A reader asks:

Why is a 30-year mortgage at a lower rate than a 5-year mortgage and what is this predicting about future rates? The stock market? The economy (recession and or inflation)?

Wow, I didn't believe it until I went to the Mortgage Bankers Association website and saw it for myself. As of March 14, 30-year fixed rate mortgages are at 5.98%, while 1-year ARM's are at 6.95%. (MBA website) With the Fed dramatically lowering interest rates, adjustable rate mortgages should be lower than 30-year fixed mortgages.

Fixed rate mortgages typically follow the 10-year Treasury note and 30-year Treasury bond yields. Thanks to fears of a recession, investors have been buying these bonds, so 10-year Treasury yields have remained at around 3.5%, and 30-year Treasury yields at 4.5%. (Source: U.S. Treasury Daily Treasury Yield Curve Rates)

Variable rates, interest-only, and adjustable rate mortgages typically follow the LIBOR rate, which usually follows the Fed Funds rate and the short-term Treasury yield rate. And, in fact, the 1-year LIBOR rate is at 2.5%, thanks to the aggressive Fed rate cutting. (Source: Bankrate.com, Libor Index)

So why are the rates high? Thanks to the Subprime Mortgage Crisis, many banks and other investors in the secondary market are loaded up with bad debt that no one wants buy. This reduces the cash available to buy new adjustable rate mortgages. Therefore, those trying to sell these mortgages on the secondary market have to make them more attractive to the few buyers who are still interested. The result is higher interest rates charged to the consumer. (See Fed Holds First Emergency Meeting in 30 Years, 3/17/08)

Unfortunately, this means that no matter how low the Fed drops the Fed Funds rate, it is not lowering the adjustable rates for mortgages. It is like pushing a string - the Fed can add all the liquidity it wants, but until these banks start to charge off their bad debt, take their losses, and start trusting each other again, the secondary market will remain frozen.

What It Means to You

Obviously, it means higher interest rates if you are trying to get an adjustable rate or interest only loan. That means most people will go will fixed rate mortgages to buy a home. Since the easy affordability of interest-only mortgages is unavailable, this will further depress the housing market, which will slow the economy, and make a recession more likely.

Every time the Fed makes a move, it reassures the stock market, but until the banks take their losses, the stock market will remain depressed. On the other hand, the Fed's actions are buying time for the financial markets to sort out this mess, preventing an all out financial panic and large-scale bankruptcies.

Here's a tip fromm Elizabeth Weintraub, About.com's Guide to Homebuying, who notes that many borrowers are refinancing with fixed-rate mortgages just to protect themselves from potential interest rate volatility. (Source: 2008 Real Estate Predictions)

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