What happened is that mortgage rates jumped by three-quarters of a percentage point in a matter of weeks — reversing a sharp drop that began in the middle of last year.
Here’s Mr. Bernanke’s answer to Congressman Guiterrez from the Congressional hearing:
“Even as the Fed has lowered interest rates, and as the general pattern of interest rates has declined, the pressures in the credit markets have caused greater and greater spread, particular for risky borrowers, like risky firms, for example,” he said. “Our easing is intended to, in some sense, you know, respond to this tightening of credit conditions. And I believe we’ve, you know, succeeded in doing that, but there certainly is some offset that comes from widening spreads. This is what’s happening in the mortgage market.”
The Congressman moved on to another question, leaving the discussion of tightening credit and widening spreads for another time.
But, judging from our mail, the question is still on many readers’ minds these days. How can mortgage rates go up if the Fed is cutting rates? Doesn’t that mean that banks are, in effect, price gouging?
It turns out that lenders don’t control the price of long-term loans any more than consumers do. What’s happened in the past month or so is that, even as the Fed has been aggressively slashing short-term rates — and flooding the banking system with as much money it will take — the global capital markets are still very nervous about the latest headlines on rising foreclosures, a weakening economy and losses from banks and other lenders that have topped $100 billion — so far.
It turns out there are two mechanisms for setting interest rates. All the Fed can do is target the interest rate paid by U.S. banks for overnight loans among themselves. But using short-term loans to back long-term mortgages can be risky.
If National Bank takes out a short-term loan of $200,000 from the Fed and lends it to Tom the HomeBuyer for 30 years, it still has to come up with $200,000 right away to pay it back. It could do so with another short-term loan, but then it has to keep doing this over and over, indefinitely “rolling it over.” If, during this process, short term rates go up, the bank loses money.
