All interest rates are determined relative to what is considered to be the real risk free market interest rate if no inflation were expected. This real risk free interest rate, which most consider to be the 90 day US Treasury bill, is the benchmark for how other market rates are determined. Unfortunately the majority of interest rates are not risk free; there are other factors that go into determining what the money you invest NOW will be worth in the future. This is the concept of “The Time Value of Money”. When placing a present value on your future cash flows you must consider several risks…these risks correspond to what you expect to receive in interest from an investment. That said, going back to how interest rates are determined…Remember all rates are based off of the “risk free” benchmark interest rate. On top of that to compensate for additional risks investors will demand additional interest based on the following…

Inflation Premium: If you invest $10 today and you expect the value of a dollar to be worth less tomorrow you will expect to be compensated for that loss of your initial investment. You will therefore demand a higher rate of return (interest rate). When inflation is expected to go up then interest rates go higher to compensate for the lost value of your principal investment.

1. Default Risk Premium: this portion of an interest rate is based off of the possibility that the person or company you are lending money to may not be able to pay you back. That is what a bond is after all, you are lending money to someone else, and in return you receive the interest rate plus the original money you lent them at a defined date. US Government Bill, Notes, and Bonds have a low default risk premium because the Federal Reserve can essentially print money to pay you back. Subprime loans have a high default risk premium because the chance that those borrowers will default on their loan is higher than a borrower with strong credit and stable income.
2. Liquidity Premium: If an investment cannot be quickly turned back into COLD HARD CASH it is said to be illiquid. The liquidity premium is based off the market demand for the type of debt (bond) you hold or issue. There is a massive demand for US Debt (bills, notes, and bonds) so if you wanted to sell your holdings of these securities it would be easy to find a buyer. If you hold the debt of let’s say a small company, it will be harder to find a willing buyer because for example information about that firm is not readily available to the public. When it is hard to find a buyer of the security you must lower the price enough to attract a willing buyer. This is said to be an illiquid security.
3. Maturity Premium: This compensates an investor for how long their money will be tied up in an investment …the longer the length of the bond contract (longer maturity) the more time there is for economic conditions to change. That means the inflation expectations may change or the ability of the debt issuer to service their loan may change as well. This is why the yield curve of US Bills, Notes, and the Long Bond is generally sloped upward. The clarity of economic expectations defines the maturity premium

So to put all this together…
Interest Rate = real risk-free interest rate + inflation premium + default risk premium + liquidity premium + maturity premium

NOW to relate all this to mortgages…In the most simplistic of explanations….the pricing behavior of a bond is as so : When there is more demand for a bond, meaning more buyers than sellers, the price of the bond goes up. When the price of a bond goes up the yield goes down until supply and demand reach equilibrium again (and vice versa). To oversimplify this happens because the price of the bond eventually becomes too expensive relative to the return that is received (the interest rate).
Although mortgage rates act similar to US bills, notes, and bonds….they do not operate the exact same way. Allow me to give some background first. The majority of mortgages that are sold in the US end up being securitized in some way or another. Usually they are put together in big groups of loans with similar interest rates and loan characteristics. Those pools of loans have a specific cash flow tied to them based on the average interest rate (coupon) of the mortgages that make up (back) the pool. When investing in that pool of mortgages, because you know what the average coupon rate, you know how much money you will get paid and when you will receive these cash flows. This is a broad description of mortgage securitization, or how your mortgage becomes part of a mortgage backed security (MBS).

Now that you have some MBS foundation, let’s build on it. How are the rates you are offered determined?
When economic conditions change or one of the above premiums changes these pools of mortgages either gain or lose value, meaning they become worth more or worth less. When those pools change value so do the interest rates you are offered when you seek to refinance or purchase a home. Here’s how: Every morning lenders publish a rate sheet and distribute it to loan officers who then offer you an interest rate. Depending on the time these rate sheets are generated, rates will either be better or worse based on the price the MBS pools are trading at when rate sheets are generated (more so dependent on when lenders locked (sold forward) their supply of loans). If “rate sheet influential” MBS are being bid up (price increases) mortgage rates will most likely be set lower compared to the previous day. If “rate sheet influential” MBS coupons are selling off, the mortgage rate you are quoted will likely be higher than the previous day.

