Why Do Mortgage Interest Rates go UP when the Fed lowers their rate?

Quite a few people are trying to understand why our current mortgage |
|rates are climbing despite the government's best efforts. This can
be summed up in one word -- uncertainty. Here is some background: |
| |
| Lenders in the London Interbank Offered Rate (LIBOR) market are |
| uncertain that counterparts will pay back loans, thus producing |
| higher financing rates while the U.S. Federal Reserve's |
| federal-funds target rate has been lowered to 1.5 percent. This |
| makes mortgages less attractive to hold since most leveraged |
| investors borrow money at or above LIBOR. |
| Investors are uncertain whether the government’s rescue package |
| will be successful. Not believing the government’s implied |
| guarantee, foreign investors have shied away from Fannie Mae and |
| Freddie Mac mortgage-backed securities (MBS). Domestic portfolios|
| have been net sellers of MBS as a way of recapitalization and a |
| reduction of risk. Wall Street is wondering how Fannie Mae and |
| Freddie Mac will be able to buy mortgages for their portfolios |
| when their cost of borrowing continues to rise. Only $5 billion |
| of MBS have been purchased so far. |
| Elevated uncertainty leads to volatility. Volatility is at |
| historical highs in both the fixed income and equity markets. |
| Volatility adversely impacts mortgage prices as cash flows from |
| prepayment become less predictable. |
| Investors are also uncertain as to the amount of additional U.S. |
| Treasury debt that will be required to fund the government rescue |
| package. Long term rates have already risen which impacts |
| mortgage rates. Only short term Treasury securities have |
| benefited from this environment and the Fed’s 50bp rate cut. |
| Investors have been willing to accept a few bps of yield in |
| exchange for the safe harbor of Treasury bills. |
| |
|Summary |
|We expect mortgage rates to be volatile through the end of 2008 as|
|both investor and dealer risk tolerance is low. However, we believe|
|mortgage rates will edge lower over time due to the slowing economic|
|landscape and the extraordinary steps that the government is taking|
|to restore confidence to the credit markets.