Mortgage Rates Would Lose at Limbo - They're About as Low as They Can Go

Wall Street Journal, Oct. 12 2010
By PRABHA NATARAJAN

Mortgage rates have hit another record low—4.27% on average for 30-year fixed-rate loans, according to Freddie Mac—but analysts and others say home-loan rates are much higher than they should be.

Don't bet the house, however, that they will drop too much lower. Rates haven't fallen further, analysts and bankers said, because banks are unwilling to lower rates and lose profit margins, and because of uncertainty in the market that makes it difficult for them to predict the number of home buyers.

Instead of moving the rate lower to 4%, which banks might have done at "normal times" when bond yields are as low as they are, "illiquidity and unusual situations are causing originators to hold rates at this level rather than risk losing money on new loans they have difficulty hedging," said Paul Jacob, director of research at Banc of Manhattan Capital, in Manhattan Beach, Calif.

Based on the yields of mortgage-backed securities traded on secondary markets, David Cannon, head of mortgage trading at Royal Bank of Scotland Group PLC, says that the mortgages in Freddie Mac's weekly survey should come with interest rates between 3.75% to 4%.

At those lower rates, a homeowner could lower his monthly payments on a $200,000 loan by $30 to $60—saving nearly $22,000 over the full life of a 30-year mortgage.

Moving toward the theoretically lower rate isn't a simple matter, however. There is a convoluted scenario at work that goes at the heart of how mortgages are bundled together and packaged into securities that are sold to investors.

Typically, local and regional banks lend to homeowners, then sell those loans to larger banks or aggregators, such as Citigroup Inc., Bank of America Corp., Wells Fargo & Co. and J.P. Morgan Chase & Co. These firms pool loans from across the U.S. into mortgage securities.

Normally, small banks would push rates as low as they could go in order to make more loans and thus make more money. But they have found that while lower rates may bring in more home buyers, there is little guarantee that many of these consumers will qualify for a loan under today's austere borrowing standards.

Further, these originators make money from the rates at which they can sell these loans to aggregators. Lower rates mean narrower margins for them, while the aggregators who buy these loans at lower rates stand to gain from selling them at higher rates in the secondary market.

Because there are so few new mortgages and so many investors eager to buy them, "the system now allows large aggregators to control the price on a loan and an interest rate the borrower gets," said Mike Delehanty, president of Apex Analytics in Wildomar, Calif., which advises banks on selling their loans to larger mortgage-finance companies.

Mortgage rates usually are based on the yield investors are paid for the risk of purchasing securities backed by home loans, and the premium that the lender charges to service the loan.

Currently, the yield on government-guaranteed mortgage security is 3.206%, and the primary mortgage rate is 1.064 percentage points higher. Historically, the difference is in the range of 0.50 to 0.70 percentage point, according to Amherst Securities Group.

That unusually wide gap indicates that banks continue to make it tough for consumers to get really low rates on loans, as they fiercely protect their gains.Representatives of the country's largest mortgage lenders, including Citigroup, Bank of America, Wells Fargo and J.P. Morgan Chase, declined to comment or didn't return phone calls seeking their views.

Mortgage rates aren't likely to drop significantly even if the interest rate on the 10-year Treasury bond and corresponding yield on mortgage securities drop further.

"Even if interest rate drops to 2%, mortgage rates are going to stay right here," said Paul Norris, a portfolio manager at Dwight Asset Management in Burlington, Vt. "Originators don't expect mortgage supply to be robust and will want to keep rates in the 4.25% to 4.625% range for the next few months."