paid off in about seven years, so the investment market seems to treat them as being almost the same when they are considering investing.

The other line is the rate of 30-year fixed rate mortgages as tracked by Freddie Mac, adjusted by the risk factor of about 2%. I then calculated the average difference and subtracted that from the mortgage yields so we can see the tracking better. You can see that the two lines track each other very well. 

So if you are interested what is happening to mortgage rates, don’t call the Fed. Just look at what is happening to the 10-year Treasury bonds. Here's a good place to check out.

Thus endeth the lesson. 

Return to Top