Mortgage Backed Securities BasicsMortgage rates are affected by mortgage backed securities, usually when the money supply significantly increases or reduces. It is important to distinguish between mortgage rates and the Federal Reserve interest rate, also known as the Discount Rate.  While the two tend to go hand in hand over the longer term, short-term variations can occur.

We shall ignore the Fed here and discuss only mortgage rates and how they are affected by investment in mortgage backed securities.

What are Mortgage Backed Securities?

When you invest in a mortgage backed security (MBS), you are fundamentally lending money to people who are buying their homes.  However, your investment is made to an institution responsible for passing the cash onto a mortgagee. That institution is then responsible for collecting the mortgage repayments, and paying you your interest.

In practice, you invest your money through an investment company who has a pool of cash to offer to banks to finance their mortgages. Your investment is backed by the mortgages that all of these banks offer their clients.

You receive your interest payments from the interest paid as part of the mortgage repayments and also from interest accrued on the pool of cash not yet loaned. The effect of a default in mortgage repayments in then minimized, and split between all investors.

Mortgage Rates and Mortgage Backed Securities

The one problem with mortgage backed securities is that this method of offering mortgages relies on its attraction to investors. In times of low employment, interest rates tend to be low in order to attract home buyers.  There is less cash available from the fewer employed to pay mortgages, so fewer homes are sold.

Lower interest rates are offered to make home ownership more affordable.  Because of this, investors receive less return, so they switch to the regular stock exchange for investment. In order to counter this, mortgage backed securities could increase mortgage rates to attract investors.  To do that, however, they need investors to provide the cash so it is a Catch 22 situation.

Why Mortgage Rates Increase with Higher Employment Rates

In addition to decreasing interest rates, less available cash means fewer mortgages.  This leads to less ROI for investors. The investors then still switch to the regular stock exchange that offers a higher return. When employment begins to rise, the greater demand for home loans results in a higher interest rate to attract investors in MBS in order to generate the cash to meet the demand.

Fundamentally, mortgage backed securities can cause mortgage rates to increase because of the need to attract investors to offer the cash to enable the purchase to take place. Going back to the bank Discount Rate, this also increases in order to prevent inflation. The higher the price of borrowing, the less likely people are to purchase on credit, but the more likely investors are to be willing to offer cash to buy homes.