We’ve spoken before about the truth of rising mortgage rates and the Federal Reserve’s indirect role in determining them. Today we’d like to talk more about the most impactful variable that affects mortgage rates: Mortgage-backed securities markets.
When a commercial bank finances a mortgage, they usually sell it to a mortgage bank or an investment bank soon after the closing. In fact, most homeowners never send a single payment to originating lender. Instead, they send their checks to the bank that purchased their mortgage.
The mortgage bank services the loan (collecting payments, charging fees, managing fraud, and corresponding with the borrower) for a time until it can be bundled with other loans that have similar interest rates. This packaging process is called securitization, and the resulting product is called a mortgage-backed security, which is a bond secured by big pools of mortgage loans.
After purchasing a mortgage-backed security, the bank puts it in a company designed to hold it called a Special Purpose Vehicle or a Special Investment Vehicle. Investors can buy shares of this company just like they would buy pieces of a public company.
In many cases, mortgages can be sold to government-sponsored enterprises like Fannie Mae, Freddie Mac, or Ginnie Mae, depending on the specifics of the loan. These enterprises buy mortgage-backed securities from banks and sell them to investors. They also guarantee the return, which makes them particularly attractive to investors.
This is what an overwhelming majority of commercial banks do. By selling the loan, they make a little money from the mortgage bank, but they free up their capital to lend to more customers.
Since these banks are on-the-ground working with people already, it’s more profitable for them to originate a loan and then get it off their books so they can originate another. They only keep a small percentage of the mortgages they originate.
Think of it like this: An investor wants to own someone’s mortgage loan. He buys the loan from the original lender and collect the homeowner’s monthly payments throughout the life of the loan (15 to 30 years), including the principal and interest. The risk, however, is that he could lose a lot of money if the homeowner defaults on the loan.
The investor can reduce that risk by buying multiple mortgages. If he purchased ten mortgages, a single default might not wipe out his investment. This is investment diversification in its most basic form.
Investors work very hard to minimize risk as much as possible. They don’t want just ten mortgages. They want thousands of mortgages. Better yet, they want pieces of multiple mortgage-backed securities to further drive down their risk.
Statistically, some of the loans in a mortgage-backed security will inevitably default. But the gains from those who pay off their mortgages will dwarf the losses from those who don’t. (At the least, that’s an investors’ hope.)
When the economy’s growth is lackluster (like what happened to the United States after the financial crisis circa 2008), investors flock to bonds like mortgage-backed securities because they’re safer. When there’s more demand for MBS products, their prices rise accordingly. Bad economic news is actually good news for MBS prices.
When an investor pays more for a bond like an MBS, the yield – his return – falls. Inversely, if he pays less for it, the yield increases. Bond prices and yields behave oppositely, but bond yields and mortgage interest rates behave similarly.
Therefore, when MBS prices rise, mortgage rates fall.
Each day, lenders set new interest rates for their loan officers and outside brokers. To set those rates, they consult with the corresponding mortgage bond associated with that type of loan.
For instance, a 30-year conventional mortgage is priced against a Fannie Mae 30-year bond. A 15-year VA mortgage would be priced against a Ginnie Mae 15-year bond.
Banks then incorporate their own criteria to decide on the mortgage interest rates they’ll offer, like how much profit they want to make or how competitive they want to be. This is why banks offer different rates even though they use the same MBS data.
Investments compete for investors’ cash. When an investor wants to purchase an investment product, he searches for the best deal. So like all products, MBS prices are based on supply and demand. When there’s demand for an MBS product, its price rises. When demand falls, so does its price.
As you know now, mortgage-backed security prices are the strongest variables that affect mortgage interest rates. This begs the question: What influences the prices of mortgage-backed securities?
Human emotions like greed and fear.What influences the prices of mortgage-backed securities? Human emotions like greed and fear. Click To Tweet
When investors purchase mortgage-backed securities, they do so because they’ve evaluated as much information as they can and they’ve decided that the asset could not possibly fall further in price. They believe the asset is as low as it can go and will only rise in the future. They’re greedy. They want to grab the security while it’s cheap and ride it up.
Sellers, who have access to the exact same information, draw the opposite conclusion. They believe the asset could not possibly go any higher. They’re fearful. They’re afraid they’ll lose their gains if they don’t get it off their books right away.
Interestingly, both parties are absolutely convinced that they’ve made the right decision. How could that be if both have access to the same data?
At some point in the purchasing decision process, all investors apply their own emotional bias to the equation. Think of it like a hidden coefficient that’s unique to every person.
For instance, does a presidential election affect mortgage-backed securities? Most likely. But the degree an election affects prices (or should affect them) is unique to every buyer and seller. Some may rate an election’s impact as substantial; others may consider it an inconsequential bump in the road.
And even more people will disagree about when the event actually affects the markets. Long before the election, no doubt, but it’s hard to pinpoint a date.
Furthermore, some investors may weigh data or events that other investors ignore. Some will argue whether a bit of information is new knowledge or already baked into the price.
Any factor that can stimulate greed or fear can affect mortgage-backed securities. For instance, a terrorist attack can make investors fear political and economic instability. Their fear turns them to safer investments, which causes MBS markets to surge.
MBS markets are highly susceptible to economic activity, just like treasuries and other types of bonds. Reports like the Consumer Price Index, Consumer Confidence Report, Gross Domestic Product Report, and others can stimulate the emotions of buyers and sellers – in one way or another.
There are countless factors that can affect MBS markets. A surge of home buying can drop MBS prices, thus increasing mortgage interest rates. If the Fed buys a bunch of mortgage-backed securities, mortgage interest rates will fall.
Inflation, unemployment, the Fed’s monetary policy, timing of events, and the speed lenders are willing to change their rates are just some of the innumerable variables that trigger people’s emotions to buy or sell mortgage-backed securities and thus influence mortgage interest rates.
Hopefully this helps you understand the real drivers of mortgage rates. At the end of the day, MBS markets and mortgage interest rates are determined by people making emotional decisions.
As a broker, we caution you not to wrap yourself too tightly in macroeconomic issues. Those issues, while relevant, have to be sifted through the emotional lenses of every buyer and seller in the MBS markets. Without sophisticated tools, it would be challenging for you to determine how a particular current event or an economic report would filter down to mortgage rates your lenders set for your borrowers.
Does this mean mortgage rates are unpredictable? While no one can guarantee the exact change in prices at any given time, experienced traders and sophisticated algorithms can create surprisingly accurate forecasts.
As a mortgage originator, the best way to survive and prosper in an era of rapidly changing market conditions is to adapt. Use TrueCast MBS Forecasting to determine changes in market cycles and give yourself a real forecast based on pricing and timing zones.
Our system is based on years of successful analytical experience that makes very specific market change predictions with equally specific levels of confidence. Use it to help your borrowers get the best deals and become the go-to resource in your referral network.