Why haven't mortgage rates dropped this year?

The Federal Reserve began to slash short-term interest rates almost a year ago. Yet we have higher mortgage rates now than we had then. What gives?

No single answer explains why some rates have fallen while fixed mortgage rates have climbed from an average of 6.43 percent a year ago to 6.6 percent this week. Among the several reasons, you can sum up the main one in two words: credit risk. Lenders behave cautiously now because they lent recklessly in previous years, leading to a surge of foreclosures.

Traditionally, observers noted a link between 10-year Treasury notes and 30-year fixed-rate mortgages: When the 10-year Treasury yield went up, the 30-year mortgage rate went up, and when the Treasury yield fell, so did mortgage rates. That linkage has broken.

Consider two dates, a little over a year apart, when mortgages had the same rates in Bankrate.com's weekly survey, while the 10-year Treasury yield dropped more than a percentage point:

On Aug. 8, 2007, the 30-year fixed averaged 6.66 percent, and the 10-year Treasury note yielded 4.85 percent.

Fifty-four weeks later, on Aug. 20, 2008, the 30-year fixed averaged 6.66 percent again -- and the 10-year Treasury yielded 3.79 percent.

Between those dates, the Fed made a drastic series of cuts in the federal funds rate. That rate, also called the overnight rate, stood at 5.25 percent a year ago. From mid-September to late April, the Fed chopped it to 2 percent in a bid to stimulate the economy. It remains 2 percent.

"The perception is that mortgage rates should be lower," says Bob Moulton, president of Americana Mortgage, a brokerage in New York. Why haven't mortgage rates fallen along with Treasuries? "That's the million-dollar question," he says.

Today's rate puzzle seems sort of the flip side of the "Greenspan conundrum." From June 2004 to June 2006, the Fed hiked the federal funds rate from 1 percent to 5.25 percent. Most people assumed that long-term interest rates and bond yields would rise, too. But they fell. Alan Greenspan, who was chairman of the Fed at the time, famously told Congress in February 2005 that "the broadly unanticipated behavior of world bond markets remains a conundrum."

Greenspan speculated that the odd rate behavior arose from a savings glut in Asia: China and Japan, flush with dollars, sent the money back to the United States so Americans would have cash to keep buying imports. Instead of buying skyscrapers and movie studios, the Chinese and Japanese bought Treasury bonds and mortgage-backed securities. They bid up the prices of IOUs -- and when IOU prices go up, interest rates go down.

"Fast forward to today," says Kenneth Thomas, a lecturer in finance at the Wharton School of Business at the University of Pennsylvania. He points out that investors around the world continue to buy Treasury debt, keeping yields low. But their reluctance to buy mortgage debt keeps mortgage rates higher.

"Mortgages are now considered riskier than they used to be," Thomas says. "That's one of the biggest factors in this credit crunch."

He cites the Fed's quarterly bank survey, in which 75 percent of lenders said they tightened mortgage lending standards in the second quarter of this year. "The tightening comes in many ways, including higher rates," Thomas says.

So Beijing has had a hand in raising mortgage rates with its reluctance to buy American mortgage debt, and Seattle and Charlotte, N.C., play their part as major banks raise mortgage rates to compensate for a perceived higher risk. The global financial system ties these decisions together.

This might seem strange if you applied for a mortgage five years ago and again recently. Lenders have become more strict -- demanding better documentation of income and assets and requiring bigger down payments. Today's new mortgage almost certainly has a smaller chance of going bad than a typical mortgage underwritten three years ago. If they carry less risk, why don't rates fall?

"To me, it says the banks are holding more of the profits on these mortgages to make up for the losses that they've experienced over the last several years," says Moulton.

X...X...X

Mortgage rates were mixed this week, with fixed rates falling slightly, and adjustable rates rising just a bit. This week's drop in fixed mortgage rates coincided with a report that federal officials were discussing bailout options with Fannie Mae and Freddie Mac. With this reminder that the federal government intends to keep the mortgage market functioning, rates went down.

The average 30-year fixed-rate mortgage fell 6 basis points, to 6.6 percent. A basis point is one-hundredth of a percentage point.

The average 15-year fixed -- a popular option for refinancing -- fell 4 basis points, to 6.14 percent. The average jumbo 30-year fixed fell 1 basis point, to 7.61 percent.

The one-year adjustable-rate mortgage rose 4 basis points, to 6.28 percent. The popular 5/1 ARM rose 1 basis point, to 6.27 percent.

Mortgage applications rose slightly for the week ending Aug. 22, according to the Mortgage Bankers Association. Application activity increased a seasonally adjusted 0.5 percent from a week earlier.

Refinancing activity increased by 0.3 percent, while applications for purchases increased 0.6 percent. Refinances accounted for roughly one-third of applications

Reach Holden Lewis at editors(at)bankrate.com

(Distributed by Scripps Howard News Service www.scrippsnews.com)