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Fed Cuts Interest Rates Down to Zero To Battle Against CoronavirusThis is an excellent question. I’ll answer it in detail, but fair warning: the answer is somewhat technical.

Before the economic effects of COVID-19 began to appear, the Federal Reserve announced that they were cutting the Federal Funds Rate by 50 basis points (.5%). They lowered it again by a full percentage point on March 15. The Fed lowers the FF rate to stimulate the economy or raise it to slow excessive economic growth, which would lead to excessive inflation.

The Federal Funds rate has nothing to do with mortgage rates. It is the rate banks charge to lend money overnight to other banks. When the Fed lowers the FF rate, the prime rate follows. That will directly affect HELOCs and often credit card rates—but not mortgages.

The money you get from a mortgage lender comes from a specialized line of credit called a warehouse line. You don’t care where the money came from, because you got the money you applied for at the terms you agreed to.

After funding, the lender sells your loan to an investor—Fannie Mae and Freddie Mac are the best-known, although there are many others—for a profit. This is the fundamental business model of the mortgage industry.

The investor pools the loans into a type of bond called a mortgage-backed security (MBS). Investors trade them on the open market like other types of securities.

When the price of MBS goes up, mortgage rates come down because lenders can get the profit margin they expect with a lower interest rate. If the price of MBS goes up 25 bps (0.25%), the rate of a 30-year fixed-rate mortgage typically goes down about 1/16%.

I should have prefaced the above with “in normal times.” The situation today is anything but normal. Here is what has changed.

When the lender agrees to lock your loan, they are promising to give you specific terms—both the rate and the discount points. One point is 1% of the loan amount. They will fund your loan at these terms regardless of the price the investor pays.

If the price of MBS goes down after the lender locks your rate, they will get a lower price for the loan, possibly less than the amount they gave you. To protect themselves against this, they will hedge the loan. The lender “shorts” MBS so that if prices go down, they’ll make money on the short position. Readers familiar with trading stock options will recognize this as a “put” or “short position.” The profit on the hedge offsets the loss from selling the funded loan at a lower price.

If MBS prices go up, however, they lose money on the short position (the hedge), but make more money when they sell your loan. The two cancel each other out. Lenders routinely hedge their pipelines to guard against the normal fluctuations in the market.

When rates drop rapidly, as they did following the week of February 24, many borrowers see an opportunity to lower the cost of their mortgage by refinancing. They may have done this even though they have had their loan for a short time. Residential mortgages no longer contain penalties for early payoff, but these early payoffs can cost the lender a great deal of money.

Even though the lender who funded your loan has sold it to an investor (Fannie or Freddie, for example), they may retain the servicing: issuing statements and collecting payments. The servicer typically receives a fee of .30% of the loan for doing this.

They purchase the rights to service the loan for about 1% of the loan amount, so it will take about three years for them to break even. Loan servicers may increase their servicing income by getting a loan, using the value of their servicing portfolio as collateral.

With the rapid drop in rates, borrowers have been refinancing and paying off their old loans far ahead of schedule. The loan servicer, who paid in advance for the rights to service the loan, may not have had that loan long enough to recover the fee they paid.

The lender typically earns additional profit from the higher volume of new loans, offsetting the servicing losses. But the COVID-19 crisis has brought much of the U.S. economy to a near-halt. Some borrowers can’t complete their transactions because their income has been interrupted or curtailed. The lender has had to pay hedging costs, but do not have the income from selling a funded loan to offset it.

Furthermore, the Federal Reserve, in its effort to stimulate a faltering economy, has launched quantitative easing for the fifth time in its history. They enter the market directly to purchase mortgage-backed securities and Treasury Bonds. They have announced that they will buy “unlimited” quantities of MBS, initially up to $50 billion each day.

Mortgage bond prices have soared as a result. Daily MBS activity ordinarily looks like this:

The green bars represent days where the MBS price closed higher. The size of the bar indicates the amount of change for the day.

Here is the activity for the past two weeks:

The scale of the two charts is approximately the same. The volatility is dramatically higher.

On days with very large green bars (higher MBS prices), lenders will take huge losses on their hedged positions. The broker-dealers issue margin calls to cover these losses. Lenders have to pay tens of millions of dollars to cover them. They must keep their rates higher to recover some of these losses.

