Since the mortgage crisis began in 2007, the U.S. financial system has been very depressed. The trouble began when households began defaulting on their mortgage payments causing lenders, i.e. mortgage companies, to tighten their grip on credit standards. One of the reasons for this tightening was due to the fact that these mortgage companies were not receiving funds from households. Due to the lack of funds, mortgage companies raised interest rates in order to remain profitable with the small amount of loanable funds they had.
From the Loanable Funds theory, it is apparent that mortgage lenders, such as Fannie Mae and Freddie Mac, raised interest rates on deficit units, such as households and businesses, because now these lenders had less of a supply to loan out. In addition, when interest rates were raised, individual, households, and businesses alike lowered their demand for these loanable funds. Nevertheless, the financial system was at a standstill with surplus units (lenders) unwilling to yield to lower interest rates in fear of taking a loss and with deficit units unwilling to apply for loanable funds at such a high interest rate. According to the article, “Mortgage Rates Slide to Near-Record Lows“, it appears that the billions of dollars that the Federal Reserve has pledged to infuse into mortgage-backed securities has finally eased up credit lending standards and as a result, interest rates are steadily decreasing.
The Loanable Funds Theory states that interest rates are directly correlated to the fluctuating supply of funds (money to be lent out) and the demand for those funds. According to this theory, the point at where the supply and demand lines intersect is called the equilibrium or market clearing interest rate. This theory states that when the supply of loanable funds is increased causing the supply line to move horizontally to the right; the equilibrium interest rate is lowered. On the other hand, when the supply of loanable funds is decreased, the supply line is moved horizontally to the left in effect raising the equilibrium interest rate. It is also important to not that when the demand for these loans increases or decreases, the equilibrium rate will either rise of fall, respectively.
A survey by Bankrate.com indicates that mortgage rates have declined over the past week across the board, ranging from 30 and 15 year fixed rates, as well as the adjustable rate for five year mortgages. The 30-year fixed rate fell 8 basis points (Note: A basis point is the equivalent to .01; 100 basis point is equivalent to 1%) to a rate of 5.29% and the 15-year fixed rate fell 2 basis points to a rate of 4.86%. Additionally, the five year adjustable interest rate for mortgages fell a total of 10 basis points to 5.24%. All in all, the article reveals that “the mortgages in this week’s [Bankrate] survey had an average total of 0.33 discount and origination points”. In addition, according to the article, “Interest Rate Roundup: Mortgages, Auto Loans, & More“, the 30-year mortgage rate is only “1 basis point above the all-time Bankrate low of 5.28 percent on both June 11, 2003, and January 14 of this year”. According to Bankrate’s survey, it seems as though mortgage rates are steadily decreasing for various types of mortgages. A year ago, the 30-year fixed mortgage rate was 69 basis points higher than it is today.
Although the lowering of mortgage interest rates is a result of the U.S. government and Federal Reserve stepping in to buy up billions of dollars of mortgage backed securities, the direct reason for these lower interest rates is the simple fact that lenders now have more of a supply of funds to lend out. As the Loanable Funds Theory tells us, more money (supply of loanable funds) equals lower interest rates. It is important to note that the Bankrate survey indicating these “near all-time lows” was taken after the Federal Reserve pledged to buy up $500 billion of mortgage backed securities and before the Federal Reserve announced its intentions to buy up another $750 billion of mortgage backed securities. So therefore, we should expect mortgage rates to steadily decrease until households and businesses are demanding funds again. As the Federal Reserve purchases more mortgage-backed securities, they are increasing the supply of loanable funds that lenders are able to give out and when there is an increase in the supply of funds, the lenders give out credit at a lower interest rate determined by the Loanable Funds graph.
In addition, the article also mentions that mortgage applications have risen sharply for the second straight week, indicating that the demand by households is also increasing. According to the article, “Applications [for mortgages] increased 21 percent for the week ending March 13 when compared with one week earlier”. While this data suggests that demand is slowly increasing for mortgage loans, most of the new applications were for households looking to refinance at lower interest rates. In order to help homeowners stay in their homes and not lose their homes to foreclosures, the Home Affordable Refinance program was announced in March. This program makes it possible for struggling homeowners to refinance their primary homes. Furthermore, Fannie Mae and Freddie Mac have made it possible for homeowners to refinance “second homes and small investment properties”.
The data that Bankrate provides is promising because it seems as though the speculation of the Federal Reserve to buy up mortgage-backed securities has made it possible for lenders to lower interest rates and as a result homeowners are looking to either refinance mortgages or obtain new mortgages. While adding liquidity back to these securities (assets) is a good sign, as well as the supply of loanable funds increasing, it should be noted that if demand were to increase exponentially, mortgage rates would rise again. It is a concern that the majority of applications for mortgages are to refinance and not specifically finance new homes because an overabundance of refinancing can raise mortgage rates without the financial sector reaping the rewards of obtaining new mortgage financing as well as the home building expansion that should typically be correlated with such an increase in demand. Perhaps it would be in the best interest of these mortgage companies, as well as the overall economy, to create two distinct columns of interest rates; one for refinancing and one for financing. This would ensure that the increased demand in the refinancing of mortgages does not interfere with the interest rates for potential new home buyers.
Image Used in this Post
Home Foreclosure image courtesy of Flickr user Joe Crawford published under the CC license.
3 Comments
I think it was really good that you pointed out most of the mortgage applications were for refinancing and then explained why that matters.
It isn’t good for the bank to let homeowners refinance because that essentially erodes the profitability of the mortgage, but it still is good for the broader economy. If homeowners can refinance that leads to lower monthly payments, which results in consumers having more free cash to spend.
I think the problem with banks trying to attract first time buyers right now has to do with two things: (1) people are scared to spend money because of the constant media mega-phone blaring about the poorly performing economy, and (2) home prices skyrocketed due to the artificial demand created by the banking industry’s creative lending practices but even after two years of declining home sales the prices have not lowered proportionally to the sharp drop-off in demand.
Jay,
I think that you are absolutely correct about how refinancing leads to increased consumer spending and thank you for pointing that out.
I am definitely with you that people are scared because of the media mega phone. Do you think that once homes are properly valued, given this economic atmosphere, that first time home buyers will react as expected?
Also, I imagine that unless our GDP starts increasing, we will experience even more inflated interest rates considering that so much money is being created to buy up these mortgage backed securities. And that will only increase inflation (which is presently hovering right above 0%), which in turn will push mortgage rates back up, regardless of demand.
Home prices unfortunately show no sign of dropping much further than they have already. The problem is people over-paid in the 2002-2006 era and they cannot afford to take a loss on the sale of their home. Many homeowners also took out home equity loans that they now have to pay back with the proceeds of the sale of their home, so they cannot afford to cut prices. It’s a total mess.