by Kevin Whatley (NMLS #113781)

Today is a holiday-shortened session but that doesn’t mean that the markets will be on vacation.

The day’s big event is Federal Reserve Chairman Ben Bernanke’s speech at the Fed’s annual symposium in Jackson Hole, WY.

Investors will dissect every phrase looking for clues about the economy and housing.

More importantly, markets want some advance notice about whether the Fed will lower the Fed Funds Rate at its next meeting September 18.

It won’t get any.

Just before his address was scheduled to begin, the Fed’s favorite predictor of inflation — the Personal Consumption and Expenditures report — was released and showed that growth is within a tolerable range.

It’s more likely that Bernanke will spend time talking about data that is known (i.e. the PCE report and other measurable statistics) versus data that is unknown (i.e. how the credit markets will impact the U.S. economy in the future).

With fewer traders participating today, expect more volatile action than usual as the three-day Labor Day Weekend begins.

Mortgage rates unexpectedly increased yesterday afternoon as the U.S. stock market staged a late rally.

By the end of the day, the Dow Jones Industrial Average was up 1.9 percent, or 247.77 points.

This is a typical pattern.

When stocks are moving higher, investors want to ride the wave and look for sources of cash. Often, bonds serve as that source.

Now, remember that mortgage rates are based on the price of mortgage bonds. When bond are in demand, bond prices increase and the associated rates fall. When bond are being sold — as what happened yesterday — prices decrease and that pushes mortgage rates higher.

That’s what happened yesterday.

As the DJIA added 150 points in the last two hours of trading, mortgage rates rapidly worsened. If you locked your rate in the afternoon, it may have been markedly worse than if you locked in the morning.

Mortgage rates are expected to be at least 0.125% worse when the markets open this morning.

As mortgage guidelines loosened between 2002 and 2006, homeowners often used their home equity to retire credit card and other consumer debt. They did this by increasing the size of the mortgage and taking “cash out” from their home.

As you’d expect, this type of mortgage transaction is called a “cash out” refinance.

Well, now that mortgage guidelines are tightening, it’s growing more difficult for a homeowner to engage in this type of home loan.

Mortgage lenders are restricting the total amount of equity that can be withdrawn from a home, usually as a percentage of the home’s value.

This may be one reason why the amount of credit card debt is rapidly increasing among Americans.

Throughout May and June, for example, credit card balances increased 12% and 8% respectively even as consumer spending remained relatively flat.

Therefore, we can hypothesize that Americans — unable to “cash out” from their homes — are putting more money on their credit cards and slowly reaching their collective credit limits (upon which the borrowing stops).

When the borrowing stops, spending stops, too, and this has the impact of slowing down the economy.

A slower economy, of course, reduces inflationary pressures and that makes the U.S. dollar stronger to international investors. That strength, in turn, creates buying pressure on mortgage bonds which pushes mortgage rates down for everyone. Naturally, lower rates encourage more borrowing.

Yes, it’s a cycle. And it’s one worth watching.

When the National Association of Realtors® releases its monthly Existing Home Sales report, people tend to watch every word, fact and figure in the statement in hopes of decoding the real estate market.

It’s all wasted energy.

It’s impossible to use the NAR report in everyday living because the NAR report is a national story. Real estate, on the other hand, is not a national market.

All real estate is local.

Think of your own town. There’s at least one each of the following:

• An improving neighborhood
• A declining district
• An abandoned area
• An out-right scary street

In a national report, these regions are lumped together into one measurement.

So, when we see that the median home sale price fell over the last year, or that national inventory rose to a 9.6 month supply, it doesn’t really mean much to your street in your town.

The NAR report lumps every street in every town together into one big blob of data.

Your area may be seeing explosive growth tied to school districts, or affordability, or proximity to transportation, or just plain “good value” — regardless of what national real estate statistics report.

So, as always, be wary of “national” real estate stories — the true story is a local one.

This week is data-heavy so markets will finally get to focus on fundamentals instead of fear.

For the past two weeks, uncertainty about the economy has led to psychologically-driven mortgage interest rate movements.

Rising defaults devalue mortgage holdings and many investors are now expecting the defaults levels to rise even more.

When defaults exceed expectations, it indicates that the risk of holding mortgage notes was estimated to be too low. As the risk is adjusted higher, mortgage rates are move higher, too.

This is a major reason why jumbo loans — loans over $417,000 — are suddenly carrying much higher interest rates.

Note: The chart above does not reflect actual mortgage rates. It is meant to show how jumbo loans are moving in a different direction from conforming, 30-year fixed rate home loans.

Markets will have some hard data upon which to reflect this week including two consumer confidence reports and the Personal Consumption and Expenditures report. The former is often to determine consumer spending patterns (although it doesn’t often work) and the latter is the Federal Reserve’s preferred inflationary gauge.

Expect markets to be especially volatile towards the end of Thursday and for all of Friday — many traders will be leaving their posts early for the three-day Labor Day weekend.

In light of today’s New Homes Sales data and Monday’s forthcoming Existing Homes Sales report, let’s review a term that real estate professionals use to describe housing inventory.

Absorption Rate is a real estate term for the length of time required to sell all of a given stock in a given area.

We can use it to determine how quickly homes are selling in a neighborhood, city, or region.

