Mortgage Rates Find Uneasy Equilibrium

Most years, the topic of mortgage rates would put most sensible people to sleep. But this year is far from ordinary.

The rate on a 30-year fixed rate mortgage began 2013 around 4%. It then fell to below 3.4%, a historically unprecedented rate, thanks to the Federal Reserve's third round of quantitative easing. But once news leaked out that the central bank is contemplating a reduction in support for the economy, rates shot back up at a harrowing clip.

As you can see in the chart above, while it's still early to say whether or not they've settled at a new level, there's evidence that they may have found a new, albeit, uneasy equilibrium around 4.5%. In its most recent primary mortgage market survey, Freddie Mac said the average rate on a 30-year fixed rate mortgage came in at 4.51%, a reduction of seven basis points from last week's 4.58%.

The big question now is what will happen if and when the Fed decides to pull the trigger on tapering, which many observers believe will occur at its upcoming meeting in September. "It's easy to conclude that rates have baked in a portion of the eventual tapering announcement, but it's hard to know how much," said Matthew Graham of MBS Live, a division of Mortgage News Daily. "Bottom line, we've priced a lot in, but probably not all."

The dislocation that occurred after the Fed's meeting in May has taken a toll on more than just homeowners. As rates rise, the value of mortgage-backed securities have fallen, wreaking havoc on mortgage REITs like ARMOUR Residential (NYSE: ARR  ) and Hatteras Financial (NYSE: HTS  ) , which have seen their book values per share decline by 25% and 21%, respectively, since the end of last year.

It's also taken a toll on banks, which hold securities sensitive to interest rates on their balance sheets and look to the mortgage market for fee-based revenue on their income statements.

Just recently, Wells Fargo (NYSE: WFC  ) , announced plans to lay off 2,300 workers in its mortgage origination department. The nation's largest mortgage originator has recorded a staggering seven consecutive quarters of $100-billion-plus underwriting volumes, but has warned that this trend won't continue in the face of higher rates -- click here for a chart of the precipitous fall in mortgage applications.

In the second quarter of this year, moreover, virtually all banks reduced their accumulated other comprehensive income thanks to a decline in the value of their securities sensitive to interest rates. For its part, JPMorgan Chase (NYSE: JPM  ) , the nation's largest bank by assets, saw its OCI fall by $3.3 billion, largely offsetting an otherwise stellar quarter in terms of earnings.

At the end of the day, there seems to be little doubt about the fact that mortgage rates will go higher. The remaining questions revolve around how far they go, and when they will do so.

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