A quick review – who “decides” what mortgage interest rates should be? The short answer is – the investors who buy mortgage backed securities on the secondary market. Unknowledgeable people say “greedy lenders” (I’m being generous with the word “unknowledgeable”. Privately, in my rants and raves, I categorize individuals who love to speak so generally as misinformed? Ignorant? Stupid?).

Several major things are contributing to the drop in rates over the past couple of weeks.

• The Fed has been providing liquidity to the credit markets.
• FHA loan limits have been raised.
• The Fed has loosened capital requirements for Fannie Mae and Freddie Mac.
• Investors cheered that quarterly loses reported Wednesday by Lehman Brothers and Goldman Sachs weren’t as bad as predicted.

So back to my original question – who “decides” what interest rates should be?

When a home buyer gets a loan from Countrywide, B of A, Wells Fargo, et al, that lender turns around and sells that loan on the secondary market. They then get cash back to make another loan.

That secondary market might be the bond market (State of California CalHFA loans for first time homebuyers), it might be pools of mortgages sold to an insurance company, a hedge fund – your 401k plan might include a slice of a mortgage backed security.

Factors that determine interest rates are fear (sub-prime mess; loss of investment), greed (I want a higher rate of return), and security (same as fear). The “safest” investments (a benchmark if you will) is Federal government debt, ie, Treasury notes and bonds. Most people don’t think the fed is going to go bankrupt – it just prints more money to pay off debt.

Any amount of interest over the fed’s current interest rate is called a “spread”. That spread is the market’s perception of risk – will be investment be lost or degraded?

The financial marketplace hates the unknown, thus the spread goes up. Once the marketplace feels it has a grip on risk, things tend to get back in line.