Saturday, February 9, 2008

The Fed Rate & Mortgage Rate - What Does This All Mean?


First a little history. The Federal Reserve System (commonly referred to as The Fed) is the central banking system of the US and is made up of 12 regional banks. The Fed manages the nation's money supply via its use of monetary policy. This refers to The Feds ability to influence the availability of money and credit which affects interest rates and therefore the economy.

Are we good so far? For our purposes here we are going to have a limited discussion and only touch upon one area of the monetary policies.

Banks are required by The Fed to have a certain portion of the total value of their demand accounts on hand. If a bank falls below this level, it can borrow the funds from another bank that has a surplus with The Fed. These are typically overnight loans. The interest rate on these borrowed funds is determined by the banks themselves but is influenced by The Fed via the Federal Funds Rate. These are more closely aligned with short term interest rates. This is the rate that we've been hearing so much about in the news. It must be understand that this is a target rate set by The Fed. The rate that is actually paid by one bank to another is negotiated between the two parties. This has nothing to do with mortgage rates.

Now we come to mortgage rates. The Fed DOES NOT control mortgage rates. Mortgage rates are market determined and are on the long term end of the interest rate spectrum. These are generally determined by the bond market. It's a financial market where debt securities are bought and sold. And this brings us to Mortgage Backed Securities. You may not have heard of these specifically, but you've most likely heard of Fannie Mae, Freddie Mac and to a lesser extent Ginnie Mae. Basically what they do is package many mortgages together and issue them as MBS's. In order to get investors to buy these, they must pay rates of interest that are competitive with alternative interest-paying investments such as Treasury bonds. There is a correlation between mortgage rates and long term interest rates. Long-term rates are governed by the overall health of the economy, and the expectations of future growth.

As you can see one is long term whereas the other is short term. So when you hear that The Fed cut the rate, you can not always expect an equal and immediate change in the mortgage rate. In fact, in many cases the opposite has occurred.

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1 comment:

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