Feds drop rates but what does it really mean?
March 31, 2008
As the first quarter of 2008 comes to a close, the credit crunch that began in the summer of 2007 is still raging affecting every corner of the globe. What started with the decline in value of Alt A and subprime loans, has now spilled over to include “prime” borrowers including FHA/VA and Conventional loans. Interest rates are more volatile than we have seen in decades, often swinging 1/2% in interest rate in one afternoon. By comparison, in the recent past interest rates for home loan rates for prime borrowers would move 1/4 or 1/2 in discount points a week, roughly 1/16% or 1/8% in rate. Now that move occurs in a single trade. The volatility has caused massive disruption within the lending community where interest rates change as much as four or five times in a single day. By the time a Loan Officer can call a borrower to refinance, the rate has disappeared (See more below).
Why so much volatility? Two major reasons: liquidity issues are forcing many banks to sell prime assets to raise cash for battered balance sheets and inflationary pressures are rising. Consumer confidence plunged to 64.5 in March to its lowest levels in five years. Sky-high commodity prices where oil reached a record $110 a barrel and rising food costs are becoming worrisome. Inflation erodes the value of money received in the future; therefore anytime inflation is an issue, rates will rise. Mortgage interest rate volatility can be directly attributed to banks needing to sell loan holdings, investors weary of any investment dealing with mortgages, and inflation fears.
What is the Fed doing? Plenty. Between adding 100’s of billions of dollars in additionally liquidity and reducing rates, Chairman Ben Bernanke has been kept awake at night. Former Federal Reserve Chairman Alan Greenspan would call the Fed’s current situation a “conundrum”. The governing body’s dictate is to control inflation while encouraging economic growth. Beginning in August 2007, they have cut the rates one bank charges to another 7 times, reducing the Fed Funds rate from 5.75% to 2.5% where it stands today. This was done to encourage economic growth. The conundrum: rising economic activity can be inflationary and as we mentioned before, inflation will cause rates to rise. Many consumers and homeowners are under the misconception that the Fed rate cuts bring lower mortgage rates, however the opposite is often the outcome. After the rate cut occurs, traders often push mortgage rates higher on inflation fears.
How can borrowers shield themselves from the volatility? No one knows the future of the economy, inflation, or rates. However everyone knows at what interest rate it makes sense to do the loan. Get a commitment from the borrower on the rate structure they desire and are willing to close the loan. When and if the market moves to that level, lock the loan and take the application. In today’s volatile rate environment, by the time a call is returned, rates may have moved substantially. This may help to reduce the stress seen following unscheduled price changes.
How does liquidity play an important role in rates? In years past a borrower would visit their local savings and loan to obtain a mortgage. The Loan Officer at the bank would approve the mortgage and fund it with cash reserves from the vault. This system worked well until the bank ran out of money to lend. Borrowers came to the S&L looking for a loan and were told to come back when a current mortgage paid off. What the bank needed was a way to sell the loans they made freeing up the capital to lend to new borrowers. This way they could lend the “same” money over and over, earning an income from servicing the loans and assisting the community by offering a near limitless pool of money.
To address this issue, FNMA and GNMA were established. The goal was to provide cheap mortgage money to prospective homeowners and a high quality bond for the investment community. The bond or Mortgage Backed Security (MBS) takes mortgages with similar risk characteristics and pools them together. Investors in the MBS’s know ahead of time the return they are going to receive, much like a Certificate of Deposit. To ensure the performance of the bond, each mortgage is underwritten to specific guidelines. By ensuring the borrower is both capable (VOE), willing to repay (credit report) the debt, has the cash to close (VOD), and the value is in the property (appraisal), the loans and thus the bond will perform as expected.
During the recent real estate boom underwriting guidelines were relaxed giving way to a whole new menu of products such as the 100% NOO with credit scores below 600. In addition, to streamline the influx of applications, income and asset verification took a back seat to a borrower with strong credit. With housing prices rising rapidly, the basis for the mortgage, the property, could be sold to cover the note and foreclosure costs if this occurred. This cycle worked well until the price of houses moderated in 2006.
Once the housing market began to cool and prices moderated, foreclosed homes were being sold for less than the note. To add insult to injury, the loans underwritten to the looser guidelines are not performing as hoped. With the value of the collateral in question (falling home prices) and the future performance of the borrowers unknown, investors’ appetite for this risk has waned. To attract investors in this environment, rates had to increase substantially.
Loans sold to GNMA or FNMA had until recently remained largely untouched in the recent credit rout, however because the of the liquidity issues this is no longer true. While not to the same extent as Alt A and subprime loans, sellers of AAA MBS’s are finding it more difficult to find buyers.
The recent rapid rise in rates not directly tied to FNMA/GNMA is an example of the pendulum swinging too wide. The fact remains that a qualified borrower is a good investment from a bondholder perspective. In a typical interest rate market, jumbo loans (loans in excess of the conforming limit) with proper documentation carry a yield about 1/4 higher than similar conforming products. Sanity will eventually return to the markets and non-conforming pricing will come in line with their risk characteristics. The depth and breadth of the current subprime issue will determine when that change occurs.