How Mortgage Rates are Set

Pretty good piece from the NYTimes.


How Rates Are Set

The New York Times



By BOB TEDESCHI

Published: November 14, 2008
INTEREST rates are often a mystery for many people applying for home loans. How is it possible, for instance, for mortgage rates to rise after the Federal Reserve cut its benchmark interest rate, which was what happened in late October? Then, in the week that followed, mortgage rates fell after a report was released showing that the unemployment rate had soared.

Borrowers can make smarter financial choices, industry executives maintain, by better understanding the economic forces that propel rates, and by keeping a watchful eye on the economic news. What is good for the Fed’s banking customers, they say, is not necessarily good for mortgage borrowers.

But that misunderstanding is common, said Alan Rosenbaum, the chief executive of the GuardHill Financial Corporation, a mortgage broker based in Manhattan. “We get that from clients all the time,” he said, “but the mortgage market isn’t tied to the Fed’s rate at all.”
Rather, Mr. Rosenbaum and other mortgage industry executives said, home-loan rates are influenced by longer-term economic indicators. The Federal Reserve Board’s benchmark rate, the federal funds rate, is the interest that banks charge one another for overnight loans. And that, in turn, is closely tied to the prime lending rate that the banks charge preferred customers.
Some variable-rate short-term loans are based on the prime, including home-equity lines of credit. But for the most commonly held mortgage — a 30-year fixed-rate loan — lenders take a longer view when determining rates. That is why the performance of the 10-year United States Treasury note is a better indicator of where mortgage rates are headed.

Earlier this month, the yield on the 10-year Treasury dropped to about 3.78 percent, compared with nearly 4 percent in late October. Rates on 30-year-fixed mortgages, meanwhile, dropped to 6.2 percent from nearly 6.5 percent in late October. (Last week, Freddie Mac said, the rate was 6.14 percent.) In New York, New Jersey and other Northeastern states, the average rate was 6.17 percent.

Mortgage rates and 10-year Treasury yields tend to drop in times of bad economic news, Mr. Rosenbaum said, in part because investors flock to safer investments like Treasuries. And that was indeed the case early this month.

In announcing a drop in mortgage rates in early November, Freddie Mac’s chief economist, Frank Nothaft, cited “new indications of a pullback in consumer spending and a weaker jobs market.” That week, for instance, the government announced a sharp increase in the unemployment rate, to 6.5 percent in October from 6.1 percent the previous month, and a shrinking of the overall economy.

The relationship between the 10-year Treasury note and long-term mortgage rates changed during the mortgage crisis, however. In past years, Mr. Rosenbaum said, 30-year fixed-rate mortgage borrowers could generally find an interest rate about 1.25 percentage points higher than the prevailing 10-year Treasury yield. But in recent months, the difference has been as much as 2.75 percentage points.

Lenders have been building a higher profit margin into their mortgage deals to recoup losses from the last year, and to hedge against a still-declining real estate market, which threatens a bank’s mortgage assets. Once the fiscal crisis eases, mortgage executives said, the difference between the 10-year Treasury note and long-term mortgage rates should return to normal.