Why Are Interest Rates Rising?

On today’s show we’re talking about the fallout of the current covid-19 crisis on real estate investors.

The news media have filled the airwaves with news of the virus outbreak. The Federal Reserve and central banks the world over have responded by lowering interest rates. Under normal conditions, we would expect to see interest rates falling.

But in a strange twist, mortgage rates have actually increased in the past few days. That’s right you heard me correctly. In a falling interest rate environment, the quoted rates for mortgage loans have gone up in the past week.

So the question is why?

Last week, the rate for the 30 year government backed JUMBO loan in the US hit a low of 3.25% on March 2. Today, the quoted rates are averaging from 3.65%. I’ve seen several explanations for this.

The folks at Barrons magazine have speculated that there is a lag between the fall in treasury yields and the yields for mortgage backed securities. The Barrons article is saying the banks have been slow to lower rates to even match the fall in mortgage backed securities yields.

Let’s dig into this aspect a little deep so that we understand how the banking system works.

The bank takes in deposits from everyday people. Most people have their bi-weekly pay check deposited into their bank account.

The bank then turns around and lends that money out to people who are looking to buy houses, finance cars, refinance their homes, buy things using credit cards and so on. Not only do they lend out the money taken on deposit, they lend that same dollar on deposit up to 9 more times. The bank regulator only requires banks to hold reserves of 10% of the total deposits in cash.

But even with this system of multiplying the deposits into an order of magnitude more loans, the banks want even more leverage. So rather than keep the loans on their books, the banks then issue bonds called mortgage backed securities. The banks then earn a profit on the spread between the interest rate on the bond and the loan being charged to the customer.

If the banks can’t sell the bonds, then they run out of cash to lend out. The deposits in the banks aren’t enough to satisfy the demand for loans.

Elsewhere in the bond market, we’ve seen money flooding into the bond market from the stock market as investors flee stocks in search of safer yields. Overwhelmingly the cash has been going into US treasuries.

So let’s go back to the mortgage market and understand what’s happening there.

According to a report in the Wall Street Journal this morning, the banks are having trouble selling their mortgage backed securities. The normal buyers for these bonds haven’t materialized in the past week. If the banks can’t sell their bonds, then they can’t write as many loans. This is translating into the banks having to offer a higher interest rate on their bonds in order to sell them. This in turn translates into a higher rate for mortgages at the consumer end of the market.

This effect is yet another example of the counter party relationships that exist all throughout our financial system.

I predict that we’re going to see a shift in lending practices over the coming weeks. I’m predicting that there will be less liquidity in the market as real investors reduce their activity in the bond market. I also predict that the Fed is going to keep printing money like never before in order to make the market appear orderly and like nothing bad is happening. How this shakes out isn’t entirely clear. For the time being, you can expect the spread between the treasury rates and the mortgage rates to increase.