Although the Federal Reserve’s intentions are laudable, their actions have the opposite from the desired effect. The rapid increase in MBS prices because of the Fed’s massive purchases is costing lenders millions of dollars in hedging losses. And with many loans not being able to close because of a borrower’s loss of income, lenders are not offsetting the hedging losses with additional income.

The Fed’s failure to communicate effectively—and communication is a critical responsibility–exacerbates the situation. When they executed two massive rate cuts in rapid succession, many borrowers with locked loans broke their locks, expecting better rates elsewhere. The first lender was left only with the hedging losses.

There will come a time when the effects of COVID-19 will subside. Lenders will clear their pipelines, and rates will return to normal. Borrowers with locked loans should do their best to meet all conditions to move through the process to funding. If rates improve later, there will always be an opportunity to refinance.

For now, we must minimize the health risks associated with COVID-19. Shelter in place, wash your hands and stay informed with reliable information. Memes and unattributed articles on social media are NOT reliable. The best places to start are the CDC website Coronavirus Disease 2019 (COVID-19), World Health Organization Coronavirus, and Johns Hopkins COVID-19 information

We’ll get through this. Stay well and be safe.

Image result for mortgage rate seesawThis is a recurring question I’ve answered multiple times, but I think it is important enough to take one more swing at it.

The first thing to know is that “the banks” are not the ones to set mortgage rates. Nor is the Federal Reserve—their recent rate cut, dropping the Federal Funds rate to near zero, has not caused mortgage rates to go down, nor will it have that effect.

Most mortgages today are sold to investors on the secondary mortgage market. Fannie Mae and Freddie Mac are the best-known players, but there are others. Fannie and Freddie pool these loans into bonds called mortgage-backed securities (MBS). These securities are traded on the market like other bonds. Their price fluctuates according to the market activity.

When the price of the MBS goes up, rates go down—normally. When the price goes down, rates go up. This is because lenders expect to earn a certain percentage on each loan they sell to the investor. When the price of MBS goes up, they can get their desired profit at a lower interest rate.

The normal intraday fluctuation of MBS prices is about 8–15 basis points (bps). One bp is equal to $0.01 per $100 of coupon value.

Bonds tend to be contrarian: when stocks sell off, bonds normally go up. This is because investors who want to get out of stocks will put the money into the comparative of bonds. This is called flight to quality.

We saw this happen during the week of February 24, 2020. Stocks began selling off sharply in response to fears of the economic effects of the coronavirus. The fear-driven sell-off was exacerbated by the sudden “emergency” rate cut announced by Fed Chair Jerome Powell on 2/28. The 50 bps cut caused stocks to continue their decline, with money flowing into MBS. Rates dropped about .375% during the week. Refinance applications spiked, with lenders getting in some cases three times their normal volume in new applications.

Here’s what MBS looked like during the week of 2/24. The green bars represent higher MBS prices and lower rates:

With the increased volume flowing into lenders, they engaged in the practice of throttling. This means that they purposely raise their rates to inhibit the flow of new applications until they can regain control of their workflow. Lenders prefer to turn business away rather than allow their service levels to decline to a point where they lose future business. In some cases, lenders increased their rates by a full percentage point or more.

As the implications of the pandemic—and the government’s ability to deal with it effectively—became evident, the stock market’s volatility increased, with intraday swings approaching 3,000 points:

All this selling would normally result in a strong rally in MBS and correspondingly lower rates. Instead, MBS are doing this:

The extreme volatility is causing investors to sit out the crisis with cash, so both stocks and bonds are under pressure. With these extreme swings in MBS prices, lenders in many cases are having to re-price multiple times each day as they try to stay on top of the markets.

The best advice I can offer in these turbulent times is this: if the rate you have now is 4% or higher, you will benefit if rates find their earlier low levels. There is no way to know for certain whether this will happen or when, but you should get in touch with your preferred lender and get an application into their system. This way, you’ll be in a position to act quickly if and when rates drop again. Expecting loan officers to call you if rates drop is not realistic; everyone will be too busy to call people who were on the fence before.

And wash your hands. 20 seconds, minimum.

