Forecasting Interest Rates

Interest rates have been staying low for quite a while
now. It's always difficult to try to predict rates, but
there seems to be a consensus building that may give
us some idea when rates may make an upward move
that will stay in place for some time.

To generalize, fixed rates on conforming loans - those
that get sold to FNMA and FHLMC with loan amounts
up to $417,000 - have been in the 4.75% to 5.25%
range for quite some time.

These rates have sustained because the Federal
Reserve is trying to spur a housing recovery by
keeping interest rates low.

In turn, lenders are willing to make long-terms loans
at these loan rates, because they have no intention
of keeping these loans on their books and carrying
the interest rate risk that goes with it. They know
that they have a ready buyer for these loans through
FNMA and FHLMC.

It is one of the main reasons why lenders are under-
writing the loans so stringently. They have to make
sure that the loan they are making is one that FNMA
and FHLMC will purchase from them. Strict adherence
to Fannie and Freddie's guidelines is vital so that the
lender does not have to keep the loan on their books,
and suffer the risk of that low-interest rate loan being
a money loser in the future when rates go up.

FNMA and FHLMC have been allotted more than
$400 billion to guarantee their recovery. But an
announcement was made on Christmas Eve, without
any fanfare, that they were given an unlimited financial
lifeline and removed the requirements to shrink
their holdings by 10% per year. Currently they are
instrumental in about 75% of mortgages made, and
their holdings amount to about $770 billion.

Additionally, there are loans that are created by lenders
that get bundled into pools of mortgages and then sold
to investors through a vehicle known as a Mortgage-
Backed Security (MBS). FNMA and FHLMC also put
together MBS pools to reduce their holdings.

Traditionally, these pools of mortgages have been sold
through Wall Street to investors, pension plans, etc.
But when the performance of mortgages began it's
decline a couple of years ago, the Wall Street investor
market dried up.

They suffered unexpected losses because the quality
of the loans in their MBS investments were not as good
as they were represented to be. Once burned, twice
shy. The investors have not rushed back into the
market to buy these new MBS issues.

To keep fluidity in the market, the Federal Reserve
has been purchasing MBS issues, since non-govern-
ment investors have been dormant.

So, the Federal Reserve is keeping rates low to stim-
ulate the economy. The interest rates are not market
driven, so investors are not excited about them unless
they can move the loans to someone else to absorb
the risk. The only players for buying these loans are
FNMA and FHLMC (Government-sponsored entities)
and the Federal Reserve buying MBS issues. It's a
giant circle, and the free market never touches it.

Now here is the indicator that rates may start to go
up: Federal Reserve policy makers are expressing
a desire to pull back on purchasing MBS issues when
they see some recovery in the economy. If this
happens, to attract investors other than the government
(since they are backing away) interest rates would
have to go higher.

When you start to hear the news reports that the
economy is recovering and that the Federal Reserve
is reducing their investment in MBS issues, be prepared
to expect higher interest rates. Some commentators
are thinking they could go up 1 to 2% from the low
rates that we have enjoyed.