A look at the bond market provides insight into what moves mortgage rates up and down.

Some mysteries can't be solved. Like the Liar Paradox, which is rumored to have sent ancient poet and grammarian Philetus of Cos to his grave by way of insomnia. Thankfully, mortgage rates don't fall into that category; they may be complex and confusing, but they aren't completely illogical.

A large part of the money used to fund mortgage loans comes from investors who purchase mortgage-backed securities (MBS). As a result, the demands and sentiments of these investors heavily influence mortgage rates.

Understanding investor sentiment for mortgage-backed securities is challenging, simply because there are so many factors that come into play. These include the health of the overall economy, the prevailing appetite for risk, expectations for inflation or deflation, and the performance of the stock market. Not withstanding all of these things, however, an investor's taste for MBS is ultimately rooted in how competitive the MBS is relative to other investment options available.

Basics of mortgage-backed securities

An MBS is basically a bond that's supported by an underlying pool of mortgages. The investor pays money upfront to purchase shares of the mortgage pool. That money then gets recycled back to lenders to fund more mortgages. The investor is then repaid over time from the proceeds generated by the mortgage payments.

The yield to the investor is driven by the mortgage rates on the underlying loans. If investors aren't buying MBS, mortgage rates will rise to make these investments more competitive.

Bond market basics

An investor looking for a fixed-income security has many options within the overall bond market: government, corporate, municipal, and MBS, among others. While investors evaluate these options relative to one another, the overriding benchmark for the bond market is typically the U.S. Treasury, because it's essentially viewed as risk-free. All other bond investments not backed by the U.S. government, including MBS, must therefore pay a higher yield-to compensate the investor for the additional risk.

The 10-year Treasury is a good benchmark for mortgages, because most such loans are paid off or refinanced within 10 years. If the risk premium for MBS was stable, then the 10-year Treasury Constant Maturity would be a reliable tracking tool for mortgage rates. Unfortunately, investor sentiment is not so predictable. In reality, the 10-year Treasury tracks with mortgage rates over longer periods of time, but it isn't a reliable indicator of short-term mortgage rate fluctuations.

In the short-term, MBS investors are motivated by the same factors that influence other bond investors. Any factor that adds risk will pressure mortgage rates up, while factors that reduce risk will allow mortgage rates to fall.

One last thing: It's great to improve your understanding of mortgage rates, but don't lose sleep trying to predict short-term rate changes. Not even the experts can do this with much accuracy. Besides, you don't want to end up like Philetus of Cos.

Published on January 2, 2009