Mortgage Q&A: Tight credit Fed’s prime challenge

The Federal Reserve Board had a two-day closed-door meeting last week. While there are signs that show the economy is recovering, the Fed has every intention of keeping rates low for an extended period of time because any recovery is likely to be a weak one. Furthermore, the Fed believes that there is little threat of inflation, which supports a policy of low interest rates.

It appears that the Fed’s policy is already proving to be a good one. One day after the meeting, the Labor Department reported that the nation’s unemployment rate climbed to 10.2 percent in October, topping 10 percent for the first time in 26 years.

The Fed has a very difficult and delicate job of maintaining the appropriate level of economic growth. If rates are too low and credit is too easy, the economy can overheat and cause inflation. On the other hand, if credit is too tight and economic activity stagnates, consumer spending wanes and unemployment rises.

It’s pretty clear the Fed is having a bigger problem with the latter.

How does all of this impact mortgage rates? The Fed has control over short-term rates, such as the federal funds rate. This is the rate that banks charge each other for overnight funds. It has very little to do with the rate on a 30-year fixed-rate mortgage.

Mortgage rates are moved by market forces. Since the subprime mortgage meltdown, investors have shied away from mortgage-backed securities as a desirable investment. The government has stepped in to stabilize this huge market by purchasing huge amounts of this debt. This is what has kept mortgage rates low over the past couple of years.

Even if the Fed maintains its policy of keeping the federal funds rate at 0.25 percent, it does not guarantee that mortgage rates will remain low. In fact, the Fed has stated that it will complete its mortgage-debt purchase program in early 2010. The simple law of supply and demand tells me that rates are likely to rise when this happens because demand for mortgage-backed securities will fall sharply.

However, some analysts say that other buyers will replace the Fed in purchasing mortgage debt, maintaining a high demand and, therefore, keeping rates down.

I’m certainly not the eternal optimist, but I do think that this is a real scenario. The mortgage meltdown was caused by easy lending to less-than-qualified borrowers. Eventually, the market was going to snap - and it did so in a big way. Today, every purchase and refinance loan I close is like pulling wisdom teeth. Borrowers must have plenty of equity, great credit and verifiable income. Every “i” is dotted and every “t” is crossed before the loan is granted.

While it’s pretty clear to me that today’s underwriting standards are an overreaction, one thing is certain - the quality of each loan made today is a lot better than the loans granted five years ago. Mortgage investors are going to realize that these securities are once again good and safe investments. This, hopefully, will keep demand high for mortgage debt and keep rates down.

I’ll reread this column in six months and see where the cards have fallen.

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