Interest rates rise as bonds slump

All borrowers seen affected

By Jody Shenn BLOOMBERG NEWS | Friday, August 22, 2008

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A decline in mortgage bond prices is raising interest rates on home loans, even for borrowers least prone to default.

Rates on average 30-year fixed mortgages rose to 6.37 percent this week, about the highest in six years, as yields on bonds guaranteed by Fannie Mae and Freddie Mac increased to almost the highest since 1986. More than 70 percent of new home loans are bought or guaranteed by the government-chartered companies, making them mostly "prime" mortgages.

Higher rates for the safest borrowers may exacerbate the worst housing market since the Great Depression and thwart efforts by Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Henry M. Paulson Jr. to bring mortgage rates down. The slowest-growing economy since 2001 is already shutting out some buyers and increasing costs for those seeking to borrow with smaller down payments or below-average credit scores.

"New home buyers are going to have to get credit at reasonable terms for the decline to stop," said Christopher Mayer, a real estate professor at Columbia University's business school in New York. "The price issue alone is having a very, very big effect."

As rates rise, sellers are forced to lower prices for buyers seeking to make the same monthly payments. A rate of 6.37 percent equates to a monthly payment of $1,871 on a $300,000 mortgage, up from $1,739 when rates were as low as 5.69 percent in May, according to data from Bankrate.com in North Palm Beach, Fla.

Applications for mortgages fell 34 percent to the lowest level since 2000 in the week ended Aug. 15 from a year earlier, partly because of the increase in loan rates, according to the Washington-based Mortgage Bankers Association.

Investors were demanding 2.08 percentage points more in yield to own Fannie's current-coupon 30-year fixed-rate mortgage securities rather than 10-year Treasuries late yesterday, according to data compiled by Bloomberg. The spread reached a 22-year high of 2.37 percentage points in March, before narrowing to 1.52 percentage point on May 20.

By packaging loans into the securities and selling them to investors such as mutual funds, lenders receive cash to make new loans. The yields that investors are willing to accept help determine the rates lenders need to charge borrowers to make the bond sales profitable.

Yields on mortgage-backed debt guaranteed by Washington-based Fannie and Freddie of McLean widened relative to Treasuries as concern escalated that the companies may stop or slow purchases amid worries they don't have enough capital to weather the housing slump.

Fannie and Freddie own or guarantee almost half of the $12 trillion of U.S. residential mortgages outstanding.

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