Here is where things get a little more complicated. If the MBS prices go up and stay up, mortgage rates will move lower and lower (to a point where primary/secondary spreads can no longer tighten). If mortgage rates move lower there may be enough incentive for you to refinance your home. When refinance you are paying off your old mortgage and getting a new one with a lower interest rate, which restarts the securitization process. But here is the thing…the bank, money market manager, pension fund, insurance company, hedge fund, or servicer that invested in the pool of MBS that your loan partially backs then loses the cash flow that you contributed when you made your monthly payment (because you prepaid/paid off your loan early). This is the big difference between mortgages and other types of bonds like the 10 yr US Treasury….an MBS investor knows about how much cash flow they will receive and when they will receive it, what they don’t know is how long the cash flow will last due to the fact that borrowers have the ability to refinance their loan at any time (when they have incentive or need). This additional risk associated with mortgages is called prepayment risk, the option to refinance is an “embedded call option” within the mortgage-backed security. Prepayment risk adds a feeling of uncertainty to MBS investors; it distorts a portfolio manager’s ability to determine the present value of the expected future income streams that are generated from pools of mortgages, especially when interest rate volatility increases.

When rates are expected to be lower in the future, well I should say low enough to provide incentive to refinance or purchase, the pools of mortgages (MBS) that are backed by loans with higher rates will begin to lose more and more value as rates go lower and more borrowers refinance their loans (they prepay their loan or use their call option). Remember the income MBS investor expect to receive is generated when you pay your monthly payment, so if you refinance your loan MBS investors lose the income stream they were expecting you to contribute to the MBS pool. MBS investors therefore must find a way to replace that lost expected future cash flow. If a group of MBS investors believes rates will go lower then they may sell a portion of their higher interest rate (fuller) MBS portfolio in favor of lower rate pools to compensate for lost income (and need to extend duration of their cash flows if yield curve is flattening). They do so because they believe they will receive stable cash flows for a longer period of time (relative to liabilities..that is the investor must offset cash inflow duration with cash outflow duration).

How does this affect day to day mortgage rates?
When the yield curve fluctuates, a shift in coupon bias (duration bias) generally follows. This can result in either buying or selling “down in coupon” (when yield curve flattens) or “up in coupon” (yield curve steeper). Often times when selling a pool of MBS made up of mortgages with higher interest rates, investors will look to buy pools secured by loans with lower rates to stabilize their expected future cash flows. This is called a down in coupon day and is a major force in the daily price movements of mortgage backed securities. The same happens on up in coupon days but in that case MBS investors sell “rate sheet influential” MBS coupons and mortgage rates generally move higher.

To summarize when reading our commentaries you should understand that when we say prices of mortgage backed securities (MBS) are going up, that the rate you are offered as a borrower will go down. The MBS is subjected to the same premiums that determine the value of other types of bonds, except MBS are exposed to prepayment risk, the fear that an investor may lose future cash flows because a mortgage holder (borrower) decides to refinance their home. This additional risk often forces portfolio managers to extend the duration of expected future cash flows by either buying lower coupon MBS pools or perhaps purchasing less risky securities with more relative value. In times of economic uncertainty and increased interest rate volatility, forecasting the expected interest rate environment becomes a difficult task. Therefore the models used to determine the future value of cash flows generated by a pool of mortgages become inaccurate. This creates a volatile interest rate market and often times confuses borrowers as the why mortgage rates sometimes fluctuate in a wide range.

By Tom Opdyke
The Atlanta Journal-Constitution

Published on: 07/07/08

Here’s a weak ray of sun in a cloudy economy: The taxable value of most metro Atlanta homes is not going up this year.

Reflecting the extended slump in homes sales, it means that unless you made improvements or additions, your tax office doesn’t think your home’s value has increased. It also means your taxes could fall by a sliver —- probably less than $10 annually —- unless your county increases its millage.

As counties finalize their tax digests —- the value of all commercial, personal and residential property —- for the Aug. 1 state deadline, most metro governments, with the exception of Forsyth County, are reporting fewer assessment increases than taxmen have seen in two decades.

Tax bases are still rising in metro counties because of increases in assessed valuation for commercial property, new construction and a boost in a small percentage of residential property. But nothing like prior years.

“Until this current market, a saying of mine was, there was not a residential property going down in value. In this market, yes, there is,” Gwinnett County tax assessor Steve Pruitt said.

With the exception of Fulton County, which showed about a 16 percent increase in its digest and increased commercial assessments by a median 44 percent, most metro counties are reporting about 6 percent growth, some less.