The formula to calculate Absorption Rate is simple:

• Add up the number of homes on the market
• Divide it by the number of homes taken off the market in the past 30 days because offers were accepted for the sale of those homes

For example, if 500 homes are on the market and 89 of these homes received offers in the past 30 days, the absorption rate is 500/89, or 5.6 months.

In generally, the smaller the absorption rate, the more seller-friendly the region.

With tomorrow morning’s New Home Sales report, markets will get a look at the number of newly-constructed homes sold in July.

The figure is expected to be in the 825,000 range. This is lower than June’s 834,000 figure.

But — as always — there is more to the story.

When the Census Bureau reports on New Homes Sales, it only counts the number of new sales contracts written. Specifically, New Home Sales doesn’t measure what happens to contracts after they are signed.

So, for each buyer that rescinds his contract or does not qualify for financing, the New Home Sales data is over-stated by 1.

A “new home sale” may cancel before closing for a multitude of reasons, including:

• Buyers can’t sell their old homes and can’t get financing
• Buyers are angry when developers reduce price on similar properties
• Mortgage products are no longer available for the buyer’s borrowing profile

According to RealEstateJournal.com, cancellation rates were as high as 40% for big builders in November 2006. We can only theorize that the number has since increased as home sales slow overall and the mortgage product menu shrinks.

In other words, tomorrow’s New Homes Sales data is somewhat irrelevant to the overall U.S. housing market. It only measures contracts being written, not contracts being closed.

The Census Bureau even acknowledges this on their Web site.

Suddenly, Private Mortgage Insurance is back in vogue. If only by default.

The story background is well-documented in this Bankrate.com article from 2002. The article is five years old, but it still raises some salient points.

What the article doesn’t highlight is that second mortgages such as home equity loans are typically sold to Wall Street, bundled in with sub-prime and “near-prime” loans.

Today, as the number of buyers for these higher-risk loan pools shrinks, some mortgage lenders have stopped offering second mortgages in order to reduce their overall lending risk.

PMI payments tend to be higher than their piggyback counterparts, but The Tax Relief and Health Care Act of 2006 narrows that gap using tax deductibility. The act grants itemized deductions for some private mortgage insurance (PMI) and government mortgage insurance (MIP) expense premiums paid in 2007.

For all loans originated in the 2007 calendar year, mortgage insurance is tax-deductible provided that two tests are met:

1. The homeowner’s household income is $100,000 or less in 2007
2. The home loan is for a primary or secondary residence

For households earning more than $100,000, the deduction is phased out to the tune of 10% per $1,000 of additional income until it reaches 0% at $110,000

So, if a single person earns $90,000 in 2007 and buys a home using MI, the MI expenses are tax-deductible in 2007. However, there’s a catch! Because the tax code is due to expire December 31, 2007, there is no guarantee that the MI will be tax-deductible in 2008.

As always, talk with your tax professional about how tax deductions work and whether you qualify for a PMI deduction.

As the number of mortgage products continues to shrink, PMI will continue to grow in popularity. The graphic/poll above will shift, too.

Friday, the Federal Reserve lowered its Discount Rate by 0.50% in an effort to preserve liquidity among our nation’s banks.

This has nothing to do with mortgage rates that people like you and I get for our homes. Well, not directly at least.

The Discount Rate is the rate at which banks borrow money from the Federal Reserve. It is different from the Fed Funds Rate which is the rate at which banks borrow from each other.

After the adjustment last week, the Discount Rate now stands at 5.750%; the Fed Funds Rate is 5.250%. Note that the Fed “charges” more than other banks because it wants to be the “lender of last resort”.

And last week, it was.

When the Fed lowered the Discount Rate Friday, it signaled that it was concerned for the nation’s banks and their liquidity. A reduced Discount Rate strengthens the system by lowering bank operating expenses and increasing capitalization.

The Fed also extended its normal payback period from one day to 30 days. The additional 29 days buys extra time for banks to rebalance their books through asset sales or debt issuance.

On Friday, mortgage rates fell in response to the Discount Rate announcement, but not because the two are related.

Inflation devalues mortgage bonds and the Fed’s move signals that inflation pressures may be subsiding. When the inflation is falling, mortgage bonds improve in price and these higher prices yield lower rates.

This is why mortgage rates dipped. Not because the Fed lowered the Discount Rate, but because what the lowering signaled about the economy.

Again last week, financiers failed to answer the major question dogging Wall Street: What is the “right” risk model to use for mortgage lending? The models of the past are being proven to have been wrong.

So, why do risk models matter?

Because the basic tenet of lending states that the riskier the loan, the higher the interest rate that should be charged on the loan. If the risk is unknown, then there can’t be an interest rate.

If there can’t be an interest rate, then there can’t be a loan.

This is one of the reasons why a few lenders chose to stop making loans last week. The decision wasn’t made because the companies are going bankrupt, it’s because they can’t determine what their loans’ interest rates should be.

Sometimes, the safest course of action for a bank is to sit on the sidelines until the market finds direction.

With very little data hitting the wires this week, expect markets to move wildly in response to Hurricane Dean’s damage toll, stock market activity and public statements from the Federal Reserve.

If the Fed signals that the economy is slowing down because of the credit markets or if the storm causes more damage than is expected, expect mortgage rates to fall as inflationary pressures will subside.

Inflation is the enemy of mortgage bonds so less inflation means higher bond prices (and lower mortgage rates).