Introduction
Who sets mortgage rates? Why do rates change? How often do rates change? What is a Mortgage Backed Security (MBS)? These are some of the questions we are often asked by our audience and following is a brief explanation of the MBS market and how it works.
Mortgage loan interest rates, and the corresponding fees or points charged for various rates, are driven by the prices of Mortgage Backed Securities (MBS). While lenders, in effect, set their own mortgage rates, how those rates are set is driven largely by the then current prices of Mortgage Backed Securities. MBS are actually pools, or groups, of mortgages packaged into securities for sale in the secondary market. One security may, for example, be made up of 500 loans totaling $75,000,000. These MBS are traded in markets in a manner very similar to stocks and other fixed income securities, and what investors will pay for these drives interest rates.
Direct lenders originate loans, and wholesale and correspondent lenders purchase loans, from Mortgage Brokers or smaller lenders, most often with the intent to resell those loans into the secondary market, packaging them into MBS. So the going price in the secondary market for loans at various interest rates influences the rates and prices a lender will offer to the public or a Mortgage Broker. Although lender and wholesaler rate sheets are typically issued no more than a couple of times each day, the value of the mortgages, or the price of MBS, and consequently the price (points) for a certain interest rate, is actually constantly changing.
Unlike purchasing or selling stock, where the price is whatever it is at the moment you make the trade, wholesale and correspondent lenders generally issue a rate sheet setting forth their rates and corresponding points/premiums for those rates, and honor those rates, until the change in MBS prices reaches a certain threshold, before passing new prices on to their customers in the form of a new rate sheet. Typically lenders will issue new rate sheets as prices move more than 4/32nds to 8/32nds, or 0.125% to 0.25% points.
A few other characteristics unique to the MBS market also distinguish it from equity and Treasury markets, but the overall operation is similar. A wide range of economic, social, and political factors leads to changes in the value of a mortgage whenever new information is released. This tutorial serves as an introduction to these influences.
As a mortgage professional, your business is greatly impacted by changes in mortgage rates. From a client relationship perspective, the implications are many. An unexpected increase in rates may cause clients to change their mind about a loan you are discussing, cause them to not qualify, result in dissatisfaction with you as their loan officer, or result in other problems. Or you may offer a rate and point quote to clients which they accept, only to find out prices have moved swiftly and suddenly, and those terms are no longer available from your lender. A sudden improvement in rates, on the other hand, if you know the possibility exists, and communicate it to your client, can create a loyal client for life when they benefit from it by receiving a lower rate. In your clients' eyes, you are the expert guiding them through the financing process, and you greatly increase your credibility with them if you are informed and help them make better decisions.
From a business and profitability perspective, your business is tremendously impacted similarly by changes in rates. Knowing in advance that rates may increase allows you to lock loans before lenders issue new rate sheets, increasing your income. Perhaps more importantly, knowing rates are improving, you may wait to lock a loan until a lender issues more favorable pricing, greatly increasing your profit. This is not to be confused with "playing the market" and simply hoping rates improve. It is simply about staying informed, with good, current, real-time prices and news about the MBS market, and making solid business decisions based on that information. In other words, you are acting only when it is to your advantage to do so.
While you may not, and need not, learn all the factors that affect MBS prices, you can benefit greatly from understanding the basics and staying informed. MBSQuoteline addresses this need by providing the complete MBS market information resource for mortgage professionals. Keeping track of changes in MBS prices and staying on top of all the news that impacts them is a difficult and time consuming job. As you're aware, there are limitless web sites, TV channels, newsletters, and other sources devoted to the stock and bond markets. But streaming real-time MBS pricing and related news is very hard to find, and until now, extremely expensive. Hence MBSQuoteline. Our primary role is to watch the markets constantly so you don't have to, giving you a cost effective source of the MBS news, pricing and information you need everyday in your business.
Our first task is to decide what information is important to a mortgage professional and relevant to improving your business decisions. For this to be useful, we must then communicate the information to you in a timely, concise, easy to understand fashion. We typically put brief summaries front and center with easily accessible links to detailed analysis. Whatever your level of interest and time constraints, you will be able to intuitively find the information you seek on MBSQuoteline, and we provide it to you in real-time. To truly get a feel for the markets, it's helpful to do more than just read reports. By looking at the actual tick by tick price movements of the streaming price quotes and the price charts for different time periods, you will become skilled at spotting patterns and trends.
Background
Before looking at the factors that drive mortgage rates, it's helpful to understand a little about the process through which a mortgage passes from the originator to the ultimate investor who will own it. In the early days of the mortgage industry, a typical transaction involved a bank originating a mortgage loan which would be held by the bank as part of its portfolio for the entire life of the loan. In this system, the bankers had to be very careful in evaluating the risk of each loan since they were the ones who suffered from making bad loans. The major downside to this approach was a lack of diversification in most portfolios. All of the loans were made in the same region to the bank's customers, so an economic downtown such as the oil bust in Texas might cause many of the loans to go into default at the same time.
As financial markets grew more sophisticated and financial institutions increased in size, new techniques were developed which helped alleviate the risks of concentrated loan portfolios. Through a process call securitization, pools of mortgages were combined together and sold as Mortgage Backed Securities. Mortgages from across the country were packaged together so that a downturn in the prospects of one industry or region would affect only a small portion of the mortgages in the portfolio. This made investors, such as mutual funds and pension funds, much more willing to own mortgages as an investment. The greater demand resulted in higher prices paid and conversely lower mortgage rates.
