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.
The Investor’s Perspective
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.
The Rise and Fall of MBS Prices
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.
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.
While macroeconomic news won’t tell you everything, it pays to keep yourself informed. Here
are the top economic indicators every mortgage broker or loan officer should follow.
Predicting MBS Markets
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 banker, 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.
Michael Lux, CDLP, GRI
Manager
[email protected]
Office: (754) 260-1516 | Cell: (954) 612-2690
3878 Sheridan Street
Hollywood, FL 33021
SERVING S. FLORIDA SINCE 1982. MichaelLux.com
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