Lord Of The Rates Part III – Mortgage and Real Estate Market


A version of this post ran in the San Antonio Express News.

Please see related posts: LOTR Part I – One Rate To Rule Them All,

and LOTR Part II – How Money Is Born

and LOTR Part IV – Consumer rates

Three rates for mortgage brokers under the sky…
One for the Yellen on her dark throne
In the land of FOMC where the money’s born

The mortgage bond market sets the major interest rates we experience as real estate purchasers and mortgage borrowers. Because these rates are market-driven, they change from one day to the next, even from one moment to the next.

In my Lord of The Rates narrative from an earlier post the High Elves of the Mortgage Market own the 3 Mortgage Rates of Power, setting 30yr, 15yr, and short-term adjustable-rate mortgage (ARM) rates.

In an Earlier Age, I worked with those High Elves on the Goldman mortgage bond sales desk.

“Bid $1 Billion Fannie Mae 30year 5% in June”

As fast as it took to read that, a mortgage-originating bank like Wells Fargo or Bank of America would promise to deliver a billion dollars worth of a diversified bundle of 30-year home mortgages, all with the same interest rate, two months from now, to Goldman’s mortgage bond structuring department. And the buyer responded with how much over face value they’d pay

The price Goldman paid for that bundle depended on an expectation of what price end-user bond buyers would pay for mortgage bonds, two months ahead.

Using Elven magic – known as securitization – our team at Rivendell would weave the dross of three thousand or so home mortgages into shimmering golden threads of valuable bonds, desired by investors all throughout Middle Earth.

That price paid – which again, fluctuated from moment to moment with the interest rate markets – ultimately drove the rate a home-buyer could lock in today.

The Fed funds rate – The One Rate To Rule Them All – anchors the interest rates that mortgage bond investors are willing to accept. And that One Rate To Rule Them All is about to go up.

Higher Rates Coming

When the Fed dropped the Fed funds rate in surprise moves in 2001, and again in 2008, mortgage bond investors accepted lower interest rates on their mortgage bonds. That lower rate allowed mortgage borrowers to save money, either by locking in new, cheaper, mortgage loans or through refinancing their existing mortgages.

rivendellUnfortunately, for home owners and buyers, we’re going the other way now.

When the Fed resets to a higher Fed funds rate – which it will do in either June or September this year – the bond investors of Middle Earth react by demanding higher returns on their bonds.

That demand for a higher return by bond buyers means mortgage originators will require future homebuyers to lock in higher rates on their mortgages. In addition, fewer borrowers will want to refinance, since they can’t save money that way.

Of course, I’m simplifying the timing. All interest rate markets are forward-looking, meaning that the probability of higher interest rates in the near term gets ‘priced in’ to interest rates throughout the mortgage system.

What I mean is this: The High Elves of Rivendell concern themselves with the future, even before it comes to pass. Professional mortgage bond investors already know rates will go up soon, so they’ve already begun to demand higher mortgage rates ahead of the FOMC’s move.

Still, higher rates will certainly affect real estate prices in the future.

Rates effect RE prices
At the risk of stating the obvious, higher mortgage rates tend to dampen the price of real estate.

Bag End for sale

With higher mortgage borrowing costs, home-buyers (as well as commercial real-estate buyers) typically can afford to buy less real estate for their money. So prices go down, or stay down, to match the newly-limited demand.

To give a quick example: A hobbit of Bag End with a $200,000 mortgage at 4% for 30 years on his burrow could expect to pay $956 per month.

That same hobbit, asked to lock in a 5% mortgage six months later – following an interest rate hike – would need to pay $1,075 per month. The $120 extra per month might be the difference between being able to afford the monthly cost of a new burrow – or not.

Since the real estate market – residential, commercial, and raw land alike – depends on borrowed money, the demand for real estate is very sensitive to interest rate changes like this.

Of course this was a huge reason why policy-makers desperately sought to keep rates low following the 2008 Credit debacle. Low interest rates provide a huge boost to real estate demand and therefore prices.

Bag End ComparablesThis in turn allowed the Sackville-Bagginses, in danger of foreclosure, the chance to work out their problems, sell at less of a loss, or deleverage their burrows less desperately.

Hopefully the Sackville-Bagginses have already locked in a low mortgage rate on their burrow, because it gets harder to afford real ownership once rates go up.

When the One Rate To Rule Them All jumps this year, the mortgage and real estate markets will be among the first to feel it.


Please see related posts:

The LOTR – The One Rate To Rule Them All

The LOTR – How Money Is Born

And The LOTR – Fed Funds effect on Consumer Rates


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Lord Of The Rates Part II – ‘Printing Money’

IsildurPlease see related posts: Lord of the Rates Part I – One Rate To Rule Them All, and Part III and Part IV.

Interest rates in the US are going up soon (maybe September? maybe June?), so what will that do to the money supply?