The last remaining major objection by investors to owning MBS was that suddenly the bankers no longer had much incentive to scrutinize the quality of the loans they originated because they were selling them off immediately to someone else. Freddie Mac, Fannie Mae and Ginnie Mae were created largely to address this issue. The credit standards created by them meant that investors no longer had to worry about the quality of the loans. Loans were also guaranteed by the agencies, removing nearly all the risk to investors of default. So when loans are underwritten to, say FNMA Guidelines, investors know there is a certain underlying credit quality for the MBS that they purchase.
To summarize, MBS are simply pools of mortgages backed by Fannie Mae, Freddie Mac, or Ginnie Mae which are traded in a manner very similar to Treasury bonds. The size of the MBS market is comparable to the Treasury market. Investors receive payments based on the level of interest and principal made by the consumers who obtained the mortgages. The calculation of the actual value of a MBS requires some extremely sophisticated mathematics, but most of the major factors can be easily understood. The main difference between MBS and other types of fixed income investments is that consumers have the option to prepay a mortgage. When a mortgage is paid off early, the expected stream of payments comes much sooner than expected. Predicting the effects of prepayments on the value of MBS is what requires the advanced mathematical models.
As a simple example, say current mortgage rates are 5.5% and there is a MBS made up of mortgages at 8%. The security would sell at a premium due to the high return, but not as high as that of a comparably yielding Treasury bond, due to concerns about prepayment. An investor would be reluctant to pay too large a premium for the security, because the mortgages are likely to be refinanced and paid off. In that scenario, the investor would receive the principal balance of the loans, but would never realize the higher return it paid a premium for. If the MBS offers a lower yield than the prevailing rates, it will be offered at a discount rather than a premium to compensate.
Factors
The major financial institutions in the mortgage industry are constantly trading in the MBS markets. They have the skill to evaluate the value of a MBS. They adjust MBS prices based on investor demand. The mortgage rates on the rate sheets reflect the rates required to produce a competitive return on the MBS. If investors can get a higher return in other markets, they won't purchase MBS. At its simplest, this is how mortgage rates are determined.
This means that the most obvious factor that affects the value is interest rates. There is not just one standard interest rate. The Federal Reserve controls the Fed Funds rate which is a short term rate that banks charge each other. The yield on a "risk-free" Treasury bond of 10 or 30 years is often used by investors as a benchmark for comparison. What matters is that all the other interest rates are alternate investment choices. When rates on the other fixed income securities go up, mortgage rates will likely go up as well, as investors will demand a higher return to continue purchasing mortgage backed securities. A higher rate means a lower price as investors will pay less for an existing security yielding 6% if suddenly there is a new security yielding 7%.
Price and yield always move in opposite directions for a fixed rate security. For example, if a $100 security yields 9% it pays $9.00 in interest per year. If you purchase the security for $100, then $9.00 is in fact 9%. However, if you can get a 10% return on another investment, you might purchase the same security for only $90, then the $9.00 in interest is actually a return of 10% per year. So you purchased the security at a discount to make up for the lower return. This is exactly why discount points are charged on lower rate mortgage loans - to make up for the lower return. As the price goes down, the yield increases. This is the mechanism through which price changes for MBS determine mortgage rates.
The two factors with the most impact on interest rates are economic growth and inflation. The faster the economy is growing, the more demand there will be for capital, leading to a higher cost for borrowing money. That's why good news about the economy is often good for stocks but sinks bond and MBS prices. A higher inflation rate will also increase interest rates, but for a different reason. Inflation erodes the value of a dollar, so a lender will demand more dollars back at a later date to compensate for the lost purchasing power.
Any news which provides information about the level of economic growth or inflation will influence prices. Economic reports are released on a regular basis which contain measurements of the strength of the various parts of the economy and the amount of inflation. Some reports have more significance than others. MBSQuoteline lists all the important reports, explains them, and ranks them by the degree to which they affect MBS markets. After reading our analysis on a regular basis, you will quickly learn what Wall Street analysts seek to discover from the data and how investors react to the results. Many events cause a similar reaction to economic reports because they give investors new information, most notably Federal Reserve meetings. We fully brief you in advance about all such events and provide thorough analysis in real time as they occur. The benefit to you is you will know what is happening, and why, AS IT IS HAPPENING, allowing you to make the right decision for your business, such as whether to lock a loan or not, or advise a client of the impending risk.
As with the price of any product, any factor which affects the supply or the demand will alter the price. In addition to economic news, there are other notable influences on the demand for MBS which often affect the price. Investors turn to MBS markets when they want an investment which is less risky than equities. In times of political instability the demand is greater for these lower risk instruments, so a terrorist attack, for example, may produce a rally in MBS markets. Foreign central banks may have motives for purchasing securities which are different from investors who are assumed to be seeking to maximize their investment return. To balance foreign exchange transactions related to imports and exports, they may be forced to buy or sell US securities regardless of what they consider to be the best investment.
We could write a book on all the factors which affect mortgage rates, but this serves as a basic introduction. By reading the easy to understand analysis on MBSQuoteline on a regular basis, you will develop the expertise to understand the events which determine mortgage rates. The result is you will become a knowledgeable and informed Mortgage Professional in your clients' eyes, giving you a critical advantage over your competitors.
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