Dallas Fort Worth Homes and Real Estate for Sale: Does the Federal Reserve Control Mortgage Rates?

Does the Federal Reserve Control Mortgage Interest Rates?  Or some other government entity or individual? 

Early this morning, the Federal Reserve announced they were cutting the Federal Funds rate by half a percentage point to 1.5%.   Many people assume this means mortgage rates will automatically follow suit.  Unfortunately this is not how it works.  Many complex factors affect mortgage rates besides the Federal Funds Rate.     

But before we discuss those, let's examine what rates the Federal Reserve DOES control.  The Fed only controls two key interest rates: The Federal Funds Rate and the Discount Rate.  Neither of these are rates charged on loans to consumers.  They are rates that banks themselves are charged to borrow money.  The Federal Funds Rate is the rate that banks charge other banks for short term (usually overnight) loans, and the Discount Rate is the rate that the Federal Reserve charges to lend money directly to banks. 

Having said that, the Fed rates do have a direct effect on some consumer loan rates.  When either of these Fed rates is adjusted, banks will usually move their PRIME RATE, which is the floor rate that is used to calculate many consumer loan rates, such as credit cards and lines of credit.  You may have noticed that credit card companies often quote rates as "Prime plus 5%" or "Prime plus 8%".   The "plus 5 or plus 8" is the "spread" or profit that banks charge to lend money.  So the good news is that a lowering of the Fed rate does often translate into lower rates for consumer loans. 

Here's a chart that shows how closely banks adjust their Prime Rate with movements in the Federal Funds rate:

As you can clearly see, the spread (difference) between these two rates is rather constant.   When one rises, the other one typically follows suit, and vice versa. 

But what about mortgage rates?  While it's true that rates on some adjustable rate mortgages (ARM's) do rise and fall with other indeces that may tend to mirror movements in the Fed Funds rate, fixed rate mortgages do not:

Notice at some points they are within one percentage point of each other, and other times they are more than five points apart. 

So why doesn't the Fed rate affect fixed mortgage rates like it affects the Prime Rate?  The answer lies in how the mortgage market works.  Mortgages are packaged and sold as bond-like financial instruments known as mortgage-backed securities on a market known as the "secondary market".  And since these securities have many similar characteristics as bonds, their price is affected by many of the same factors that affect bond prices, such as inflation, stock prices, unemployment, consumer confidence and the price of competing bonds. 

Some other unique factors also contribute to the price of mortgage backed securities, such as confidence in entity that guarantees timely payments to the investor and lenders' ability to accurately predict the risk of default.   The price and yield of mortgage-backed securities are influenced by all of these factors (plus some other ones) and the rates are ultimately a reflection of the price and yield of these securities.

The secondary market is extremely vital to providing funds to banks for new mortgages.  If banks held these loans on their books, they would run out of money to lend to new customers.  This is essentially how the mortgage market has worked in the U.S. for decades.  Many people had no idea of this until the mortgage crisis shed a light on how this process works.  

At this point, Fannie Mae, Freddie Mac and Ginnie Mae are the only significant players in the secondary market since almost every other significant player is now gone and investors simply refuse to buy mortgages that are not backed by Fannie Mae, Freddie Mac or Ginnie Mae.  This is because Wall Street made huge errors in judging the risk of default for sub prime and Alt A loans, which is one of the root causes of the mortgage crisis. 

Here's one more thing that's a bit off the subject, but many people do not realize.  The bank that collects their mortgage payment probably does not own their loan, they probably just service the loan for either Fannie Mae, Freddie Mac or Ginnie Mae. 

Once a loan is sold, banks will either keep or sell the right to service a loan since Fannie, Freddie and Ginnie do not have customer service departments for borrowers.  Lenders get to keep a fee, called a servicing release premium, in exchange for paying the taxes and insurance from escrow, and providing a customer service department for borrowers that have questions or issues.   They also forward the payments to Fannie, Freddie and Ginnie so they can pay the investors who bought the mortgage bonds. 

Most borrowers never realize this since they may make their payment to the same lender that originated their loan.  Confusing, huh?  Very.       

So in conclusion, THE FEDERAL RESERVE DOES NOT DIRECTLY CONTROL MORTGAGE RATES.  This is probably the one misconception that I hear more often than any other.  The media often oversimplifies the effect that the Fed rate has on mortgage rates, and many lenders use deceptive advertising that implies the two are interconnected just to get a surge in phone calls and applications. 

Fixed rate mortgages quite often move in the OPPOSITE direction of the Fed Fund rate in the short term because a Fed rate cut can often trigger a flood of bond sales by investors.  This happens because a lowering of the Fed rate is often viewed as bullish on Wall Street, which triggers the selling of bonds to free up capital for investors so they can buy stocks.  And when mortgage bonds are sold, they YIELD rises (price and yield have an INVESRSE relationship).  And when the YIELD rises, mortgage rates rise also.

So the next time you hear that the Federal Reserve Bank lowered interest rates, don't assume that means mortgage rates will also drop.  Many complex factors affect mortgage rates.