Thursday, September 27, 2012

Mortgage Rates Hit New Record Low: Where Are They Going Next?

Mortgage rates just touched down this week at new all time record lows as reported by Freddie Mac at 3.40%.


How much lower can mortgage rates fall? Much lower.

The chart below shows the incredible (record) spread between the interest rates where mortgages are being sold at to home buyers compared to what they are being purchased at in the secondary market by banks, institutions, etc. through mortgage backed securities (1.70%).

3.40% - 1.70% = 1.70% Spread


As a quick side note: the rates on these mortgage bonds is now only .03% away from federal treasury bond rates. Soon mortgages will have lower rates (higher prices) than treasury bonds! In other words, the bond market is pricing in American home buyers as less of a risk of default than the federal government of the United States. I could write a book on the absurdity of this one wrinkle of the financial world we live in today, and people will look back a decade from now and spend years studying and writing about the mania currently taking place in the bond market. But back to the present:

Owners of these mortgage backed securities have the ability to pocket this "spread" creating huge profit windfalls for the banks. How did this spread occur?

The demand for new mortgages and refinances has been so great as mortgage rates continue to fall that banks cannot keep up with the orders. Even if they could keep up with the orders, they are dragging their feet in order to slow down the amount rates can fall over the short term for consumers.

Scott Simon the mortgage head of Pacific Investment Management described it best:

"Think about it this way: If you had a restaurant with 100 people out the door waiting in line, would lowering prices be the first thing on your mind?"

What does this mean if you are a buyer or someone looking to re-finance in the short term? Wait. More competitors will enter the market to take up the massive demand. The spread seen in the chart above will contract to the downside (unless of course the bond market finally implodes, which it could at any moment).

I joked years ago that the Fed would try to artificially bring rates down to 2% to raise home prices, something that seemed completely impossible at the time. We may now only be weeks away from that point.

Ultimately this story will end in disaster.

h/t Calculated Risk, Sober Look

2 comments:

  1. So interest rates are low now, but what happens when they go back up? Disaster! Lets say you remortgaged or bought a $200,000 house. Now interest rates go back up, and you want to sell 5 years from now. As interest rates go up, affordability goes down. So your potential list of buyers just got smaller because they wont be able to qualify for a loan that is even close to what you owe.

    The US annual median income is $50,054.

    $50,054 annual income @ 3% APR can afford a $198,332 house ($1,167 month)
    $50,054 annual income @ 5% APR can afford a $155,764 house. ($1,167 month)
    $50,054 annual income @ 8% APR can afford a $113,957 house. ($1,167 month)

    ReplyDelete
    Replies
    1. Exactly. Excellent use of the interest rate levels as examples. I have discussed this simple idea during every real estate related article I've written over the past few years. People only see lower payments today meaning a "stronger" investment for the future. That is a realtor sales pitch. The reality is the exact opposite.

      Buyers today have no understanding of economics.

      Delete