Should Mortgage Rates Even Be Lower?

The Wall Street Journal

Mortgage rates are the lowest on record. But by a key historical measure, they should be even lower.

Over the past year, a wide gap ripped open between the mortgage rates house hunters see and a benchmark interest rate investors demand to buy bonds backed by home loans.

In normal times, this obscure metric would only be of interest to bankers, brokers and traders of mortgage-backed securities. But with housing still dragging on the economy, the spread is potentially slowing the recovery—and important to everyone from top Washington policy makers to strapped homeowners who could use a few extra dollars each month.

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For months, a key interest rate on mortgage-backed securities—known as the current coupon yield—has tumbled faster than average U.S. 30-year mortgage rates.

In recent weeks, the difference between the two has flirted with levels seen in the aftermath of the financial crisis.

Some say the wide spread shows the large banks that dominate the mortgage market are flexing their muscle by keeping prices relatively high. Others argue the gap reflects increased regulatory costs, risks and new realities of mortgage making.

Either way, the spread is wide. Tuesday afternoon, it was 0.96 percentage points—almost double its average over almost 30 years. It has been as high as 1.20 percentage points this year.

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"To me what it tells us is that traditional monetary-policy measures to help get the housing market rolling again…are weaker than they normally would be," said Columbia University's Frederic Mishkin, a former Fed governor.

The effort by the Federal Reserve and others to boost housing depends on the mechanics of the banking system to pass along savings and benefits to consumers. The wide spread between the mortgage rates and mortgage-backed bonds suggests the gears of that mechanism are gummed up.

"This is not a rounding error, this is something to take note of," said Susan Wachter, a professor of real estate and finance at the University of Pennsylvania's Wharton School.

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To be sure, consumers are seeing the lowest rates in several generations already. The 30-year fixed mortgage rate averaged 3.87% for the week ended Thursday, down from 5% the previous year. That is the lowest in Freddie Mac's survey data, which stretches back to 1971.

If history is any guide, it should be a lot lower. With yields on mortgage-backed securities at these levels, the 30-year fixed rate mortgages would be roughly 3.40% if the spread was around its historical average of 0.50 percentage points.

That rate would save a U.S. homeowner with the average outstanding loan balance of $155,000 about $41 in mortgage payments each month, versus the current rate.

Over the seven-year period someone usually holds a 30-year mortgage, that translates into a roughly $3,446 difference, according to numbers provided by trade publication Inside Mortgage Finance.

Wider spreads generally translate into better margins for banks and brokers. And some lenders have seen profitability on mortgage origination improve as the spread has widened.

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Some mortgage-finance observers suggest that increased concentration among the large banks that dominate the mortgage market better helps explain the wide spreads. They argue that because there are fewer banks doing the bulk of the mortgage lending than in years past, it is easier for them to capture market share without offering rock-bottom prices.

"It's a lack of competition. We really haven't seen a competitive marketplace since 2008," said Guy Cecala, publisher of Inside Mortgage Finance.

In 2011, the top five banks had a hand in 59% of the mortgage loans packaged into government-guaranteed mortgage-backed securities, up from 45% in 2004, according to Inside Mortgage Finance. Recently, major banks have cut down on their mortgage business sharply.

Bankers push back against any notion of oligopoly.

"The mortgage business is extraordinarily competitive," said Franklin Codel, head of mortgage production at Wells Fargo Home Mortgage.

There are other factors at work. For one thing, fees charged to lenders by government-controlled mortgage-finance companies Fannie Mae and Freddie Mac are set to rise this year. The increases paid for the payroll-tax break passed by Congress in December.

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Analysts stress it is difficult to disentangle how much of the spread is due to pricing power from banks with more control of the market, and how much might represent structurally higher costs of doing business in the U.S. mortgage market reshaped by the crisis.

Banks and mortgage lenders point out that costs of underwriting loans—conducting the detailed scrutiny of financial statements and employment background—has gotten more expensive and time consuming.

In part that reflects the experience of some banks, which have been forced by Fannie and Freddie to buy back loads of loans that soured, making them more cautious. Others say Fannie and Freddie have grown much tougher over the documentation they accept on loans.

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