As the ancient text translated from Isildur bane says:

Three rates for mortgage brokers under the sky

Seven for the bankers in their halls of stone

Nine for consumers doomed to die

One for the Yellen on her dark throne

In the land of FOMC where the money’s born

One rate to rule them all, one rate to find them,

One rate to bring them all and in the darkness bind them

In the land of FOMC where the money’s born.

Printing money

Economists don’t like to say that the Fed ‘prints money’ since the physical act of manufacturing bills and coins has very little effect on the actual money supply available in the US Economy. The US Mint, not The Federal Reserve, creates physical coins and bills.[1]

The Fed funds rate and the open market operations used to enforce the Fed funds rate, plus the market-based reactions of large banks to those interest rates, plus the invisible hand of separate self-interested actions by borrowers in an economy, is really how the Fed ‘prints money’ when it wants to increase the money supply.

In an important sense, private banks are the ones who really ‘print money,’ with the Federal Reserve’s agreement and nudge, when they make loans to businesses, governments, and consumers through our system of ‘fractional reserve banking.’

‘Fractional reserve banking’ kind of works like this: At any given time period, a bank needs to keep available in cash only, say, 10% of its total deposits, while the other 90% is available for investing or lending.

So with your $1,000 CD for 1 year that you opened, your bank actually plans to lend out $900 of that while keeping only $100 on hand as a ‘fractional reserve’ of your CD deposit.

When your bank lends $900 to the local coffee shop,[2] the $900 is really almost like ‘printed money,’ sort of, kind of, invented by the bank out of thin air. How’s that?


You deposited $1,000, and that money still exists as yours, or at least will exist for you in a year from now. The coffee shop meanwhile has use of $900 for its own purposes. When the coffee shop then deposits, for the meantime, the proceeds of its $900 loan into its own business bank, the ‘fractional reserve banking’ system keeps on going, inventing more money.

The coffee shop’s bank can take the $900 deposit, and lend out $810 of that again to another business (again retaining the $90, or 10% fractional reserve.) Continuously lending 90% of deposits is how private banks and the borrowing customers’ create money’ in an economy.


With low interest rates and lots of borrowing in an economy, the original $1,000 CD gives birth to much more money circulating in the economy, first $900, then $810, then $729, then $656, etc.

As long as lots of businesses, governments and consumers want to borrow money – and they generally want to borrow more when rates remain low – the money supply grows via this fractional reserve banking system.

The Fed funds rate
Returning to the role of the Federal Reserve in this process: To the extent the Fed funds rate remains low, a private bank can access money cheaply and make money relatively easy for its borrowers to access.

As long as borrowers have a need for capital, the money supply grows easily in response to economic activity, when Fed funds and other interest rates in the economy remain low.

By contrast, when the Fed funds and other interest rates rise – as they are about to do, soon – a reversal of the fractional reserve lending process occurs. As interest rates rise, fewer business and consumer borrowers may find it profitable or attractive to take out loans, thus slowing the growth of the money supply.

If interest rates rise enough, they effectively reverse the ‘money printing’ of a fractional reserve system. The coffee shop doesn’t want to borrow the $900 in the first place any more, and all that later money ($810 + 729 + 656, etc) remains ‘unborn’ as well.

That’s good for limiting the money supply and therefore inflation, but also risks choking economic activity if an interest rate hike is too high or too fast, relative to the economy’s natural demand for money.

Anyway, in simplest form, that’s the mechanism of how the Fed – via the Fed funds rate, the actions of banks, and subsequent actions of borrowers – determines the money supply.

Please see related posts:

LOTR Part I – One Rate To Rule Them All

LOTR Part III – Fed Funds, Mortgage and Real Estate Markets

LOTR Part IV – Fed Funds Effect On Consumer Rates


[1] For a little tangential info on the profitability – via seigniorage – of The Mint when it does create coins and bills, see this note on why I use dollar coins.

[2] Can you guess where I wrote this?

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Lord of the Rates, Part I – The One Rate To Rule Them All

One Rate To Rule Them All

Our present Phenomenally Low Interest Rate Era slips quietly into the next.

Interest rates will rise very, very, soon.

We sense the change, but wonder, what does this mean? For many here in Middle Earth, interest rates remain mysterious.

Fortunately, I found an ancient scroll during my sojourns in the Eastern Lands. Many nights, like the Grey Wizard Gandalf himself, I studied Isildur’s ancient texts, and translated that scroll from the Black Speech  of the land of FOMC. I can now reveal the scroll to you, as it explains the mysteries of interest rates. My best translation:

 Three rates for mortgage brokers under the sky

Seven for the bankers in their halls of stone

Nine for consumers doomed to die

One for the Yellen on her dark throne

In the land of FOMC where the money’s born

One rate to rule them all, one rate to find them,

One rate to bring them all and in the darkness bind them

In the land of FOMC where the money’s born.


To state a commonly held view1, the Fed funds rate  (aka The One Rate To Rule Them All) goes up in September 2015. Or June 2015, I don’t know, they don’t tell me these secret things anymore. Soon, though.

