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Why are mortgage rates up if the Fed is cutting?

30-year fixed mortgage rates chart
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A lot of readers have been wondering why mortgage rates are jumping — even as the Federal Reserve is busy cutting interest rates. This week, Fed Chairman Ben Bernanke makes a special guest appearance at the Answer Desk to help explain what’s going on.

Why is it, that even though Bernanke and the Fed have been lowering interest rates, ostensibly to "help the economy and the housing market", the rates on 30-year mortgages have actually risen?
— Brian W., Knoxville, Tenn.

One of the more touching moments of Mr. Bernanke’s two-day testimony on Capitol Hill last week came when Democratic Congressman Luis Gutierrez of Illinois quizzed the Fed Chairman on this very subject.

The Congressman told the Chairman of making a call last month to his daughter, a first-time home buyer, to offer her some fatherly guidance on locking in her mortgage rate.

“I think I gave her good advice: I said, ‘Go and lock it in for as long as you can,’" Guiterrez said. “Because it was like 5-1/2 percent. I said, ‘It's time, honey.’ And then I checked The Wall Street Journal, and it's like 6.38 percent. What happened?”

What happened is that mortgage rates jumped by three-quarters of a percentage point in a matter of weeks — reversing a sharp drop that began in the middle of last year.

Here’s Mr. Bernanke’s answer to Congressman Guiterrez from the hearing transcript:

“Even as the Fed has lowered interest rates, and as the general pattern of interest rates has declined, the pressures in the credit markets have caused greater and greater spread, particularly for risky borrowers, like risky firms, for example,” he said. “Our easing is intended to, in some sense, you know, respond to this tightening of credit conditions. And I believe we've, you know, succeeded in doing that, but there certainly is some offset that comes from widening spreads. This is what's happening in the mortgage market.”

The Congressman moved on to another question, leaving the discussion of tightening credit and widening spreads for another time.

But, judging from our mail, the question is still on many readers’ minds these days. How can mortgage rates go up if the Fed is cutting rates? Doesn’t that mean that banks are, in effect, price gouging?

It turns out that lenders don’t control the price of long-term loans any more than consumers do. What’s happened in the past month or so is that, even as the Fed has been aggressively slashing short-term rates — and flooding the banking system with as much money it will take — the global capital markets are still very nervous about the latest headlines on rising foreclosures, a weakening economy and losses from banks and other lenders that have topped $100 billion — so far.

It turns out there are two mechanisms for setting interest rates. All the Fed can do is target the interest rate paid by U.S. banks for overnight loans among themselves. But using short-term loans to back long-term mortgages can be risky.

If National Bank takes out a short-term loan of $200,000 from the Fed and lends it to Jane HomeBuyer for 30 years, it still has to come up with $200,000 right away to pay it back. It could do so with another short-term loan, but then it has to keep doing this over and over, indefinitely “rolling it over.” If, during this process, short term rates go up, the bank loses money. 

That’s why mortgage lenders making long-term loans turn to the capital markets — a global network of banks, corporations, institutions, pension funds, governments and individual investors who buy and sell money. When these players lend money for the long term, they agree to get paid back in installments, plus an interest rate that’s usually fixed for the life of the loan. As long as the rate the mortgage lender agrees to pay the investor is lower that the rate it charges its customer, the lender makes money.

Interest rates on long-term lending are based largely on the rates paid by the U.S. Treasury when it auctions off new paper to fund budget shortfalls. Because Treasuries are considered the gold standard of safety, turning over your money to other lenders is considered riskier — so the interest rates you get are a little bit higher. When an investor with money to lend in the capital markets get nervous, they demand an even higher interest rate to make up for the risk that they won’t get paid back.

During the easy-money days of the housing boom, investors showered cash at mortgage loans and asked relatively little extra “risk premium” in return. The feeling was that housing prices would continue to rise forever, and investing in mortgages – which paid higher returns than “super safe” Treasuries — was a no-brainer. Or so it seemed at the time. Now that home prices are falling, that risk premium — the “spread” between the higher rate on mortgage loans and the benchmark rate on Treasuries — has widened.

As long as that’s the case, the Fed could cut short-term rates to zero, and it wouldn’t cut the cost of long-term mortgage rates.

What is a recession?
Kathy, Bettendorf, Iowa

Mr. Bernanke was asked this one in his testimony to the Senate Banking Committee, and the answer he gave was a little clearer.

“Recessions are generally ‘called,’ so to speak, by a committee called the Business Cycle Dating Committee, which is part of the National Bureau of Economic Research, a committee of which I was once a member, by the way, which looks at a wide variety of indicators to see essentially if the economy contracted over a period of time,” Bernanke said. “And it's a somewhat subjective decision and is often made well after the fact, because of the revisions of data and so on.

“A more informal but widely used definition of recession is two consecutive quarters of negative growth. That would be an alternative that people use," he said.

Using the second definition, the economic data has yet to confirm that the U.S. economy is in recession. The widest measure of growth, the Gross Domestic Product, rose by 0.6 percent in the last three months of the year — the latest data available. That’s down sharply from the 4.9 percent growth rate in the third quarter of 2007 — but it’s still growth, not recession.

The GDP, according to the keepers of the data, measures “the output of goods and services produced by labor and property located in the United States.” But it’s an average of all regions and all industries; the housing industry is clearly in a deep recession, as are some parts of the country, especially in the industrial Midwest.

Some readers — along with some economists, Senators, investment managers and CEOs — believe we’re already entering a national recession.  So the entire U.S. economy could well be in the middle of the first of those “two consecutive quarters of negative growth.” But because it can take months for the economic data to be collected and revised, we won’t know for sure that a recession has hit until at least the second half of this year at the earliest.