Well they don’t have to.  We cannot know the future.  New and unknowable information creates the future for us, and even though we are told that certain things are going to happen, we don’t know for sure that they will until they do.

Let me give you an example.  Most people are sure that rates will rise this year.  But if you asked them to bet their $1,000,000 retirement account double or nothing on it, they wouldn’t do it.  So are they really sure?  They must not be or they would make that bet and double their money.

Yet we can make prudent decisions based on what we do know.

We know that the price of Mortgage Backed Securities determine interest rates.

We know that when the prices on MBS rise, rates go down.

We know that there have traditionally been two main buyers of Mortgage Backed Securities – Wall Street Investors and other countries (China mostly).

We know that in the past, when the Stock Market is struggling, market timers on Wall Street have an appetite for Bonds and MBS.

We know that in December last year the US Government, through the Federal Reserve, began buying them too as way to drive the prices up and bring the rates down.  They became a third buyer of MBS.

We know that this worked – over the last year, rates have been very low.

We know that the US now owns more than 1 trillion dollars in these debt instruments, and we know what they have been saying about that.

They’ve said that they will continue to buy but slow down that effort.

They’ve also said that over time they will want to get rid of them.  That means that they will flip from being a buyer to being a seller.

So right now, the MBS market has three buyers that all have a hefty appetite.  The prices are very high and rates are low reflecting this reality.

Soon, we will likely lose one buyer altogether as the Fed stops buying.

And when the Stock Market heats up, the emotional public will make investments there again rather than in the MBS side of things.  Who knows when that will happen?

China threatens, but so far has not made any substantive changes in their buying patterns.

The US will likely become a “seller” rather than a buyer.

So the long story short – the current demand for these MBS could turn into an over-supply and falling prices, causing the rates to rise.

That said, I think as consumers, we ought to make decisions based on what we know now.  Rates are very low today.  5.25% is available with no points and no origination fees if your home’s value is higher than what you owe and not much worse than that if the value is less than what you owe.

Mortgage processing is bearable again too.  If this works for you, then you should take action now rather than waiting.

Any day now, high demand could flip to extra supply, and rates would rise if that happened.

Oh, and pay off your credit cards and car notes too.  You will want to have extra cash around if that happens. And those who do will have very good investment opportunities available to them.

But, according to New York Fed Bank President William Dudley, the Fed is not on “auto pilot” and will restart the MBS purchasing program if mortgage rates spike.  “If there is a sharp turn in the road” Mr Dudley said, the Fed would intervene.

This would potentially stave off what many feared would be a sharp increase in interest rates just as the new Refinance Programs have gotten going.  Normally the two main buyers of Mortgage Backed Securities are China and Wall Street.  For the past year, the US Government has been a major buyer forcing the prices of these debt instruments up and the yeilds (or interest rates) down to record lows.

So, if you are in the market for a new home or a low rate refinance – don’t expect rates to go down any further because of this news; but you may have  a little longer before they rise sharply.  It looks like the party isn’t over just yet.  Stay tuned.

Interest rates are the result of the yield on Mortgage Backed Securities (MBS).  When MBS are sold to investors they are purchased at varying levels of demand.  If they are in low demand, the price of the security will go down and the yield (or return) will go up.  This will result in higher rates to the consumer.  When there is a high demand for these securities, the price rises and the yield falls – interest rates in turn come down.  This is simple supply and demand economics.

Why does the Yield travel opposite the Price?

This is more easily understood using an example.  If I could buy a home from you and guarantee my profit when I sell it, that would be like buying a bond.  Lets say I guarantee my profit up front to be $10,000.  If I had to purchase a home at $100,000 to make a $10,000 profit then my return (or yeild percentage) would be 10%.  But if I could buy a home for $50,000 and gain the same $10,000 profit, then my yield would be 20%.  A bond or a mortgage backed security is simply an investment with a known profit and a variable price.  So when the price goes down the fixed yield – as a percentage - goes up.

Who buys MBS?

Until last December (2008) there were two main buyers of these types of guauranteed yeild investments.  Wall Street is the main investor – mutual fund companies use these securities to offset risk of owning stocks.  The second investors are foreign countries, mostly China and a few others.   (China and other Asian countries currently own over 1/3 rd of our debt.)  Last December, on their own, interest rates were around 6% to the consumer on a 30 year fixed rate loan with no points based on the activity of these two main buyers.

Enter the US Federal Reserve.

In an attempt to bring long term interest rates to a target of 4.5% and moving as fast at the Treasury’s printing presses could carry them, the US government became a competing buyer for this kind of debt creating a “false demand” for MBS which drove the prices up.  This in turn caused the yields to decline and at their lowest, the consumer was able to lock in at 4.875% with no points a time or two during the past year.

When will they Stop?

The Fed decided originally to spend around $750 billion buying treasuries, bonds and securities and then earlier this year bumped that to $1.25 Trillion.  As of last Friday $977 billion have been spent leaving $277 billion in purchases over the 22 weeks that remain in the program.  The average purchases have been around $20-25 billion per week all year.  This will decline to about $12 billion per week through the end of the year and then drop off.

Prices will almost assuredly fall.

If that happens, the rates WILL rise.