I translated the Black Speech from this Ring I found

Looking back from the future, we will recognize clearly the specialness of this Era, the Phenomenally Low Interest Rate Era.

We will see it as a halcyon time for some, such as prime mortgage and prime auto-loan borrowers.
(I still can’t believe I got a 2.75% 15 year mortgage!)

We will see it as a desert wasteland for people and institutions trying to live off scant bank or bond interest.

But wait, a Hobbit now pulls at my wizard sleeves. “What is an interest rate again?”

Hobbits wonder: What is an interest rate?

A bridge

An interest rate is a mathematical bridge linking money today to money in the future. Money today is always worth a different amount than money in the future. (This, according to the Wizards’ mysterious spell-chant known as ‘The Time Value of Money.’)

As the near-immortal High Elves of Middle Earth knew, the present ever-slips into the future.

Elves pass into the West, just as money fades into the future

Just as the Elves – sensing the end of their Age – passed wordlessly but inexorably into the West, so too does our money fade imperceptibly but inevitably in value as it slips into the future.

To make up for that loss, the wise ancients decreed that the borrower of money must always provide additional money in the future to the lender.

But how much additional money?

Ah! There you have it. ‘How much additional money?’ is exactly what an interest rate tells us.

If the interest rate is 6%, the borrower owes $6 for every one hundred dollars borrowed for a year. If the interest rate is 18%, the borrower owes $18 for every one hundred dollar borrowed for a year.

Back to Fed funds

Perhaps you’re also wondering, how does the Fed funds rate – aka The One Rate To Rule Them All – actually work?

We start with the fact that US banks are required to hold a certain amount of money, called “reserves,” at the Federal Reserve. Some banks may periodically have too much, or “excess reserves” with the Federal Reserve, while others may periodically have too little.

Banks with too little reserves – presumably temporarily – are allowed to borrow from banks with excess reserves.

The Federal Reserve (Well, a specific board known as the Federal Open Market Committee, made up of regional Federal Reserve Governors) sets a rate at which big banks may borrow that money, for just one day, from each other, using their own reserves held with the Federal Reserve.

A bank that needs money in the short-term – for making new loans, paying its lenders, or returning money to depositors for example – can borrow money overnight from banks that have this surplus sitting with the Federal Reserve.

That specific one-day interest rate – known as the ‘overnight rate’ since the loan from one bank to the other bank lasts ‘overnight’ for just one day – serves as the anchor for all other interest rates in the US dollar economy.

The Fed funds rate, currently set by the committee at a range between 0 and 0.25%, allows large commercial banks to borrow money very, very, cheaply. That cheap bank borrowing in turn fuels very cheap loans to the rest of us in Middle Earth.

Everyone who is not a bank, but who gets a bank loan, will borrow at an interest rate higher than the Fed funds rate, as determined by a combination of their bank and ‘the market’ for loans.

Since your bank can borrow money at 0.25%, it can choose to offer you the chance to borrow money pretty darn cheaply, while still making a profit.

The Riders of Rohan probably floated municipal bonds to raise their army

The dwarves, burrowing in their mountains, borrow cheaply for mining operations. The elves borrow to maintain their palace at Rivendell with attractive home equity lines of credit. Halflings can fill up on ale, on credit, at The Golden Perch or The Green Dragon. The humans of Rohan maintain expensive cavalry regiments through their municipal bonds. Each race responds to the incentives of their particular interest rates. But those are all at rates set by the market. Only the Fed decides, by a small committee, the One Rate To Rule Them All.

If the Fed needs to nudge banks to lend to each other at or near its target rate, the Fed’s trading desk uses a market mechanism called “open market operations.” These are really market-based purchases or sales of bonds to soak up money or release money into the economy.

You could think of the Fed’s open market operations as analogous to the Strategic Petroleum Reserve that the federal government controls, periodically soaking up oil supply or releasing oil supplies, pushing oil prices up or down in the short run.

Something similar happens with the supply of money via bond purchases and sales, when the Fed wants to enforce its Fed funds rate or range.

Like the One Ring of Power, the Fed funds rate interacts with other key ‘Ring Bearers,’ such as mortgage bankers, commercial bankers, and consumer borrowers, each of whom in his own way determines the other interest rates in the economy of Middle Earth. All respond to the inexorable pull of the One Rate To Rule Them All.


Please enjoy subsequent (upcoming) nerdfest posts on this “Lord of the Rates” Theme.

LOTR Part II – Does the Fed ‘create money?’ How is Money Born?

LOTR Part III – Mortgage Rates

LOTR Part IV – Consumer Rates


Related posts on similar themes:

My 2.75% mortgage, Timing, and I am a Golden God

Fiduciaries: Is It all Unsustainable Right Now?


Also, see related video posts

Video: Interest rates are a bridge linking money today to money tomorrow

Video: Interest Rates – Time Value of Money





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  1.  Ok, it’s really a Goldman Sachs economist’s view, but we all know who pulls the strings. Haha, kidding. Sort of. Not really.