Since the Fed Lowered Rates to 0%, Why Haven't Mortgage Rates Fallen Farther?

A friend was over on Sunday and asked this question.  I tried to explain, but don’t think I did a very good job.  But, it is a good question and one that I hear a lot, so I am going to try to explain it here (within the limits of my understanding).
First of all, let’s define a couple terms:

• Fed Funds Rate – This is the rate set by the Fed.  It is currently targeted to be between 0% and 0.25%.  This is the rate that the Fed uses to provide short term loans to banks.
• Prime Rate – This is the interest rate that commercial banks offer to their most valued and credit worthy customers.  It has tracked at 3% over the Fed Funds Rate over the last several years.  This 3% is the spread that banks make.  Think about it this way; if the bank borrows at 1% from the Fed, they will loan to their best clients at 4% and to others at more than that.  That difference is their profit and how banks typically make money. Note that their profit is a lot more than 3% because with $1,000 of assets, they can borrow $10,000 to loan out a total of $11,000.  So, in that case, they pay your grandmother 2% for her deposit of $1,000 and the Fed 1% on their $10,000 for a total of $120 cost a year and earn $440 (4% on $11,000) for a profit of 367% (ok, they had operating costs, but who can’t cover operating costs on a 367% gross margin?)
• US Treasury Bonds -Bonds issued by the US Government paying the buyer interest payments every 6 months.  They usually have a maturity rate of 30 years.  The payments are set by the government, but when the bonds are issued, they are done so in an auction and they are in $100 increments.  The amount paid in the auction determines the Yield, or actual rate the holder will receive.  For simplicity, lets say the bond is going to pay 5% a year for 30 years.  If people think that is too low, they will bid less than $100.  If they bid $90, they are still going to get $5 a year, plus their $100 back in 30 years, so the effective interest, or Yield, would be closer to 5.7%.  Likewise, if they think 5% is a great rate, people may bid the bonds up over $100, lowering the yield.  This is why when bonds go up, it is the same as saying the yield, or interest rate is coming down.  Since US Treasury Bonds are guaranteed by the US Government, they have historically been considered the safest investment and offer the lowest yield.

It is important realize that your bank does not keep your loan.  (Remember from above that every $1 your bank has in deposits allows it to borrow $10 to loan out.  Once they loan out $11, they are done.  To get around this, the bank sells your loan (hopefully for more than $11) takes the profit and loans it out again).  Your bank sells these mortgages to investors such as insurance companies, foreign governments, pension funds, Bill Gates, etc.  (from here on out, we will call this group Pwtom for People With Tons of Money).  This buying and selling of mortgages is what is called the Secondary Mortgage Market.  Here is the important part.  Your bank does not set the price on the secondary market – the buyers do, by insisting on a yield.  So, what determines the yield the investors want?

Treasury Bonds.  Treasury Bonds are (historically) the safest 30 year investment because they are backed by the US Government and everybody knows the US Government is safe (isn’t it?).  So, if Pwtom has a choice between buying Bonds from the government or a mortgage from your bank, what is going to determine which he buys?  Basically, the difference in the yield, or interest rate, between Tresuries and mortgages.  If the difference (or spread) is too small, Pwtom buys Treasuries and to get him to buy mortgages, the rate on mortgages needs to go up (remember that if Pwtom doesn’t buy mortgages, your bank has to hold onto them and can not lend out anymore money).

Let’s look at today.  Treasury Bonds are currently trading at historically low rates.  So, why aren’t mortgages falling as far as Treasuries?  It’s the risk involved in mortgages.

Imagine that you are Pwtom and you are trying to decide where to put your money.  You have always bought Treasuries and in the past several years have bought US backed mortgages.  You were willing to buy the mortgages because they were guaranteed by Fannie Mae and Freddie Mac – basically by the US Government, not so different from Treasuries.  However, now the administration is talking about requireing banks who are going to get government aid to “modify mortgages”.  While mortgage modification sounds great to those of us with a mortgage, what about Pwtom?  He basically bought a bond in the form of a mortgage that he thought was guaranteed by the United States Government and now he is being asked to accept a lower interest rate or less money at the end when the mortgage is paid back.   Now, we don’t have to be smart like Pwtom to realize he is getting screwed in this deal.

The important thing to realize is that if Pwtom thinks that there is a chance the mortgage he is buying will be re-negotiated or go into foreclosure, he is going to require a much higher interest rate on all the mortgages he invests in to cover the ones that go bad.  So, the exact thing we are hoping will help, mortgage modifications, is creating uncertainty for buyers of mortgages and causing mortgage rates to stay higher than they otherwise would.