The storm cloud surrounding this silver lining: slower growth in the tax base could foreshadow an increase in taxes or service cuts in coming years.

Because the assessments are based on market value as of Jan. 1, 2007 —- and the Standard & Poor’s/Case-Shiller Home Price Index shows the Atlanta resale market has fallen 6.5 percent since March 2007 —- assessors foresee smaller tax base growth in 2009 unless sales heat up.

“I do think 2009 will be a lot more challenging than 2008 for local government,” said John Scott, chief assessor in Bullock County and executive director of the Georgia Association of Assessing Officials.

Only property owners whose valuation changes get a notice from the tax assessor, and not all properties are evaluated every year.

Cobb and DeKalb counties mailed the fewest notices of assessment changes in two decades.

“It would be normal for us to mail out in excess of 100,000 notices on an average year. This year it was about 26,000,” said Tom Stump, interim chief assessor in DeKalb. For about 1,700 who received notices, assessment went down.

Forsyth sent about 56,000 notices, with about 43,000 showing increases. But they were the exception.

Cobb’s Board of Tax Assessors in March ordered no increases in residential assessments unless a property had been improved —- an addition, a new bathroom or the like.

Instead of sending out the year’s typical 70,000 notices —- about one-third of the county’s residential stock —- Cobb sent about 13,000, and about 2,300 were notices of decreased valuation, said chief assessor Phil Hogsed.

Most assessors said the valuation decreases were not in a particular area or city. In some areas, the types of houses in the same subdivision have changed.

In the Hays Farm subdivision in west Cobb, larger houses that sold in the $500,000 range are now near smaller homes by a different builder that sell in the $300,000s.

While the assessors are not permitted by law to use foreclosures as part of their calculations, they are sensitive to the impact of foreclosures on communities.

“If 30 percent of the sales in a neighborhood were foreclosures, we tried not to make any adjustments,” said Rodney McDaniel, Clayton County’s chief assessor.

FREQUENTLY ASKED QUESTIONS

Q: I have foreclosures in my neighborhood that I think are dragging down my property value, why is it not reflected in my real estate assessment?

A: Foreclosures are not directly considered in property assessments because the taxman is required by law to consider only sales between a willing buyer and seller. A foreclosure is viewed as a forced sale.

Q: How do I appeal my property reassessment?

A: Most counties have an appeal process outlined on the assessment notice you receive. An appeal must be mailed within 30 to 45 days of the notice’s mailing date, depending on the county. Counties often provide a form on their Web site so you can file electronically. Go to your county Web site and click on the link for the Board of Tax Assessors.

Q: If I didn’t get a reassessment notice but believe my property value has diminished, what can I do?

A: Probably nothing this year. Early next year —- the deadline can be March 1 or April 1, depending your county —- go to your tax office and file a real estate tax return. You also can obtain the form by going to http://www.etax.dor.ga.gov/ptd/adm/forms/pt.aspx and downloading form PT-50R. Tell the assessors what you think your property is worth. Assessors will review your property and your will get an assessment.

A QUESTION OF VALUE

A tax digest, which includes residential, commercial and personal property assessed at 40 percent of market value, is set by the county appraisers. They determine the market value of property but do not set taxes. Once approved by the state, it is used by the county, its cities and the public school systems as the basis for setting tax millage. Here is what metro counties reported:

Clayton

2007……$8.1 billion

2008……$8.5 billion

Increase..5.9 percent

Cobb

2007……$26 billion

2008……$27.6 billion

Increase..6.2 percent

DeKalb

2007……$23 billion

2008……$24.1 billion

Increase..4.8 percent

Fulton

2007……$54.4 billion

2008……$63 billion

Increase..15.8 percent

Gwinnett

2007……$27 billion

2008……$28.5 billion

Increase..5.6 percent

In a new Q-Series report released this morning, UBS analysts David Goldberg and Alexander Goldfarb selected Atlanta, Austin, Charlotte, Dallas/Ft. Worth, and Houston as their top picks for markets that will lead in a housing recovery.

The outlook for those five markets was optimistic because they exhibited stronger positive trends in demographics, economic growth, affordability, and inventory than the other eight markets examined.

Based on these same metrics, Orlando, Las Vegas, Phoenix, Riverside, and Tampa fared the worst. For-sale inventories and declining home sale prices have increased competition among single-family builders, a fact that also poses hurdles for apartment fundamentals.

