Mortgage Rates: Why They Could Explode Higher This Month


If you're thinking about buying a home but are waiting for mortgage rates to settle back down, then I hope you're in it for the long haul.

With the Federal Reserve scheduled to meet this month to decide on the fate of its monetary policy, many analysts and central bank observers are speculating that it may finally pull the trigger on beginning to wind down QE3. If it does so, you can rest assured the reverberations will be felt in the mortgage market -- and no, the result won't be lower rates.

Are rates headed higher?
To get an approximate idea of what could be in store for the mortgage market, the chart below shows what happened when the central bank merely intimated back in May that it could, at some undetermined point in the future, begin to reduce its support for the economy.

As you can see, the rates shot through the roof, climbing by more than 100 basis points over the course of two months.

Before getting to this, however, it's first necessary to assess the likelihood that the Fed may indeed be on the verge of tapering. Although it's never prudent to predict what the central bank will do, there's a growing chorus of opinion that such a move is in order.

Earlier in the week, Mohamed El-Erian, the chief executive and co-chief investment officer of Pimco, suggested that it was all but certain that the Fed would do so. "The longer you stay unconventional, the greater the risk of policy ineffectiveness," he told Bloomberg's Tom Keene.

And on Friday, one of the most outspoken doves on the central bank hinted that he too could finally be in favor easing off the monetary gas pedal. As The Wall Street Journalreported, the official, Charles Evans, who is president of the Federal Reserve Bank of Chicago, acknowledged that he was "open-minded" about the idea.

So, what will happen to rates if it does so?
Similar to the futility of forecasting the Fed's next move, it's impossible to say how much rates will increase if it decides to taper its open-market bond purchases.

As Matthew Graham of MBS Live told me at the end of last month, "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." At the same time, however, Graham was quick to note that, "we've priced a lot in, but probably not all."

Either way, it's worthwhile remembering that mortgage rates, even if they increase from here, are still likely to remain dirt-cheap on a historical basis. Will it cost more to buy a house? Yes. But the cost won't be inordinately expensive compared to what, say, your parents or grandparents paid.

The more interesting question concerns what will happen to financial companies that hold mortgage-backed securities for investment purposes. As mortgage rates go up, the value of these go down, putting downward pressure on book values across the financial industry.

The hardest-hit have been mortgage REITs, which maintain massive, and often exclusive, portfolios of MBSes. The following chart illustrates the impact of this on the book values of four such mREITs: Annaly Capital Management , American Capital Agency , ARMOUR Residential , and Two Harbors .

NLY Book Value Per Share Chart
NLY Book Value Per Share Chart

While the downward trend for all of these companies began in the latter half of last year, it's accelerated over the last eight months. Just since the beginning of the year, for instance, ARMOUR's book value per share is off by 20%, American Capital's by 19%, Annaly's by 18%, and Two Harbors' by 9%. Indeed, the carnage in the MBS market has spared no one.

With so much of the financial industry getting bad press these days, it may be a greedy-when-others-are-fearful moment. Not surprisingly, some of Warren Buffett's biggest investments are in the space. In the Motley Fool's free report, "The Stocks Only the Smartest Investors Are Buying," you can learn about a small, under-the-radar bank that's too tiny for Buffett's billions. Too bad, because it has better operating metrics than his favorites. Just click here to keep reading.

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