Banking on Mortgage-Interest Changes: What Happens when the Fed Cuts Rates

That simple question unfortunately doesn't have a simple answer. But it does have an easily explainable one.

When we say that the Federal Reserve Bank — which is actually the Federal Reserve System of 12 regional Federal Reserve Banks — is cutting interest rates, it can mean one of three things: It is adjusting the "discount rate" (a fixed-interest rate the Fed charges its member banks for short-term loans); or its target for the "Federal Funds rate" (an interest rate, determined by supply and demand, that banks charge each other for overnight loans); or both.

Whenever the Fed adjusts either of these key rates, the effects appear almost simultaneously in other short-term interest rates. For example, most banks will change their prime lending rate, usually by the same increment as the Fed changes. However, Federal Reserve policy is just one of the many factors that influence mortgage and other longer-term interest rates.

First, most mortgage lenders set the interest rate on a new loan by adding a margin, or "spread," to some market index. Lenders use a variety of indexes, depending on the type of loan that they are making. Many commercial mortgage lenders, including most co-op underlying mortgage lenders, use the rate on 10-year U.S. treasury securities. These are favored as safe investments by many institutional investors, and their rates, which fluctuate daily in response to supply and demand in a broad, active market, are reported in the financial pages of most major newspapers and on financial websites like CNNMoney.com or Bloomberg.com.

The rate on 10-year treasuries does not move in lock-step with changes that the Fed might make in short-term interest rates. In fact, since treasury securities are backed by the full faith and credit of the U. S. government, they are viewed worldwide as relatively risk-free "safe haven" investments in times of political or economic upheaval. An increase in Mideast tensions, for example, might generate a surge in treasury investments. That increase in demand will drive up treasury prices and reduce their rates — totally independent of any Fed action.

Alternatively, let's assume that the Fed cuts short-term interest rates by a relatively aggressive half-point to prop up our sagging economy. If the broader market views that change as doing more to ignite inflation than to spur economic activity, treasury rates actually might trade higher!

The Point Spread

A second determinant of mortgage rates is the spread that a lender adds to the chosen index when pricing a loan. Many co-op board members are surprised to learn that spreads also trade daily, just like the 10-year treasury rate. Loan spreads are "built up" by combining two principal components. The first is the "Wall Street spread," or the return demanded by secondary-market investors who buy loans from lenders after closing. Whenever there is turmoil in the financial markets, this component of the loan spread is where it shows up. To put this in perspective, as the wider effects of the subprime-mortgage mess became more apparent, the Wall Street spread grew by more than 100 basis points!

The other piece of the loan spread is the "lender spread," or the fee charged by the lenders for servicing the new loan during its term (i.e., collecting the monthly payments and handling all of the administrative issues related to the loan) plus their profit. A lender may choose to decrease either or both of these amounts for competitive reasons, or they might decide to increase either or both of them because of uncertain market conditions or profit goals.

After many years of relative calm and growing prosperity, world financial markets are now in disarray because of the subprime-mortgage debacle. What initially was thought to be a problem confined to a small segment of the U.S. single-family home mortgage market has grown to a worldwide financial crisis affecting virtually every financial transaction in some way. The effect within the co-op underlying mortgage market has been a dramatic increase in loan spreads, averaging almost 10 basis points per month over the last year.

Fortunately, the 10-year treasury rate has fallen by almost the same amount over that period, so the net effect on underlying mortgage rates has been minimal. The decline in treasury rates has received lots of coverage in the press, while the rise in spreads has not, so the general public may feel distrustful of lenders' rates. The good news is that underlying mortgage rates really do remain pretty good right now, despite the subprime-mortgage mess.

Patrick Niland, a mortgage broker, is the principal at First Funding of New York .

Adapted from Habitat May 2008. To get the print magazine, visit our Subscription Page >>