Why are Mortgage Rates so high?

The premise of the question, “Why are mortgage rates so high?” is the belief that the spread between mortgage rates and treasuries is too wide based on the historical norm. Realtors are pushing for 4.5% mortgages for both purchasing and refinancing, and builders want rates below 3% for new home purchases. The builders say that special offers of 4.5% have not generated enough sales.

Bloomberg “Mortgage Rates Left in Dust by Treasuries, Failures” cites foreclosure history and mortgage company failures as important factors in keeping Fannie Mae (FNM) and Freddie Mac’s (FRE) 30-year cost of funds close to 4%, while long term treasuries are yielding between 2% to 3%. The cost of funds spread has reached 1.4% versus a historic 0.14% over the last five years. The 30-year fixed rate conforming mortgage was still able to drop to 5.16%, certainly a generous offer to home buyers.

The cost of funds spread is indicative of many factors beyond the credit risk of home buyers and falling home prices. There are two main factors: First, treasury yields are unsustainably low. Despite the Fed’s commitment to keep rates low for several quarters, rates are especially low because of the transactional value and necessity of treasuries. Treasuries serve as collateral for many financial derivative transactions with cash being the only substitution. In many respects the Fed has little control over the actual value of treasuries. And without an explicit government guarantee, GSE debt will never substitute for treasuries.

Second, every government and industry official is telling us that the financial crisis is directly tied to the value of residential real estate. Stop values from falling, or even try to inflate them, and all will be well. But the market does not buy into the artificial inflation of home values through artificially low mortgage rates. The market does not believe that homes priced for mortgage money below 5% will maintain their values when mortgage rates return to reasonable values.

Long term recovery will only get started when homes are priced at values supported by mortgage rates sustainable over the next 5 to 10 years. Isn’t the market always forward looking?

Why isn’t our brain trust saying that we have a mortgage repayment problem and not a home value problem? I believe the reason is that we have a collateral based financial system, so increasing the value of collateral is the easy answer. Adjusting to lower collateral values takes more time than desperately trying to prop up values. And we are an impatient society. This has not worked and will never work.

Disclosure: Author is long FNM and FRE.

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