What Interest Rate Spreads Can Tell Us about Mortgage Markets
The target for the federal funds rate has been slashed three full percentage points since September, from 5.25 to 2.25 percent. Yet, despite this steep drop, the average interest rate on 30-year fixed-rate mortgages has fallen only about half a percentage point—from about 6.4 to about 5.9 percent—over the same time span. Why has the central bank’s aggressive action had such a small impact on these mortgage rates, and what does this mean?
The Fed does not set mortgage rates, but it does set a nominal target for the federal funds rate, the rate at which depository institutions lend their reserve balances to one another, usually overnight (a very short maturity). The fed funds rate in turn directly affects the price of other fixed-income assets of similar maturities and quality (measured in terms of default risk and liquidity); this is the case for short-term Treasury securities, for example. However, as the maturity of an asset gets longer, the link between its price and the funds rate becomes more tenuous. This is because the price of a long-term bond incorporates not just recent changes in the short-term rates of all relevant assets but their expected future short-term rates as well. For example, the spread between the interest rate on a 10-year Treasury note and the federal funds rate has risen recently because the future path of the federal funds rate is expected to go up.
Once we control for maturity, the spread between securities should tell us something about the role that liquidity and risk are playing in pricing the assets. A good benchmark for the 30-year fixed-rate mortgage is the 10-year Treasury note, because 30-year mortgages usually get paid off in 10 years. The spread between the average prime conforming mortgage rate and the 10-year Treasury note has been heading north since the summer of 2007, reflecting turbulence in the mortgage-backed security market, a secondary market for mortgages. With the housing meltdown, pricing mortgage-backed securities, especially the more sophisticated ones, has become even harder, as risk has increased, and liquidity in the mortgage-backed security market has dried up (just think about the billions of dollars in write-downs). An illiquid mortgage-backed security market, in turn, makes the repackaging of mortgages more difficult. Because mortgages are more difficult to repackage, mortgages themselves become less liquid for mortgage originators, who then seek higher compensation for the loss of liquidity. In fact, although the average 10-year Treasury yield has fallen 93 basis points to 3.59 percent since September (when the Fed started cutting the fed funds rate), the average yield for 30-year fixed-rate mortgages has fallen only 50 basis points to 5.88 percent. As a result, the spread between the average 30-year mortgage and the 10-year Treasury note has widened about 60 percent over the past year. The spread stood at 148 basis points in April 2007 and now stands at 233 basis points, having reached its peak of 262 basis points in March at the time of the Bear Stearns bailout. The risk of a financial meltdown clearly affected the prime conforming mortgage rate and even caused its level to increase. More recent data, though, show the spread retreating from its peak, suggesting that the risk of a financial crisis has decreased (as other indexes also indicate).
Compared to the 1990s, the spread between mortgage rates and treasuries is elevated, which suggests that financial markets are still working through their prior excesses. To find levels higher than the current ones, we have to go back to the 1980s, in particular to the early part of the decade, when the spread reached its historic high. This was a time of great economic turmoil, with a high rate of inflation, two back-to-back recessions, and banking deregulation.
Given the excesses that occurred in the housing and mortgage markets, it is not surprising that market participants are being more cautious. Some potential home buyers are holding back, and lenders have implemented tougher lending standards and are charging more for loans. From January 1972 to April 2008 the median weekly spread is about 160 basis points between the 30-year fixed-rate mortgage and the 10-year Treasury note. If this more normal spread prevailed, fixed-rate mortgages would be around 5 percent today, instead of the current 5.88 percent. Until market participants regain confidence, rate spreads are likely to continue to deviate from their historical norm. Had the Fed not lowered the funds rate, mortgage rates would likely be even higher. Assuming there are no more large shocks, it is likely that the spread will ease back to more normal levels, providing a boost to home buyers, who, after all, care about their mortgage rate, not the fed funds rate.