The Source of Mortgage Money
Where does mortgage money actually come from? When you get a $500K mortgage, who actually writes the checks? Most people have no idea. Does it come from a bank? Does it come from the government or some large quasi-governmental agency like Fannie Mae or Freddie Mac? It all seems so confusing and the numbers are so big that they become abstract. But understanding where the cash comes from is the first step to understanding how the mortgage industry operates.
You can effectively break down the source of money into two broad categories. On the one hand, you have banks that recycle money that's been deposited into personal and corporate accounts. We all have bank accounts—checking accounts, savings accounts. That money all belongs to us, and the bank pays us interest on it. But they, in turn, lend that same money out to people who want to borrow it. These banks then charge their borrowers a higher interest rate than they offer to their savers. That's how they make their money. They charge what's called "a spread" between their borrowing interest rates and their deposit interest rates. In fact, banks can even lend out more money than they physically have on deposit, based on ratios federally regulated by certain governmental agencies. But the details of that mechanism are beyond the objectives of this article. The point is that banks get money from our deposits, and that's what they lend out to their borrowing clients.
The interest rates charged by these banks are heavily influenced by the decisions of the Federal Reserve. Most of us are familiar with Alan Greenspan, who has been the chairman of the Fed since 1992. His term just came to an end on January 31, 2006, and he is now being replaced by Ben Bernanke. At the time of this recording, the Fed has raised interest rates 14 consecutive times during the past two years to gradually tighten a highly accommodating monetary policy that's been in place since 2001.
The Fed manipulates interest rates by buying and selling bonds in the bond markets. During challenging economic times, the Fed buys bonds on the open market, and they pay for these bonds with cash. As the Fed continues buying bonds, it floods the market with cash. All of this excess cash makes money more available for people who want to borrow, and interest rates naturally come down as different lenders compete for a limited number of borrowers. Think about it. If there's excess cash out there, the interest rates to borrow that money get bid down as different lenders compete for the business. Borrowers naturally go for the lowest rate.
When the economy starts growing again, consumer confidence starts rising, and people start spending money again. They buy cars. They buy stainless steel refrigerators. They buy computers. With rising demand, companies can start charging more for their products. Profits start rising, and soon, workers start asking for raises and better benefits. That increases costs for companies, and a vicious cycle of inflation begins. Inflation is a complicated phenomenon, but suffice it to say, it can send the economy into a tailspin. So, to slow down that cycle, the Fed can start selling bonds on the market. Buyers pay for these bonds with cash, and the Fed immediately puts that money away, taking the cash OUT of the economy. With less cash available on the open market, borrowers start bidding up interest rates, which dampens the feeding frenzy and keeps the economic growth at a sustainable level.
The interest rate directly affected by the Fed is what's called "the Overnight Rate." This rate is what the banks charge each other. You may or may not be familiar with the Overnight Rate, but most of us are familiar with the Prime Rate. This rate is simply the Overnight Rate plus 3. Right now, for example, the Overnight Rate is 4.5%, so the Prime Rate is 7.5%. Every time the Fed makes a change, the Prime Rate changes at the exact same time.
There are also a number of indexes that are affected by these policy changes made by the Fed. Some of you have heard of the LIBOR index. If you're curious, the acronym LIBOR stands for the London Inter-Bank Offered Rate. You may have also heard about the MTA index. It stands for the Monthly Treasury Average, and there are others like the Cost of Funds Index and so on. All of these indexes are heavily influenced by the actions of the Fed. So as you can imagine, they have all gone up significantly during the past two years. In 2003, the Prime Rate was at 4.00%. Today, it's at 7.5%. In 2003, the LIBOR and MTA indexes were both around 1.00%. Today, they're at 5.3% and 4.7%, respectively.
The Prime Rate and all these various indices govern the interest rates of all variable rate loan products. For example, a home equity line of credit is a variable rate product and is generally tied to the Prime Rate. There are also a lot of loan products these days that are fixed for the first few years, but that become variable after that. Once the fixed period expires, they are tied to one of the indices like the LIBOR or the MTA. Anyone who has a variable rate product has seen their payments go up significantly over the past two years.
We started this discussion by saying there are two primary sources of mortgage money. The first is from bank deposits. The second comes from a wide variety of "investors" who provide money through Wall Street. But don't think these are just a bunch of super wealthy individuals. They're actually Money Managers that are managing our own money. Most of us have investment accounts like Insurance Funds, Pension Funds, and various Retirement Funds. Many of the accounts that contain all these funds end up housing huge amounts of cash. You can imagine the Pension Fund for General Motors or some other Fortune 500 company. Think about Insurance Companies like New York Life or State Farm. These companies manage immense sums of money; money they have accumulated from all their contributors—people like you and me. These huge funds are managed by professional Money Managers. They are always trying to maximize the return they get on this money, so they look for good places to invest.
For the most part, they end up putting the cash into three main areas. They buy equities—stocks of various companies that trade on the stock exchanges—shares of General Electric or Google or Starbucks Coffee. They also buy corporate and government bonds. That's the second choice. And they buy what's called "mortgage-backed securities." That's the third choice. Well, those are mortgages! They're bundled mortgage loans that are bought and sold on Wall Street every day. Essentially, these various Money Managers approach the mortgage business and say, "all right, you can lend out our money as long as you follow these guidelines." The guidelines they're referring to are the underwriting guidelines Mortgage Brokers have to follow when helping someone apply for a loan.