San Diego, Los Angeles/Orange County, and Washington, D.C., were identified as “coincident” markets, meaning they were somewhere in between market leaders and market laggards.

Using the results of this analysis, Goldberg and Goldfarb also calculated home builders’ and apartment REITs’ exposure to each market and were able to forecast which companies would be the best positioned for a housing rebound. Out of the nine public home builders in Goldberg’s coverage universe, The Ryland Group was the big winner. With the release of the report, Goldberg upgraded Ryland stocks to a buy status.

Ryland’s geographic diversification–it has no more than 10% of its business concentrated in any one geographic market–merchant builder model, and strong balance sheet puts it in a position to take advantage of a market return quickly.

Moreover, the company has a higher concentration in markets with more favorable outlooks and less of a presence in more troubled markets such as Las Vegas, Phoenix, and Tampa. In a related conference call, Goldberg pointed out that, based on community counts, Ryland has roughly 33% of its communities spread across top pick markets Atlanta, Dallas, and Houston versus an average of 24% for the group.

On the multifamily side, Essex Property Trust was Goldfarb’s buy-rated stock. He pointed to the company’s exposure in coastal California and Seattle–markets less affected by the housing downturn–as major pluses.

During the call, Goldfarb also pointed out that the market report was slightly more reflective of single-family building than multifamily activity. “A good apartment market is where single-family remains in check,” he explained. Thus, as the single-family market has struggled, the apartment industry has felt some fallout.

He also stressed this point in the report: “There has not been an influx of new renters as the housing market collapses–indeed we are seeing competition from rental homes in some markets. For example, 14% of Camden Property Trust’s move-outs in Las Vegas are to rental homes.”

By Kevin Duffy
The Atlanta Journal-Constitution

Published on: 06/23/08

Caleb Atkins gave himself a heckuva birthday present Sunday: a two-bedroom, two-bath condominium on the top floor of the Tribute Lofts building east of downtown Atlanta.

Tribute sold 26 units in an unusual one-hour auction Sunday at the Omni Hotel at CNN Center. The developers, Greg and Brian Wohl, decided to go the auction route because the condo market is so sluggish.

In a year’s time, Tribute, which recently won a new-construction award from Atlanta’s Urban Design Commission, has sold fewer than half of its 147 units. Many of the condos put up for auction had been under contract, but the deals fell through.

“I’m about to go and celebrate pretty heavily,” said Atkins, a Georgia Tech graduate who works in Suwanee and turns 25 on Friday. “I prefer to live where I play.”

Even before learning of the auction, Atkins was planning to buy a Tribute condo and say goodbye to his house-sharing in Virginia-Highland.

“But two days before I was to make that offer, the auction was announced,” he said. “We freaked out. The two-bedroom unit that I couldn’t afford, I could afford now.”

Atkins is a homeowner for the first time. He paid $263,000 —- the highest price at the auction —- for the 1,306-square-foot unit. Atkins pointed out his winning bid was “30.77 percent” less than the original asking price of $379,900.

Initially, the Wohls and auctioneer Accelerated Marketing Partners intended to auction 40 units. But 10 units were nixed beforehand because registrants showed little or no interest in them.

Four more units were not offered for sale when the sellers ended the auction early; they feared prices might go too low as the crowd thinned. “We had gone as low as we could tolerate,” said Jon Gollinger, Accelerated Marketing Partners’ co-founder and East Coast chief executive officer.

Nevertheless, Greg Wohl said he was pleased because selling that many condos will stabilize the development and help his company pay off its construction loan.

The project still has about 40 market-rate units left to sell, which will be reduced in price as a result of the auction, Wohl said. Tribute also has 10 unsold affordable-housing units.

Representatives of two of Atlanta’s biggest condominium sellers, the Marketing Directors and Coldwell Banker the Condo Store, were on hand to observe the results.

The cheapest sale was $132,000 for a 795-square-foot one-bedroom unit that originally was priced at $183,900 —- a discount of 28.2 percent. Minimum bid prices for the one-bedroom, one-bedroom-with-den and two-bedroom units ranged from $110,000 to $198,000.

Paul Nichols, a 30-year-old software engineer and Georgia Tech graduate, earned a round of applause as the first winning bidder. He paid $144,000 for his one-bedroom unit.

Nichols said he plans to move there from Buckhead and enjoy the seventh-floor view while waiting for his new home to appreciate.

“And if it doesn’t,” he said, “America is in trouble.”