What Bonds Affect Mortggage Rates?

The bonds that affect mortgage interest rates are “ Mortgage Backed Securities”. The easiest way to describe this is that they are packages of many loans, placed together and then sold as an investment. As the market for these instruments moves, interest rates move accordingly. I’ll give you a quick overview on what exactly a Mortgage Backed Security is, and then how their movement coincides with mortgage rates.

The majority of loans being written at the writing of this article are conforming or FHA loans. In either case, that loan, once closed, can be sold. Depending on the type of loan it may be sold to Fannie Mae, Freddie Mac, or Ginnie Mae. Being ‘sold’ in this case means that the bank that lent the money, can sell the loan to one of these entities and get their money back to lend again. Here’s an example:

Joe goes to see his neighborhood mortgage broker, who arranges a mortgage loan for him. The loan conforms to Fannie Mae guidelines and is written through ABC Bank. ABC, once they fund the loan, let’s say for $150,000, can sell that loan to Fannie Mae. If they do, they will still retain the servicing of the loan, so they will accept payments, handle customer service, etc, however, by selling the loan they are able to get their money back. In this case, they would sell the loan to Fannie, who would give the bank $150,000 for that loan. ABC can then lend that same $150,000 out to new borrowers.

Once Fannie has purchased the loan (or loans), they will package similar loans together into a security. A security in this case simply means an investment. It is a “mortgage backed” security because it is backed up by a number of mortgage loans and their repayment. Individuals or groups can then invest in these securities. This means that they would buy the security that Fannie Mae sells, so that Fannie Mae now has money to be used to go and buy more loans.

The overall process, simplified, goes like this: Joe Borrower makes his house payment to ABC Bank, ABC takes out a small portion of the payment for servicing the loan (accepting payments, providing customer service) and passes the rest to Fannie Mae. Fannie Mae then takes out a small portion from the payment before disbursing the rest to the investors in the mortgage backed security. These investors have put their money into the MBS and receive payments in the form of interest paid by the borrowers, as well as principal repayment.

That’s a simple look at what a mortgage backed security is, and how they function. Now we’ll talk about price, the “how” of how they [affect mortgage rates. Most MBS are sold TBA (to be announced), meaning that the actual loans that will go into that specific pool are not determined yet. All you know is that they will fall under Fannie, or Freddie, or Ginnie guidelines. These investments are traded in a market just like any other bond market, where prices fluctuate based on risk/reward. As is the case with any bond, there are 2 functions, Price and Yield. Price is what you pay for the investment; Yield is what you get for investing. Think of it like a CD at a bank, if you bought a $50,000 CD paying 4%, $50,000 is your price, 4% is your yield. The market for MBS is more complicated, but works akin to any other market.

The price/yield functions of a bond work in opposite directions. This means that as price rises, yields fall. In that way, higher MBS PRICES mean lower YIELDS, or lower interest rates. So if mortgage rates are going down, this means that MBS prices are going up vice/versa. The movements are subject to many factors but ultimately prices change due to supply and demand as in any other market. If more people are willing to buy MBS, prices go up (more buyers than sellers means sellers can charge a premium). Additionally, if more people are interested in MBS, yields (what they pay out) can be lower, which in turn means that mortgage rates come down. If there are more sellers than buyers, prices drop and yields rise (meaning rates go up). The why’s of what makes MBS move is a very complicated subject outside the scope of this commentary, but ultimately Mortgage Backed Securities are what move mortgage interest rates, and as prices for MBS go up, mortgage rates fall.