The Fed Dropped Rates - Why Didn’t Mortgage Rates Go Down?

If you're new here, you may want to subscribe to my Blog Update Announcement List. Thanks for visiting!

Every time the Federal Reserve cuts the Fed Funds rate, as they did by .75 percent the other day, mortgage companies are deluged by calls from borrowers with loans in process hoping they can get a better rate. Most of the time the answer is no! Don’t worry though - this isn’t your loan officer trying to take advantage of lower rates to make more money without passing it along to the consumer.

To better understand this, it helps to take a look back in history to the last extended series of rate cuts by the Federal Reserve. This occurred between January of 2001 and June of 2003. During this time the Federal Reserve lowered its target Fed Funds rate 13 times. In the month following each of those rate cuts, the 30 year fixed mortgage rate fell 8 times, but 5 times it went up! In fact, almost every time on the actual day the Federal Reserve cut rates, mortgage rates went up even if they later continued going down. Most of the time it took them a week or two to even return to pre-rate cut levels.

The reason why is, in the end, pretty simple. There is absolutely no direct relationship between the rates controlled by the Federal Reserve and mortgage rates. Only a very slight indirect relationship. The Federal Reserve controls the rates they charge banks to borrow money and the rates banks charge when loaning money to each other for very short terms. Often for money just loaned overnight. This is why you keep hearing the term “liquidity” thrown around on the financial news when discussing Federal Reserve rate cuts. When banks don’t have enough liquid cash on deposit to cover their daily obligations, which is often, they borrow it from each other. This rate indirectly affects credit card rates, bank personal loan rates, and banks use it to set their “prime rate”. The prime rate is the rate that banks charge their most credit worthy customers. Most customers don’t get that rate. Home equity line of credit rates are based on the prime rate plus some factor which depends on the loan characteristics. Home Equity rates will usually be quoted as “prime plus x” where x is some factor like 1 or 1.5 or 2 added to the prime rate. None of this affects 30 year fixed FHA or conventional rates.

The money that the bank uses to loan you for your mortgage comes from the sale of mortgage bonds. There are many different types of bonds including mortgage bonds, treasury bonds and corporate bonds and they are all competing in the marketplace for investment money. This money comes from individuals and also pension funds, retirement funds and money market funds. These bonds are also competing for investment dollars with the stock markets and commodity markets. There are three primary agencies that sell most mortgage bonds. These are FNMA (Federal National Mortgage Association or Fannie Mae), FHLMC (Federal Home Loan Mortgage Corporation or Freddie Mac) and GNMA (Government National Mortgage Association or Ginnie Mae). You hear about Fannie Mae and Freddie Mac in the news all the time today. They each issue bonds for conventional mortgages. You don’t hear much about GNMA, but they sell the bonds which fund government mortgages like FHA and VA loans.

These “mortgage backed securities” are traded on the open market daily and prices change constantly throughout the day. The prices go up and down just like the stock markets. Here is where it gets a little tricky. The bonds are pooled in huge amounts based on their face interest rates. So the price quotes will go up and down from 100% of the face value of the bonds. So when the price goes down, the yield goes up. For instance, when traders can buy FNMA 6% mortgage bonds for less than 100% of the face value the effective interest rate goes up. To simplify it, if they pay $99 for $100 of face value at 6%, the owner is getting a yield or interest rate above 6%.

At all hours of the day as borrowers are locking loans, lenders have to make an educated guess about how much they will be able to sell that mortgage bond for. What they hope is to be able to sell the bonds for more than 100% of face value, but they don’t know the price they will get on the open market, so they try to add a cushion to the rates to make sure they have room to profit. It is this price which determines the mortgage rates you get when you lock in your mortgage.

Because these bonds are competing in the marketplace for the same pool of investment money available for stocks as well as other types of bonds, the prices of mortgage bonds usually go down when the stock market goes up. People have to sell their mortgage backed bonds in order to buy stocks. As they sell, bond prices go down and interest rates go up.

Mortgage rates had been falling for weeks prior to the .75% Federal Reserve funds rate cut the other day. The Federal Reserve cut the rate because of massive losses in stock markets all over the world. They wanted to prevent such losses in the U.S markets and boy did it work. Stocks were down almost 300 points for the day in middle of the next morning and ended up from there approximately 600 points by the end of the day. Guess where the money for all that stock buying came from. Yes, people (institutions really) had to sell their bonds causing bond prices to drop and mortgage rates to go way up that afternoon. Most lenders changed rates for the worse 4 times in one afternoon trying to catch up with the falling prices. In one afternoon, rates lost weeks of improvement. And they haven’t recovered it yet.

So there you have it. If your eyes haven’t glazed over or you haven’t fallen asleep yet, you at least know the basics of what happens behind the scenes where interest rates are being set.