Mortgage Q&A: Liquidity, credit will lower rates

The stock market’s free fall last week prompted Federal Reserve Board Chairman Ben Bernanke to abruptly lower two key interest rates. The federal funds rate, which is the rate banks charge each other for overnight funds, was lowered to 1.50 percent. The discount rate, which is what the Fed charges banks for short-term funds borrowed from the Federal Reserve, was lowered to 1.75 percent.

What’s interesting is that the Fed coordinated its rate cuts with other world economic powers. Central banks in England, Canada, China, Sweden and others also lowered key interest rates.

Contrary to what many believe, these rate cuts don’t necessarily equate to lower mortgage rates. Remember, most mortgage programs carry fixed-rate terms of 15 or 30 years. This is a very different financial instrument from an overnight loan. In fact, mortgage rates rose after the announcement.

This is easy to explain: Mortgage rates are tied more closely to other long-term, fixed-rate instruments, such as the 10-year Treasury bond. During uncertain economic times, investors will rush into the bond market as a safe haven to park their money. The Fed’s announcement gave the market a confidence boost, triggering a selloff in Treasury bonds, sending their yields higher. Mortgage rates followed.

The credit crunch and struggling economy make this picture a lot more complicated. Ever since the subprime mortgage debacle and subsequent credit crunch, investors have shied away from once-popular mortgage-backed securities. Mortgage rates — while still relatively low, in my opinion — have remained artificially high.

The federal government is making a tremendous effort to free up cash and jump-start the economy, but so far, the markets have been relatively unresponsive. Two factors must combine to alleviate the credit squeeze:

• As the federal government relieves financial institutions from underperforming assets, such as delinquent mortgages, banks will become more liquid. (Despite the increased liquidity, however, banks still may be reluctant to lend money. “Once burned, twice shy,” as they say.)

• Credit standards are much higher than a couple of years ago. The majority of new mortgages originated, for example, are likely to be approved only if the borrowers have a decent down payment, good credit and verifiable income. Lenders don’t want a repeat of the subprime fiasco.

The combination of these two things should relax the banks’ purse strings and get money flowing through the economy again. Barring any new outside economic news, mortgage rates should fall, making homeownership more affordable. The question is when. I’m hoping to see it sometime in 2009.

• Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail at henrysavage@pmcmortgage.com.