Why Mortgage Rates Should Be Even Lower

By some measures, buying a home now is more affordable than almost any time in the past 50 years. Nationwide home prices are down by a third, and mortgage rates are at record lows. But some argue that rates should be even lower.

As it turns out, there's something in the mortgage marketplace that's preventing rates from falling further, and keeping many would-be homeowners from getting an even cheaper loan.

What's keeping mortgage rates from falling further?
There's no question that a recovery in housing is imperative to a recovery in the economy. Federal Reserve Chairman Ben Bernanke has explicitly stated the central bank's commitment to revive the housing market, which he called "the missing piston" in the economic recovery.

Indeed, a major goal of the Fed's latest round of quantitative easing (QE3) is to provide support to housing by driving mortgage rates down further and making the prospect of owning a home even more appealing.

But so far, QE3 doesn't appear to have benefited homeowners much; mortgage rates are only marginally lower than before the program commenced. But QE3 has been a godsend for banks, whose profits from new mortgages have risen substantially since the Fed embarked on the program last month.

So why exactly are banks reporting abnormally large profits from mortgages?

Why banks are pulling in so much dough from mortgages
It boils down to the way banks originate mortgages, package them into bonds, and then sell them to investors, such as pension and mutual funds. Banks' profit is determined by the spread between the mortgage rate borrowers pay and the interest paid on mortgage bonds. Simply put, banks make more money when homeowners' mortgage rates are high and when the interest paid on mortgage bonds is low.

In the decade since 2000, this spread averaged just 0.5%. But over the past year or so, it has risen noticeably and currently hovers around 1.6% -- a historical outlier. On September 12, the day before QE3 was announced, the interest rate banks pay on mortgage-backed securities was at 2.36%. Towards the end of September, that rate dipped as low as 1.65%.  

If banks were content with the profit margins they enjoyed just a few years ago, the interest rate on a 30-year fixed-rate mortgage would be around 50 basis points lower. According to a recent New York Times article, the reduction in mortgage rates from 3.55% to 3.05% would save a borrower some $30,000 over the lifetime of a $300,000 mortgage. That's no pocket change.

A big change in the mortgage market
Another driver for increased profits may be less competition among mortgage lenders. After the housing bust and consequent financial crisis, a few major banks have emerged as the dominant lenders.

For instance, Wells Fargo (NYSE: WFC  ) , JPMorgan Chase (NYSE: JPM  ) , and US Bancorp (NYSE: USB  ) together commanded half the market for new mortgage originations in the first half of the year, according to Inside Mortgage Finance, an industry publication. Bank of America (NYSE: BAC  ) , which has lost substantial market share in recent years, was the fourth-largest lender in the second quarter.

This trend reveals a drastically different mortgage market than just a few decades ago. In the not too distant past, entities such as savings and loans associations, credit unions, commercial banks, community banks, and mortgage brokers played a much larger role in the mortgage market. Just two decades ago, a lender that commanded a 10% market share would have qualified as one of the largest. Compare that to last quarter, when Wells Fargo alone originated 32.4% of all new mortgages.

This virtual oligopoly in the mortgage marketplace has raised concerns from many important commentators, including the inspector general for Freddie Mac and Fannie Mae, regarding the risks it poses not only to borrowers, investors, and taxpayers, but also to the health of the housing market and the financial system.

But it should come as no surprise that the banks are keeping mum. With less competition, the remaining players are seeing fatter profit margins. Wells Fargo, for instance, pulled in revenue of $4.8 billion from its mortgage origination business in the first half of the year, representing a 155% increase from the same period a year ago.

Does QE3 actually help?
As you can see, the biggest beneficiaries of QE3 appear to be the big banks that originate mortgages. While mortgage rates for borrowers have fallen somewhat over the past month, they would likely fall much further if banks were willing to accept tighter spreads. And besides providing little support to homebuyers so far, QE3 may actually be bad news for a certain type of company -- the mortgage REIT.

Mortgage REITs make their money from a simple yet lucrative business model. They borrow money at low short-term interest rates, which they then use to buy higher-yielding mortgage-backed securities. They earn their profits on the difference between these two rates. The larger this interest rate spread, the more money they pocket.

For years now, they've benefited tremendously from the Fed's pledge to keep short-term rates near zero. While this has allowed them to maintain some pretty impressive payouts, many have seen cuts in their dividends lately.

Last month, Anworth Mortgage Asset (NYSE: ANH  ) reduced its dividend by 17%, which represents the second consecutive quarterly drop in the company's payout. While it still offers an eye-popping 9.7% yield, the company has cut its payout by more than half over the past three years.

Anworth isn't alone. Chimera Investment (NYSE: CIM  ) has also cut its dividend five times in the past two years. And Annaly Capital (NYSE: NLY  ) has cut its dividend by a third since 2009, and lowered it by 9% in the most recent quarter.

Going forward, the outlook for these companies isn't looking as bright as it did a few years ago. Mortgage REITs face major headwinds including narrowing interest rate spreads and an accelerating trend of prepayments, bolstered by the refinancing boom.

To find out more about the risks facing mortgage REITs and whether or not your investment is safe, be sure to check out The Motley Fool’s recently released in-depth report on Annaly Capital Management. It outlines three essential points that all current and prospective Annaly investors need to know, as well as a host of other important information put together by our analysts. On top of that, the report comes with a full year of exclusive updates. To unlock your investing edge, just click here.

Fool contributor Arjun Sreekumar has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, JPMorgan Chase & Co., Annaly Capital Management, and Wells Fargo & Company. Motley Fool newsletter services recommend Wells Fargo & Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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  • Report this Comment On October 15, 2012, at 3:10 PM, jonkai wrote:

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    QE3 may actually be bad news for a certain type of company -- the mortgage REIT

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    now there is a silly argument if you believe banks are 'raking it in' because of getting interest from how much a borrower pays on a mortgage, and the difference between that and the mortgage bonds...

    a MReit is doing even better... they are getting the Mortgage rate paid by the borrower, and paying an even smaller interest rate from the repos they use....

    they take a smaller haircut than the banks on the long rates,

    but to say one is "raking it in" while the other is being hurt is just "challenged" to say the least, when they both make money the same exact way in General...

  • Report this Comment On October 15, 2012, at 4:39 PM, contactgep wrote:

    The argument this author makes about rates being kept artificially high sounds good, but this is not actually how mortgages work. Neither loan originators nor loan servicers directly benefit from having a high rate on a mortgage.

    Loan originators want to sell mortgages at the lowest rate possible, driving the price down to whatever the market will bear. Servicers prefer having lower rate loans on their books (within reason) because it lowers the chance of pre-payment, driving up the value of the asset.

    The only party in the transaction that really profits from higher rates are the investors in the mortgage backed security (with the caveat that again, higher rate loans are more likely to pre-pay). But with rates so low, and mortgages still such a risk, very few independent investors are in this market.

    Thus, the stated intention of QE3 was to buy MBSs for as long needed. So if you want someone to blame for rates not declining, look no further than Ben Bernanke.

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