Mortgage rates are down, as measured by the BankingMyWay Weekly Mortgage Rate Tracker, but that’s almost the side story this week.

First, let’s go to the numbers. Borrowers this morning will wake up to some welcome rates – 5.33% compared to 5.52% for 30-year fixed rate mortgages, and 4.88% for 15-year fixed rates, compared to 4.92% last week. Five-year adjustable-rate mortgages are also down,to 4.86% from 4.98%. Three-year ARMs are the exception, rising to 4.97% from 4.92%.

So getting that 5.25% fixed-rate mortgage is pretty doable.

But amidst the tea leaves, a stronger narrative is emerging: specifically, what will banks do if rates go even lower?

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Banks are already sitting on loads of  foreclosed properties (economists call them “shadow” properties), in hopes that inventory will fall and the higher prices that would result from such a decline would translate into higher prices for foreclosed homes that banks want to sell.

In that light, lower mortgage rates help the cause of mortgage lenders by increasing demand for home purchases. No doubt there – lower interest rates lead to more interested homebuyers.

But Act II of this passion play between banks and mortgage rates reveals the downside of falling rates for financial institutions. With mortgage rates lower this week, banks don’t make as much money on loan spreads. It’s a quandary. Higher mortgage rates may garner bigger profits for banks, but they also diminish demand from consumers.

Entering stage right is an “x” factor that banks likely don’t want to acknowledge: if the economy really is improving, then it stands to reason, as history shows, that inflation will rise, too. That should force the Federal Reserve’s hand to raise interest rates. But raising interest rates reduces demand for new mortgages, and that leads us back to all those foreclosed properties that are on the market.

If banks can’t unload those “toxic” properties, then they’ll be stuck with them until mortgage loan conditions once again improve. But in an upward inflationary environment, who knows when that will be?

It’s a big risk for banks. According to RealtyTrac, there are 600,000 foreclosed properties nationwide that mortgage banks have not put on the “sale” block, and thus, have not been included in foreclosure listings. As Realty Trac points out, if these properties had been added to the public foreclosure list, the housing market would look a lot worse than it does now.

Add to the mix some inconvenient truths about the housing market. Inventories remain at historically high levels, and mortgage rates are at historically low levels – but still, demand is weak. And then there are those “shadow” properties that stand vacant, but one day will have to hit the open market.

Add it all up and what do you have? A great period of uncertainty and instability for mortgages – and for the companies that lend them.

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