Using the Fed Mortgage Backed Security Purchase Program to Predict Interest Rates

Fannie Mae and Freddie Mac sell mortgage backed securities that pay 4%, 4.5%, 5%, 5.5% and so on. If you read the previous post, you will notice that the investor that purchases mortgage backed securities gets paid about 0.75% to 1% less than the interest rate that is charged to the home owner.

In other words, an investor that owns a 5% mortgage backed security owns a group of mortgages that have interest rates of about 5.75% to 6%.

Furthermore, when the Fed purchases a large portion of 5% mortgage backed securities they are attempting to manipulate mortgage interest rates to be about 5.75% to 6%. For this reason, we watch which mortgage backed securities the Fed is purchasing in order to predict the future of interest rates.

Right now, this is exactly what the Fed is doing. They are buying 5% mortgage backed security coupons. This is why we expect mortgage interest rates to be in the upper 5s by the end of the year.

This is just one factor that is used to determine mortgage interest rates at this time, but this technique has proven to be pretty reliable this year.

By the way, I do understand that this is all pretty boring to most people. I also understand that there is a good chance that you are more confused after reading my explanation than you were before reading my post. Finally, I am quite certain that most people did not make it this far in their reading of this post.

Mortgage Backed Securities, Fannie Mae, Freddie Mac, and more

I am going to describe what a mortgage backed security is by telling you what happens to a mortgage after the loan closing.

Step 1: A homebuyer gets a mortgage through a mortgage company. The mortgage company sells that mortgage to a bank, also known as a loan servicer. (Citimortgage, JPMorgan Chase, US Bank, etc.)

Step 2: The bank sells the loan on the secondary mortgage market. Typically, these loans are bought by Fannie Mae and Freddie Mac.

Step 3: Fannie Mae and Freddie Mac then securitize a group of mortgages and sell them to investors. These securitized mortgages are called mortgage backed securities.

The reason that it works like it does is because individual banks, even very large individual banks, have restrictions on how much money they can lend. By selling these loans on the secondary mortgage market, they free up money to loan to the next person.

Loan servicers like Citimortgage, JPMorgan Chase and Wells Fargo make money on mortgages because Fannie Mae and Freddie Mac pay them a servicing fee. This servicing fee is usually 0.25% of the remaining principal on the loan.

Fannie Mae and Freddie Mac make money when they sell the mortgage backed securities because they pay the investor about 0.5% to 0.75% less than the interest rate they are collecting on a mortgage from the homebuyer.

If you followed all of that, then you understand that the loan servicer (Citimortgage, JPMorgan Chase, Wells Fargo, etc.) gets paid about 0.25% of the interest collected on a home loan. Fannie Mae and Freddie Mac get paid about 0.5% to 0.75% of the interest collected. The rest goes to the owner of the mortgage backed security.

Mortgage Rate Outlook

Rates are going to go up. It is almost inevitable. Why and how can I be so sure? Let me count the ways.

Reason 1: The Federal Reserve Bank is purchasing Fannie Mae, Freddie Mac, and Ginnie Mae mortgage backed securities. As you know, the value of these mortgage backed securities directly affects mortgage interest rates. This Fed program to purchase mortgage backed securities began in January and will end when they have spent $1.25 trillion. As of August 13th, the Fed had bought $741.6 billion of Fannie Mae, Freddie Mac, and Ginnie Mae mortgage backed securities. This leaves the Fed with about $500 billion more to spend. When this money runs out, mortgage interest rates will go up.



Reason 2: The United States Government is spending money at an unprecedented rate. In order to do this, they have to either print money or borrow from a country that is going to print it. What happens when governments print money? The money that already exists loses value. This, as you know, is called inflation. When inflation goes up, mortgage interest rates do as well.



Reason 3: The United States Government is borrowing money at an unprecedented rate. In order to borrow this money, they sell treasury securities. The sale of these treasury securities competes with the sale of mortgage backed securities. How? An investor who might have bought a mortgage backed security might now buy a treasury security. The sellers of the mortgage backed security will now have to raise the yield, ie. interest rate, in order to entice buyers to buy their security instead of the treasury security. Make sense? Increased competition in the securities market will make interest rates go up.



Where rates will stop is obviously unknown. Many experts believe that we will see mortgage interest rates go back to where they were before the government started their mortgage backed security purchase program. That point is the mid 6s. However, if the economy gets really hot again, inflation is really going to be a problem. If this happens, it is possible that we will see double-digit interest rates again.