falling mortgage rates

[Jim Devine <jdevine03@xxxxxxxxx>]

from the International Herald Tribute at
http://www.iht.com/articles/2005/06/10/business/fed.php

>For the past year, the Federal Reserve has been conducting a
relentless campaign to raise interest rates. And over that same year,
the rates that matter the most to many people - mortgage rates - have
fallen to near 30-year lows....<

>Since last June, the Fed has raised its benchmark interest rate,
which sets the rates that banks charge each other for overnight loans,
to 3 percent from 1 percent. In the past, a two-point rise in the
Fed's benchmark rate has typically led to a one-point rise in
long-term rates. Simple logic suggests that when the cost of borrowing
money for a year goes up, as it has, so should the cost of a 30-year
loan...<

but it hasn't.

>... The list of reasons for the falling rates is both long and
controversial, taking in everything from the aging of the population
to the growth of China. Economists generally argue that investor
psychology also plays some hard-to-define role and that rates will
soon rise. But they have been making similar predictions for the past
year...<

If the standard theory is right, this suggests that "the market"
expects short-term interest rates to fall in the future.[*] Alan and
the Feds have been emphasizing their determination, to prove their
credibility, so that "the market" would assume that short-term rates
would rise in the future, or at a minimum, reach a plateau. But "the
market" isn't convinced. Falling short-term rates would be a result of
Federal Reserve "wimping out" (and beginning to lower short-term
rates), a recession, or most likely a combination of the two. (A
severe recession at a politically inopportune time -- like right
before the 2006 election campaigns -- would encourage Fed easing.)
Further, if people expect _deflation_ in the future, that encourages
falls in nominal rates.

The only problem with this scenario is that if deflation also hits the
housing market, it means that a lot of mortgage loans would go bad.
(People's housing assets fall in value, possibly below their mortgage
debt, producing negative net worth.)  This would raise the risk
premium of mortgage loans over long-term Treasury bonds. Maybe the
lenders expect that the borrowers would suffer all of the
consequences.... That is encouraged by the recent bankruptcy "reform."
But if a severe recession and deflation hit, that optimism would be
wrong, since the bankrupt borrowers wouldn't be in a good position to
live up to their obligations.

[*] The dominant theory is that:

the long-term rate (on treasury issues) = the average of actual and
expected short-term rates (again, on treasury issues) over the term to
maturity of the long-term bond _plus_ a standard premium for locking
one's money into a long-term bond.

If expected future short-term rates are low, that lowers the average
(the first term) and the long-term rate.

the mortgage rate = the long-term rate _plus_ a risk premium.
-- 
Jim Devine
"Segui il tuo corso, e lascia dir le genti." (Go your own way and let
people talk.) -- Karl, paraphrasing Dante.