The Best Borrowers Now Feel Interest Rate Pain

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mortgage-loan-markets on 3/5/08 reported that the economic stress from both sub-prime mortgage loan failings and decreasing housing values is now being felt by all borrowers. The people taking out mortgages who have excellent credit and qualifications, the best borrowers, now feel interest rate pain due to investors requirements for yield on mortgage-backed securities.

 "...[the] yield that investors demand to own agency mortgage-backed securities over 10-year U.S. Treasuries reached the highest [spread] since 1986, boosting the cost of loans for homebuyers considered the least likely to default.

The difference in yields on the Bloomberg index for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10- year government notes widened about 12 basis points, to 215 basis points, or 79 basis points higher than Jan. 15."  read full article here

If that paragraph is confusing, let me provide some basic definitions and background to assist you in understand.

When a home owner takes out a mortgage loan, that loan ultimately is packaged with others and sold as a mortgage-backed security.  A comparison can be made that investing in a mortgage backed security is very much like buying a government (US Treasury) bond. You invest $10,000 and receive a guaranteed rate of return, but the return is a lower percentage then one would expect putting money into stocks or mutual funds because there is a perception of less risk. You are supposed to get the 4% return on your investment with a bond, there are no guarantees when buying stock, but there is more potential upside.

Note the word "agency" in the first sentence? When you see "agency mortgage-backed securities" the term agency means that those securities are created either BY Fannie Mae or Freddie Mac or by another entity but the security includes loans underwritten to Fannie Mae and/or Freddie Mac underwriting guidelines. Today, with the exception of "government" loans such as the FHA, VA, USDA rural housing, etc. programs the only conventional loans to make up a mortgage-backed security that investors are willing to buy are "agency" loans.

So the article quote above is saying that "investors" - meaning those who buy "shares" of AGENCY mortgage-backed securities (bonds) are requiring a HIGHER rate of return than the US Government is paying on 10-year US Treasury Bonds.  For the last dozen years, the same type of investor purchased mortgage-backed securities that purchased 10-year UST bonds. Because we are talking about agency mortgage-backed securities, the investors believed that those securities were as safe and secure as a 10-year UST bond.  Therefore, the rate of return was fairly similar between the two.

A quick explanation of the term YIELD is appropriate here. Yield is the percentage earned from investing in a bond or security. If you invest $10,000 in a bond with a 4% yield you expect to earn $400.  Your $10,000 "yields" $400.  Mortgage industry professionals have used the 10-year UST bond yields as an indicator of interest rate movement. If the yield on a bond is HIGHER today then yesterday that is an indicator that the yield on mortgage-backed securities will also be going up.

If you can follow the mathematics that if investors require a higher return (yield) for putting their money in a mortgage-backed security then consumers have to pay a higher rate of interest.  If a loan being made today at 6.00% and the yield is 3.50%, but tomorrow investors require the yield to be 3.75% you can assume interest rates for a loan being made tomorrow will be higher.

The current spread, as reported by Bloomberg of 215 basis points, is more easily understood if expressed as a percentage (2.15%). In other words, a 10-year UST bond is being purchased by investors at 3.69% yield and the Fannie Mae MBS is having to pay 5.84% in order to attract investors.  This is the highest spread between the 2 since April of 2000 and is nearly the highest ever which was seen in 1986.

What this means to consumers is that even having excellent credit, job stability and money in the bank is not enough to offset concerns of securities investors. Partly this is due to a fear of further declining real estate property values. Another cause is a lack of investor trust in Fannie Mae and Freddie Mac as being equally safe as the US government. Although both agencies enjoy a status of "government sponsored entity" that's a status without definition. Investors aren't fully sure they know what the government would do if either agency were to actually fail. So when investors feel there is increased risk in an investment, they demand increased yields. On mortgage-backed securities, that means increased interest rates to the best consumers.

©2008 Ken Stampe 

Ken Stampe is a Mortgage Loan Originator, Mortgage Author and Mortgage Loan Officer Instructor living in Dallas, TX. Ken provided his first client a mortgage loan in 1996 and writes about home buying and mortgages to help clients make smart home mortgage loan decisions. Contact by email at  

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