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Understanding the Mortgage Market, by MBS Quoteline

Mortgage loan interest rates, and the corresponding fees or points charged for various rates, are driven by the prices of Mortgage Backed Securities (MBS). While lenders, in effect, set their own mortgage rates, how those rates are set is driven largely by the then current prices of Mortgage Backed Securities.  Although lender and wholesaler rate sheets are typically issued no more than a couple of times each day, the value of the mortgages, or the price of MBS, and consequently the price (points) for a certain interest rate, is actually constantly changing.

Unlike purchasing or selling stock, where the price is whatever it is at the moment you make the trade, wholesale and correspondent lenders generally issue a rate sheet setting forth their rates and corresponding points/premiums for those rates, and honor those rates, until the change in MBS prices reaches a certain threshold, before passing new prices on to their customers in the form of a new rate sheet. Typically lenders will issue new rate sheets as prices move more than 4/32nds to 8/32nds, or 0.125% to 0.25% points.

To summarize, MBS are simply pools of mortgages backed by Fannie Mae, Freddie Mac, or Ginnie Mae which are traded in a manner very similar to Treasury bonds. The size of the MBS market is comparable to the Treasury market. Investors receive payments based on the level of interest and principal made by the consumers who obtained the mortgages. The calculation of the actual value of a MBS requires some extremely sophisticated mathematics, but most of the major factors can be easily understood. The main difference between MBS and other types of fixed income investments is that consumers have the option to prepay a mortgage. When a mortgage is paid off early, the expected stream of payments comes much sooner than expected. Predicting the effects of prepayments on the value of MBS is what requires the advanced mathematical models.

The two factors with the most impact on interest rates are economic growth and inflation. The faster the economy is growing, the more demand there will be for capital, leading to a higher cost for borrowing money. That’s why good news about the economy is often good for stocks but sinks bond and MBS prices. A higher inflation rate will also increase interest rates, but for a different reason. Inflation erodes the value of a dollar, so a lender will demand more dollars back at a later date to compensate for the lost purchasing power.

Any news which provides information about the level of economic growth or inflation will influence prices. Economic reports are released on a regular basis which contain measurements of the strength of the various parts of the economy and the amount of inflation. Some reports have more significance than others.  Any factor which affects the supply or the demand will alter the price. In addition to economic news, there are other notable influences on the demand for MBS which often affect the price. Investors turn to MBS markets when they want an investment which is less risky than equities. In times of political instability the demand is greater for these lower risk instruments, so a terrorist attack, for example, may produce a rally in MBS markets. Foreign central banks may have motives for purchasing securities which are different from investors who are assumed to be seeking to maximize their investment return. To balance foreign exchange transactions related to imports and exports, they may be forced to buy or sell US securities regardless of what they consider to be the best investment.

The views and opions expressed above are those of Jim Hungerford personally and are not associated with any business or organization. They were gathered from various sources of information available on the internet and are for informational purposes only .

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