Image result for roller coaster volatilityOn Sunday, March 16, Fed Chair Jerome Powell announced a second “emergency” rate cut, three days ahead of the scheduled meeting of the Fed Open Market Committee. Powell also announced a new round of Quantitative Easing—the fifth move of its kind in recent history. This means that the Federal Reserve will enter the market and purchase $500 billion in Treasuries and $200 billion in mortgage-backed securities (MBS) over the next few months. The latter normally affect mortgage rates directly, but with the current turmoil in the markets, borrowers are unlikely to see significantly lower rates immediately.

The reason for this, as I mentioned in a recent article, is that lenders are currently dealing with more new loans than they are equipped to handle. They are “throttling” their pipelines, keeping their rates comparatively high to slow the flow of new business. We are likely to see improvements only once they have gotten control of their pipelines.

The reaction to the Fed’s announcement was extreme in both equities (stocks) and bonds—including MBS. Stocks plummeted on the news, triggering automatic “circuit breakers” to halt trading as all major indexes plummeted. The Dow fell at one point to 20,387—nearly 2,800 points below Friday’s close.

MBS, on the other hand, rallied strongly, continuing the recent theme of high volatility. At this writing, the Fannie Mae 3.0 coupon is up 123 basis points. Higher MBS prices (green bars) normally mean lower mortgage rates.

MBS volatility

There is a very good possibility that rates will come close to the low levels we saw two weeks ago but this is by no means a sure thing. If your rate is higher than 4% today, you’ll benefit from refinancing.

I have two pieces of advice to offer. First, don’t wait until rates drop further to start the process. When loan officers get overwhelmed with new applications, they simply do not have the time to go through their database of “possible” clients to convince them that now is the time to refinance. A far better strategy is to start an application now, with a clear idea of what your goal rate is. Doing this means that you will be a client, rather than someone who once expressed a casual interest. When you are in the loan officer’s pipeline, you can be assured that they will contact you when the rates drop.

Second, don’t get greedy. If you can lock a rate that makes economic sense, do it. Holding out for another 1/8% could mean losing your opportunity it rates move back up, as they did without warning last week. To put this into perspective, the difference of 1/8% on a $400,000 loan is a payment difference of $28 in your monthly payment.

If you’d like to start an application today, you can do so on our secure client site:
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arrowsThis is a good—and frequently asked—question.

To understand what’s going on now, you have to know at least the fundamentals of how the mortgage industry operates.

When a lender underwrites, approves and finds a loan application, they do so with the intent of selling that loan on the secondary mortgage market. Fannie Mae and Freddie Mac are two of the best-known participants, although there are many more.

The lender sells the newly-funded loan at a profit—over the face amount of the loan. This is where they make their money, not with any interest they collect from the borrower.

Fannie and Freddie and other secondary market players pool their loans into a type of bond called a mortgage-backed security (MBS). These bonds, which investors perceive as having extremely low risk, move up and down in price in response to the way investors buy and sell them.

When the bonds are in high demand, their price goes up. Rates always move in the opposite direction: higher bond prices mean lower mortgage rates, and lower prices mean higher rates.

The MBS market normally fluctuates about 10–15 points per day, although 25-point intraday moves are not unusual. Here is a daily chart of recent MBS activity (December 20-Jan. 19). The longest bars represent a range of about 25 points.

In “normal” times, a change in MBS prices results in a proportionate change in the cost of mortgages to consumers. These changes appear more-or-less immediately. Some lenders issue mid-day price changes in the case of larger moves in MBS prices. Others may wait until the next day to publish the changes.

If MBS prices go up 25 points in one day, the consumer’s cost of a $400,000 mortgage will go down by $1,000, assuming they have not previously locked. The converse is also true: if MBS prices go down 25 basis points, the consumer’s cost of a $400,000 loan will go up by $1,000 if they have not locked.

That’s what happens in “normal” times. Here is what has happened recently.

On February 24, 2020, investors began selling stocks in response to fears of the economic effects of the COVID-19 virus. The Dow lost 3,000 points in one week. The money flowed into bonds—including MBS, increasing their price. This movement in bonds is called “flight to quality,” as investors seek to minimize their risk in turbulent times. As MBS prices increased, mortgage rates dropped. Lenders experienced a sudden influx of business and were overwhelmed. More about this momentarily.

