Good Luck Searching For Long-Term Returns

Investors are wary of pipeline renegotiations

Insider

Contributing Writer

It was only a few years ago that conjecture arose about the likelihood of U.S. Treasury yields turning negative, and if they did, would the 30-year mortgage rate go to 0%? That did not happen, and now rates have moved higher. But the question is often asked, “Why are mortgage rates higher than a 10-year or 30-year Treasury yield?”

The short answer is, who would you rather loan money to: yourself or the U.S. government? The U.S. government is considered to have zero default risk. You will be paid, on time, for the duration of that specific financial instrument. With a loan to yourself, there is a much higher likelihood of default and early prepayment. Those two factors mean investors need to be compensated with a higher yield for the increased risk.

Throughout most of 2023, bond prices have fallen. Given the inverse relationship between price and yield, rates have moved higher, and 30-year fixed-rate mortgages are well above 7%. Inflation has been higher than the Federal Reserve’s target rate, and so the Federal Open Market Committee has ratcheted up the Fed Funds rate. Higher rates discourage, in theory, borrowing. A negative interest rate means that the central bank (and perhaps private banks) will pay regularly to keep depositors’ money with the bank. This incentivizes banks to lend money more freely and businesses and individuals to invest, lend, and spend money rather than pay a fee to keep it safe. As we head toward the 2023/2024 winter, we are faced with the opposite problem.

We are still, however, paying the price for low rates, which contributed to driving home prices higher as home affordability improves with lower monthly payments. During deflationary periods, people and businesses hoard money instead of spending and investing, collapsing aggregate demand, depressing prices, slowing real production and output, and increasing unemployment. Theoretically, during inflationary times the opposite occurs.

Head Scratcher

The 2023 movement in treasury yields, and therefore mortgage prices, has the industry, and potential borrowers, scratching their heads as to why mortgage rates have fared worse than Treasury rates. Looking back to 2020, rates dropped as the 10-year first broke below 2% but didn’t change much afterward. Though the MBS market does loosely track the Treasury market, with its 10-year yield, it does not quite achieve a 1:1 ratio of movement when rates are falling or rising. This is due to several factors, such as Wall Street traders hedging the difference in price movement, prepayment risk, and everyone else strategically pricing for when rates inevitably change again. Wall Street firms don’t renegotiate prices, but borrowers can through refinancing. And when a borrower refinances, and the loan pays off prematurely, mortgage lenders and servicers are on the hook.

As mortgage rates have gone up through 7%, investors have been wary about owning any loan or MBS. What happens when rates go down? Prepayment risk is a big issue: who wants to pay 105, with a 5-point premium, for something that pays off a short while later. (“I pay you $210,000 for that $200,000 loan, and in four months you give me $200,000 back? Let me run that by my boss.”) Many investors don’t even offer to pay premium prices above par (100), resulting in price compression. (“Why should I pay you more for a 7.75% 30-year Fannie loan than a 7.50% loan; they’re both going to prepay.”) And when loans prepay, often the cash is put into the Treasury market, with the demand driving prices higher and yields lower for securities that don’t pay off early.

The 2023 movement in treasury yields, and therefore mortgage prices, has the industry, and potential borrowers, scratching their heads as to why mortgage rates have fared worse than Treasury rates.

In the primary markets, should rates drop, lenders don’t want their entire pipeline to renegotiate (those hedges with Wall Street firms don’t have their prices renegotiated), so many capital markets staffs set rates that are “sticky” when Treasury rates drop. No one has a crystal ball, no one knows what inflation is going to do or how long these mortgages will be on their books, and if rates drop, pipelines will be filled with illiquid coupons that are hard for investors to value. How much would you pay for an 8% loan in a 7% world? So, there is a big premium for uncertainty.

The Real Driver

In 2020 and 2021, the real driver behind the fact that the rates are not moving in sympathy with the 10-year was capacity. Lenders had to hire actual underwriters and then train them which adds months to the lead time for a lender to ramp up. In the old days, lenders would hire clerical staff to help move the streamlined refinance paper around, but with Dodd-Frank it is all 100% underwritten and verified to be eligible for delivery to the GSEs. However, lenders are continuing to lay off staff due to over-capacity. Now, with the Federal Reserve no longer buying MBS and, in fact, shedding securities from its balance sheet, and the bank failures from March, mortgage prices have worsened compared to Treasury prices.

No one has a crystal ball. It is especially difficult given that higher rates have not impacted the U.S. economy as much as one might have thought a year or two ago. The trend, however, is toward higher rates, but investors are still wary about paying prices above par.