Who sets these darn rates anyway?

Posted: Sep 05, 2006 12:35 PM
Who sets these darn rates anyway?

I will start with a long time coming confession: it isn't me. So many of my clients are wary about me that they are sure I have my hand in it some how. Nope! It is way more complex than that. Let us begin at the beginning, we are talking about mortgage rates in these United States. And no the Federal Reserve doesn't set them either.

The President doesn't have a say nor does Congress or the Senate, and you can also rule out the Secretary of the Treasury.

If you have ever gone to Chicago and been to the Chicago Board of Trade and seen all the people running around in those wild jackets (smocks) with a strange name or group of letters, then you have been to the mountain top when it comes to mortgage rates. Those people are heavily responsible for the mortgage rates, albeit indirectly. If I quit now, I would be ahead and you wouldn't, so I will go on. These traders work in the trading pits and trade U.S. Treasury notes, bills and bonds which are the benchmark for mortgage backed securities which determine, for the most part, our mortgage rates.

Now that we know the players, it’s time to explain the game. The Federal Reservehas the duty of regulating the money supply at the nations banks and setting the rates for the shortest maturity we know: overnight money. Generally known as the Federal Funds rate, there is also a re discount rate which is the cost of short term money to the banks. In normal times short term money is the cheapest in the yield spread with interest getting higher as the maturity gets longer. Just to add reality to a puzzling situation, the aforementioned "short term money" carries the highest interest rate in our society at this time (Inverted yield curve).

Forgetting yield curves for now, we continue our quest to understand why they are what they are at any given time and who determines this. The traders in the pits in Chicago get and exercise orders from clients (including hedge funds, foreign nations and individual investors). This open market bartering or auction determines the rates for the Treasuries which are considered the safest instruments in the world. The 10 year Treasury note is the instrument that the mortgage backed securities most closely follow. If this note goes up in price, and down in yield, within a few days the mortgage backed securities will follow. They are considered a secure investment because they have pools of mortgages as their security. They aren't as secure as Treasury instruments and thus carry a higher yield.

Generally the 30 year fixed mortgage is priced first for conforming loans. These loans have a maximum of $417,000 and any loan over that limit is a jumbo loan. Jumbo's are generally 1/4% higher than conforming rates. The 15 year conforming is usually 1/4% lower in rate than the 30 year. When everything is in balance in the fixed rate mortgage market you will find that the 15 year conforming is 1/4% lower than the 30 year fixed and the 15 year jumbo and the 30 year jumbo is 1/4% higher than both the 30 year fixed conforming and the 15 year jumbo.

Why is that important to know? If you understand the relationship, you can act when these particular loans are out of sync. Last year the 15 year conforming was 1/2 to 5/8% lower than the 30 year. It was a sign to those looking for a well priced 15 year that the time had come to act. Many people felt that the 30 year was too high not that the 15 year was too low and lost out. Rates always tend to go up easier than they come down so it was evident that the 30 year wouldn't be coming down to meet the 15 year. As it turned out, it was as I suspected an anomaly that corrected itself rather quickly.

All of the rest of the mortgage loans, (anything considered a non fixed rate), are portfolio loans that are funded with investors money and sometimes kept as their portfolio of investmentsin mortgages. The lenders tend to check each other daily to see if any one is trying to buy business with lower rates and to see if their own rates are in the ball park.I will get into a discussion of variable and hybrid loans in another column.

For now, let the word go out to everyone that the traders, not traitors, rule. Watch the bond market and you will be able to ascertain when the right time comes to move when it pertains to the mortgage market. With knowledge, you can be sure of what you want or need to do with your mortgage and not have to rely on someone to tell you the time is right. Talk about turning the tables!

Roger Schlesinger's Mortgage Minute is heard on hundreds of radio stations and daily on the Hugh Hewitt radio show and Michael Medved shows. Roger interacts with his hosts and explores the complicated financial markets in order to enlighten his listeners and direct them along their own unique road to financial freedom. Roger is the President and founder of Manhattan West Mortgage.