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Mortgage Q&A: Bailout doesn't fix rate spread

By Henry Savage SPECIAL TO THE WASHINGTON TIMES | Friday, September 26, 2008

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Two weeks ago, I wrote about the federal government's announcement that it was bailing out mortgage giants Fannie Mae and the Federal Home Loan Mortgage Corp. (Freddie Mac). These huge so-called government-sponsored enterprises were chartered by the federal government to ensure consistent availability of mortgage money to the American public.

Specifically, Fannie and Freddie purchase mortgage loans from banks, package the loans into mortgage-backed securities and sell them to individual and institutional investors. The arrangement had been wildly successful, making housing more affordable and mortgage money available to everyone.

In recent years, however, the housing bust coupled with easy mortgage money backfired, causing the rate of defaults and foreclosures to skyrocket. Fannie and Freddie, which collectively hold or guarantee nearly half of all outstanding mortgages in America, reported losses in the past year of $14 billion.

Considering the gargantuan size of these two institutions and the predicted consequences of their failure, the federal government decided to spend taxpayer money with a bailout plan.

My column two weeks ago predicted that mortgage rates would subsequently fall. It makes perfect sense. Part of the bailout plan calls for the Treasury Department to purchase Fannie and Freddie's mortgage-backed securities, which would provide liquidity to the marketplace.

My recollection of my economics classes in grad school led me to predict that mortgage rates should fall. It's simple supply and demand. The demand for mortgage-backed securities should increase the price of these securities, which would lower the yield, reducing interest rates.

Indeed, mortgage rates did fall significantly on the Monday after the Fed's announcement of the bailout. Rates on 30-year fixed mortgages fell about three-eighths of a percent - a huge one-day drop.

Since then, however, mortgage rates have crept back up to levels prior to the bailout announcement. I'm having a hard time explaining this. Since the mortgage meltdown, it's no secret that mortgage-backed securities have been out of favor with investors. However, the Fed's actions to provide liquidity in the marketplace coupled with the stringent post-meltdown underwriting standards should create demand for mortgage securities, resulting in lower rates. It hasn't happened. What am I missing?

Let's consider the spread between the yield on the 10-year Treasury bill and a 30-year fixed-rate mortgage. The yield on the 10-year T-bill has been a loose but reliable gauge to determine the movement of fixed-rate mortgages. If the yield on the T-bill dropped or rose by a quarter percent, we could expect mortgage rates to move in the same direction and by roughly the same amount.

Let's compare the 10-year Treasury yield with the rate offered on my oft-touted zero-closing-cost, 30-year fixed-rate mortgage for a refinance. Back in mid-2003, the yield on the 10-year Treasury bill was floating in the 3.50 percent to 3.75 percent range. At the same time, my company was quoting a 30-year zero-cost refinance rate between 5.50 percent and 5.75 percent.

By contrast, the 10-year Treasury yield has been hovering in the same 3.50 percent to 3.75 percent range all month. With the exception of the one day after the bailout announcement, the rate on the zero-closing-cost, 30-year fixed refinance has been hovering in the 6.25 percent to 6.50 percent range.

The spread between the Treasury yield and mortgage rates is three-quarters percent to 1 percent higher than it used to be. This tells me investors are still shying away from mortgage-backed securities, despite the government's efforts.

While the current rates are certainly at acceptable levels, if the spread between T-bills and mortgage rates would go back to its traditional range, millions of homeowners would be able to save a lot of money by refinancing, which would pump money into the economy, possibly staving off an economic recession.

If any of my clients are reading this, rest assured I'm keeping a keen eye on it.

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

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