John M. Lee: Why Are Interest Rates Low?

I can still remember purchasing my first house in 1981 and obtaining my first mortgage. Homes were not selling, and no wonder ... the interest rate was at 17 percent! And guess what, after I closed escrow, rates went up and I was happy with my 17 percent rate loan.

So, when I look at today's all-time low mortgage rates of about 4 percent, a 60-year low, I had to reflect back to those times and laugh at how they have changed. And, when people are waiting for another 1/8 percent drop to commit to a loan, I just have to tell the story of my happiness with a 17 percent interest rate loan!

But, why are current interest rates so low? The answer is that interest rates are determined by the market for money – a function of supply and demand. For example, when the demand for money is high and supply is low, interest rates go up. It is also a function of the economy, where investors choose to put their money after they determine potential risks and rewards.

Generally, when a mortgage loan originates, either through a purchase or refinance, it goes through a process called "securitization." The real estate is the collateral for the loan and if the borrower does not pay the mortgage, the lender gets to foreclose on the property and take back the asset. Most lenders do not keep the loans in their portfolio, usually selling their loans in the secondary market.

Loans from other banks and lenders are then pooled together and assigned to a trust. The trust then secures the pool by issuing mortgage-back securities, which other investors will purchase. In the U.S., two of the best known and most influential securitization trusts are Fannie Mae and Freddie Mac, formerly government sponsored enterprises (GSE), whose primary function is to provide for a smooth and orderly mortgage market by buying and selling these securities. They set the criteria for the loans and the interest rates they will purchase at; and because they are so large they can influence the mortgage market.

Although there is no explicit government guarantee of Fannie and Freddie, there is an implicit guarantee that the government will not allow them to fail and default. This "concept" was put to a severe test during the mortgage crisis in 2008 when securities backed with mortgages, including sub-prime mortgages, lost much of their value. At the end of 2008, the government placed Fannie and Freddie into a conservatorship and bailed them out by increasing the Treasury's debt ceiling by $800 billion in order to provide the liquidity necessary to relieve pressure in the mortgage market. That move saved our mortgage market and demonstrated to investors that the U.S. government will pull out all the stops to make sure that this market does not collapse.

Rates dropped to record lows when the Federal Reserve announced at the end of 2008 that it would buy $1.25 trillion in mortgage securities to bolster the faltering real estate market. By pumping money in, or increasing the supply of money, our government caused mortgage rates to decrease.

Our government made purchases in installments during 2009 and ended in 2010. Many, including myself, predicted that rates would then bounce back up, but we were wrong. What happened was that the investors came back into the market and started buying mortgage securities to take the place of the government purchases.

Why would private investors do that? Because our economy was still not doing well and mortgage backed securities were a better bet than investing in other financial instruments. In contrast, if our economy was strong, mortgage rates would tend to go up because investors could find a better rate of return elsewhere, which forces mortgage backed securities to offer a higher rate or return in order to attract investors.

So, the cycle continues. The best advice I can provide is to lock in on these historically low mortgage rates before they go up. There really is no down-side risk because if the rates were to decrease again you could always refinance again. And, if the rates do go up you will be smiling like I was when rates went above 17 percent!

For questions about real estate, contact Lee at (415) 447-6231 or johnlee@isellsf.com.