Confused? That's what an unprecedented decline in the nation's credit rating will do to you.
Mortgage interest rates--aka "nominal interest rates"--have been driven downward by a massive flight-to-safety purchase of U.S. debt, which is seen as a safe place to park money, even if it yields virtually nothing to investors.
Mortgage rates should have fallen even more
That fall in nominal interest rates actually masks the effect of the downgrade of the debt of the U.S. (and Fannie and Freddie), which in turn raises their borrowing costs somewhat. As mortgage shoppers know all too well, riskier borrowers are required to pay more. How much more is a function of the demands of investors in the market.
With so much bleak economic news both here and abroad, the effect of the credit-rating downgrade has merely served to keep interest rates from falling even further than they would have absent the downgrade. The tremendous rally in Treasuries--fueled by scared investors looking for a place to park money--would likely have driven those yields even deeper into record low territory.
Borrowing costs have risen
This is perhaps more so the case with mortgages. The credit rating of Fannie, Freddie and the Federal Home Loan Banks–all wards of the government--were also downgraded this week. This in turn raises their cost of borrowing which will ultimately be passed along to borrowers.
Also, while there seems to be unlimited appetite for Treasury debt, that is less the case for Fannie and Freddie debt, and especially true for mortgage-backed securities, which carry all kinds of additional risks.
Investors may still be willing to lend to Uncle Sam at rock-bottom interest rates, but the definition of rock-bottom has just been moved up somewhat. Where investors might have been interested in a 2 percent yield with a AAA rating, they might now only be attracted to AA+ debt with a 2.1 percent yield. As such, the base cost of borrowing has increased. If mortgages are priced at a markup over the 10-year Treasury, the cost of borrowing is bumped up along the line.
After effects masked by “flight to safety”
However, these more or less permanent increases in the cost of borrowing are being fully masked by a massive flight to safety as investors run for cover from brutal market conditions. As a result, and despite the increase in the "real" cost of credit, “nominal” mortgage rates are falling... but they aren't falling as steeply or as deeply as they might have, in the same market conditions, absent the downgrade.
This actually means borrowers (including the U.S.) are paying a higher "real" rate to borrow, even as they are paying a lower interest rate.
Interest rates are down, borrowing costs are up
This can be seen in widening spreads. Assuming mortgage rates are priced off the 10-year Treasury, the differential (spread) between the average conforming 30-year fixed-rate mortgage and the 10-year Treasury yield was about 180 basis points (1.80 percent) or so before the credit downgrade.
After the downgrade, and with the massive rally in treasuries, that gap has widened to over 200 basis points, as mortgage rates have declined far less than the Treasury. Even though your "nominal" interest rate is lower, your "real" borrowing cost has moved higher.
This being the case, interest rates are down, but borrowing costs are up.
Mortgage rates didn’t fall as much as they could have
This would be more visible in a different set of market conditions, but for now let’s just say that the effect on mortgage rates is that they didn't fall as much as they could have, as part of the decline has been absorbed by the increase in spreads.
Of course, you, the borrower, don't pay spreads; you pay nominal interest rates, which are still more attractive than they were, at least for now. However, if you're expecting to find plummeting mortgage rates, you might be a little surprised to discover how sticky they actually are.
The volatility in the market is making it hard to know what's going on with rates. Mortgage rates headed down sharply starting last Friday, rose sharply by day's end Friday, then went back down the other side of the roller coaster in an even larger dip on Monday, back higher to start Tuesday, and even further down as we write this.
The whipsaw continues. Mortgage rates are declining... somewhat. Stay tuned.
A 25-year expert observer of the mortgage and consumer debt industries, Keith has been cited in tens of thousands of articles covering a wide range of consumer finance topics. These articles have appeared in publications and outlets including The Wall Street Journal, USA Today, Money Magazine, The New York Times, Kiplinger publications, US News and World Report, BusinessWeek, Forbes, Bottom Line Publications and dozens of local newspapers. He has been a featured guest on NPR Radio and Oprah Winfrey's XM Radio program with Jean Chatzky, and has been seen on CNBC, CNN and the national news broadcasts for ABC, CBS and NBC television networks.
Keith has authored or co-authored a number of consumer guides on first mortgages, refinancing, home equity, mortgage prepayment and more, and is the primary researcher and writer for HSH.com's MarketTrends newsletter. He has contributed expertise to a number of books written by Jane White, Beth Kobliner, John Dorfman and others.
