Weekly Mortgage Rate Review, July 2, 2010

By:: David Coster - MortgageLoan.com

Mortgage Rates— Walking Up the Down Escalator

As a child, despite the admonitions of our parents, most of us found a way to try a “reversal”, going down an escalator then—before reaching the bottom—heading back up. The challenge was too much to resist—to overcome the forces of a machine (not to mention gravity) and prove our strength superior. Success yielded a sense of pride and accomplishment. Lately mortgage rates have been engaged in a similar pursuit, albeit one in which the ultimate outcome is still undetermined.

The machine (the stock market) is telling us that our economy is moving downward. The mortgage-backed securities market, sensing the direction of the economy, has pushed lenders to move rates downward. But as we have approached the bottom (hypothetically), rates, first slowed their downward decent, and, for the last few weeks, have seemed to turn. At this point, rates are not making a sprint upward, but clearly MBS traders and mortgage lenders have shown a clear aversion to allow further decent, despite continuing gravitational moves down in the stock market. Just as a child must turn and exert substantial energy to overcome the power of mechanics and gravity on an escalator, so have MBS traders had to purposely keep rates from moving lower. Why?

First a review of the week

While remaining near record levels, mortgage rates this week have seen little real change. A slew of economic reports came in worse than expectations: Personal Income-Monday, Consumer Confidence-Tuesday, Jobless Claims-Thursday, ISM Index-Thursday, Pending Home Sales-Thursday, Non-Farm Payrolls-Friday and Factory Orders-Friday. The stock market responded with substantial declines for the week. The bond market, as expected, responded with sharp gains.

Continuing struggles with debt issues in Europe added to concerns regarding the impact on the world economy as did economic forecasts of slowing growth in China. However, currencies around the world rallied in value against the US dollar, as the weakness in our economy tended to overshadow these equally troubling signs internationally.

Now back to our puzzle as to why mortgage-backed securities did not follow (as is typical) the rally in the bond market.

Fear or Rationality

According to market performance in the last month, mortgage rates have fallen only half as much as might normally be expected. Given that I have asked some questions. The first question I asked is: “Are lenders withholding lower rates that they could afford to give?” This is the “gas station” argument that I highlighted in last week’s review that says lenders are simply slow to pass along improvements in rates that they could provide because their costs have gone down. While it is certainly true that many lenders do not immediately pass along pricing improvements (for a host of reasons, some legitimate, others perhaps not), the data from the MBS markets clearly refutes this argument. Lender’s “costs” in the MBS markets have not permitted them to be more aggressive than reflected in current pricing.

The second question I have asked is: “What are others in the mortgage industry saying to explain this situation?” Here are a few of the reasons I have seen reported this week for this unusual situation:

-Psychologically MBS traders don’t want rates below 4.5%

-Mortgage servicers don’t want a new refinance boom

-Lenders know there are not qualified borrowers, even at lower rates

-Lenders are hunkering down and saving cash to pay Fannie and Freddie claims

While there may be some truth to these explanations, I would tend to discount any impact from MBS trader’s psychological frame of mind or mortgage servicers wishes. The fact is that mortgage rates and the people who set them respond in very rational ways to market and economic realities. So the third and final question I pose is this: “What market and economic realities are keeping mortgage rates from falling lower?”

Here is my analysis:

It is a reality that there is not a liquid market (willing buyers and willing sellers) for a 30 Year MBS with a lower coupon (interest rate paid to investor) than 4.0%. There is simply no experience selling or buying shares in pools of 30 Year loans that provide a 3.5% return to the investor. Investors have other investment options, with similar or better risk profiles at that level. Consequently, it is completely rational that MBS market-makers have refused, thus far to try to create a market where none has existed before.

Finally, it is an accepted principle of economics that inflation accompanies economic growth. While our economy is still in recovery mode it is growing. Inflation has been kept in check by what some would call artificial means: the decision of the US Federal Reserve to keep key interest rates low for an extended period of time. There is a reasonable expectation among investors, traders and even consumers that inflation will soon begin to be seen in our economy. This would very quickly drive mortgage rates up. Once again it is completely rational for MBS market-makers to restrain the drop in mortgage rates to avoid the effects that a potential sharp rise in inflation would have on MBS with lower rates of return (lower coupons would be worth substantially less).

While there is still limited room for mortgage rates to fall, I believe they have hit a “functional bottom”. But unlike our current situation, when rates move on to the up escalator, no one will have a rational reason to fight the machine.

Next Week

Because it is a shortened holiday week (Independence Day observed on Monday, July 5), there is limited economic data scheduled to be released. On Tuesday the Institute for Supply Management will release its report on activity within the service sector of the economy and the weekly Jobless Claims report will be released on Thursday.

News from Europe regarding policies to deal with the debt crisis will also be instrumental in providing direction for markets.

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National Rates

Loan Type	Today	+/-
30 yr fixed	3.72
15 yr fixed	3.03
5/1 ARM	2.75

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