Mortgage Insights Blog

Since last week we have seen interest rates on the 30 year fixed mortgage rise more than 1%. You may be asking “How is this possible?” especially since the Fed’s just lowered interest rates and the Treasury is actively buying up bad mortgages.

The main reason for the sudden increase in mortgage rates is due to the increase in mortgage yields in the secondary mortgage market, or an increase to the return that purchasers of Mortgage Backed Securities (MBS) require relative to their investment.

After being originated in the primary mortgage market, most mortgages are sold into the secondary mortgage market. Unknown to many borrowers is that their mortgages usually end up as part of a package of mortgages that comprise a mortgage-backed security (MBS), asset-backed security (ABS) or collateralized debt obligation (CDO). The current MBS yield is over 2.11% higher than (yield spread) the 10 year Treasury bond – meaning that buyers of MBS require a much higher return on their investment when compared to investors of Treasury bonds.

Also, the MBS coupon is now trading at 6.20% which is higher than it was this summer when the government felt it necessary to put Fannie Mae (FNMA) and Freddie Mac (FHLMC) in conservatorship. Interest payments to investors of MBS are determined by the coupon rate, which tends to be about 50 basis points above the mortgage rate on the underlying mortgage loans, with this difference diverted to cover the costs of servicing the mortgages and insuring against default.

This recent increase in mortgage yields and thus mortgage rates is clearly in direct conflict with the Government’s goal of supporting housing and reason would suggest they cannot allow it to continue. Here are a few of the drivers:

• The freeze of short-term credit markets means that the cost to finance MBS positions is increasing. Dealers and investors relying on Libor-index-based funding are struggling to maintain access to funding and/or are seeing the cost increase. They rely on borrowing funds at a lower rate to purchase securities that offer them a larger return – but lately the cost to borrow these funds has unexpectedly increased making it difficult to profit on MBS unless they receive a higher return. These costs must then be recouped by investors in the form of higher yields and lower prices, which is then passed through to borrowers in the primary mortgage market in the form of higher interest rates – less demand means lower prices and higher yields.
• Fewer dealers and investors in MBS markets mean liquidity is tightening and any move in mortgage rates will likely be exacerbated. MBS dealers are very jittery as MBS flows are increasingly dominated by very large players (MSR servicers, big funds, etc. who purchase large amounts of MBS at a time) and unpredictable changes in government policies. Mortgage servicing rights (MSR) trade in the secondary market much like mortgage-backed securities. Large mortgage servicing companies purchase and sell the right, or rights, to service an existing mortgage. Common rights included are the right to collect mortgage payments monthly, set aside taxes and insurance premiums in escrow, and forward interest and principle to the mortgage lender.
• With increased risk investors require higher quality for their investments. All longer-term yields, even Treasury yields, are moving higher as the flight to quality doesn’t just mean Treasuries, it means very short-term Treasuries. Longer-term Treasury yields (2 year, 5 year, 10 year) are moving higher while very short-term yields are approaching zero. As these rates move higher, mortgage servicing companies must sell off their MBS thus reinforcing the trend lower in prices, higher in yields.
• As market volatility in general increases, the embedded call option in a mortgage backed security becomes more valuable and MBS yields must increase to cover it. Due to increasing uncertainty about how that embedded call option should be modeled given recent developments in housing, credit, and the economy investors will require wider yield spreads on MBS when compared to Treasuries. The existence of the embedded call option of a MBS comes from the ability for a borrower to return additional principal either by increased monthly payments, default or paying off the mortgage all together before the scheduled return dates. This option affects a bond's value because as the potential for pre-payment or default increase, the value of the MBS will decrease – the value of the MBS comes from the expected cash flows to be received from versus the likely hood for the MBS to be called.

What will cause this to reverse? More direct purchases of MBS by the Treasury along with time for all the other Treasury/Fed actions to repair credit markets and return financing costs to more reasonable levels. The Treasury has been buying, but not enough and not publicly enough.

Also to consider are how today’s rates compare historically - At the beginning of the 1990s, primary conventional mortgage rates were slightly over 10%. Mortgage rates trended down to slightly below 7% in late 1993, were back up to above 9% by the end of 1994 and have bounced up and down in roughly the 7% to 8-1/2% range during the latter half of the 1990s. Rates are currently in the mid to high 6% range, so historically speaking, rates are still very good.