On March 3, Fed Chair Jerome Powell announced an “emergency” cut in the Federal Funds rate of .50%. This announcement came as a surprise, as the market had widely expected the Fed to lower the rate at the March 18 meeting. Although Powell intended the sudden large rate cut to stimulate the economy, investors were surprised and taken aback, and the Dow plunged 526 points on the news.

There have been ongoing concerns about the U.S. response to the crisis as the virus was declared a pandemic, and stocks continued to fall while exhibiting spectacular volatility. There were several times where automatic “circuit breakers” halted trading during the day. At this writing (3/13/2020), the Dow has lost more than 5,200 points, often fluctuating 2,000 points in either direction.

Here is a chart of the Dow, from February 24 to March 13:

The volatility in stocks has appeared in the MBS market as well—and this has been a rare occasion where sell-offs in equities has not consistently resulted in purchases of bonds. Here is the MBS chart for the same period as the Dow, above:

Thank you, patient reader, for sticking with this lengthy explanation. The real answer is near. For anyone who might have dozed off or forgotten the original question, it was why rates have not dropped after the Federal Funds cut.

The first part of the answer is that the Federal Funds rate has nothing to do with mortgages. It is the rate banks charge each other to loan other banks money overnight. Mortgage rates are a function of mortgage-backed securities.

Except when they’re not.

When rates drop suddenly, many people submit refinance applications to lower their rates and save money. Lenders have a finite capacity for the number of loans they can handle, and they quickly get overwhelmed. The volume of new loans is about 2.5 times what it normally would be at this time of year.

Lenders manage their workload by “throttling.” This means that they purposely increase their rates to discourage borrowers (and brokers) from submitting new loans. While purposely turning away business may seem like a poor business strategy, it makes sense; lenders would prefer to keep their service levels high to avoid losing relationships with the borrowers, brokers and correspondents who are the source of their business.

The perceptive reader may notice that there have been four days of red bars on the MBS chart (lower prices, higher rates) at the end of the week even as stock prices have also been under pressure. The simplest explanation for this unusual phenomenon is that with the extreme volatility in both stocks and bonds, together with continuing uncertainty surrounding the effects of the novel coronavirus (and the U.S. response to it) that they have elected to “sit out” this period and wait to see a predictable direction in the market. Rather than parking their money in bonds, investors’ flight to quality over this past tumultuous week has been to move into cash—the ultimate safe-haven investment.

Mortgage rates, which bottomed out around 3.25% for a 30-year fixed-rate conventional loan, have gone back to 4% this week. Will they rebound? Probably—but it remains to be seen whether we will see them drop as far as they did earlier in the month.

The best advice I can offer today—and what I tell my clients who were hoping to see lower rates—is this: If you are buying a home, lock your rate as early as possible. Playing “bond market roulette” is always a risky (and often expensive) proposition. You can always refinance later if rates drop again.

To people who had been on the fence about refinancing but took too long to decide: don’t ask lenders to call you if and when rates drop. We won’t. When rates drop as they did earlier in the month, we are too busy answering our phones and originating loans to call people who couldn’t decide earlier. Start an application now, with a clear goal of what your target rate is. When you are a client, with an application already in the lender’s system, you’ll get a call if and when rates improve. If you are a prospective borrower who is only mildly interested, loan officers will be too busy to reach out to you. This may seem callous, but it is the way things are.

I hope this somewhat lengthy explanation is helpful.

If you’d like to start an application, go to our secure online application. You can also call or text us directly at 925-383-2846

Supplemental Taxes

Congratulations on your new home! You can expect to get a LOT of mail from now on. Some of this will be from people who want to sell you things. You may want to toss some of this into the trash as junk mail, but there is one piece of mail that you should pay attention to.

The county will send you a Supplemental Tax Bill shortly after you buy your home. You should call your new lender immediately to find out whether they have also received a copy. If they haven’t send the one you’ve just received to them. When we set up your new loan with an escrow account, we made allowances for the supplemental taxes, so the lender will pay them, but only if they get a copy of the bill. This is not always automatic!

This short video refers to San Diego, but it applies to your county as well.

As always, you should reach out to us with any questions or concerns. We are here to help!