Mortgage-Backed Security Primer

What Inversions And The Timing Mean For A Possible Recession

A business man looks at an inverted graph

Insider

Contributing Writer

As we make our way through 2022 and the pandemic continues to wind down, it is helpful for anyone attempting to understand the mortgage-backed security (MBS) market to remember what happened in March of 2020 and its ramifications going forward. Especially the role that the U.S. Federal Reserve played in trying to maintain the stability of the economy through its Quantitative Easing actions. Namely, the Fed’s purchases of MBS (and Treasuries) caused prices to shoot higher, thus dropping rates, but there were risks. The Fed’s desire to bring mortgage rates down wreaked chaos in lenders’ ability to hedge their risk.

Let’s look at what happens when a borrower locks in their mortgage rate with a lender. Mortgage rates are based on the trading and prices of MBS, which are determined by the supply of and demand for those securities. As MBS rise in price, interest rates improve and move lower. A locked rate on a mortgage is nothing more than a lender promising to hold an interest rate, for a period of time, or until the transaction closes. The lender is at risk for any MBS price changes in the marketplace between the time they agreed to grant the lock and the time that the loan closes.

If rates were to rise because MBS prices declined, the lender would be obligated to buy down the borrower’s mortgage rate to the level they were promised. And since the lender doesn’t want to be in a position of gambling, they hedge their locked loans by shorting (selling) MBS. Therefore, should MBS drop in price, causing rates to rise, the lender’s cost to buy down the borrower’s rate is offset by the lender’s gains of their short positions in MBS.

Price Fluctuations

Now think about what happens when MBS prices rise or improve, causing mortgage rates to decline. On paper the lender should be able to close the mortgage loan at a better price than promised to the borrower, giving the lender additional profits. The lender’s losses on their short position, however, negate any additional profits from the improvement in MBS pricing. This hedging system works well to deliver the borrower what was promised, while removing market risk from the lender.

But in March 2020, in an effort to reduce mortgage rates, the Fed began purchasing an incredible amount of MBS, causing their price to rise dramatically and swiftly. This, in turn, causes the lenders’ hedged short positions of MBS to show huge losses. These losses appear to be offset on paper by the potential market gains on the loans that the lender hopes to close in the future.

But broker dealers did not wait on the possibility of future loans closing and demanded an immediate margin call. The amount that lenders were paying in margin calls was staggering… millions of dollars for many. And while the Fed believed it was stimulating lending, its actions resulted in the exact opposite. The market for government loans (such as the servicing value for FHA & VA loans), jumbo loans, non-QM, and loans that don’t fit ideal parameters virtually vanished. And many lenders had little choice but to slow their intake of transactions by increasing their profit margins and moving mortgage rates higher and by reducing the term that they are willing to guarantee a rate lock.

Unintended Consequences

Furthering the Fed’s unintended consequences were announcements in March and April of 2020 to cut interest rates on the Fed Funds Rate by 1% to virtually zero. Because the Fed’s communication failed to educate the general public that the Fed Funds Rate is very different than mortgage rates, it prompted borrowers in process to break their locks and try to jump ship to a lower rate. This dramatically increased hedging losses from loans that didn’t end up closing.

Which brings us to today. The Federal Reserve is still in the headlines. It has ceased the outright purchases of MBS and moved toward only reinvesting the early payoffs (refis) from its portfolio. The Fed is also in the headlines for its expected increases in the targeted overnight Fed Funds rate that will eventually dampen inflation.

Metric To Watch

Meanwhile, the markets are watching the yield curve which “inverted” in late March, meaning that short-term rates were higher than long-term rates. What does it mean for your clients? A graph of yields, which have interest rates along the Y axis and time along the X axis, typically slopes upward, so when short-term yields return more than longer-dated ones, it suggests there is reason to worry about the long-term outlook. It can also signal that the high levels of short-term yields are unlikely to be sustained as economic growth slows, which can have an impact on a range of asset prices. The typical metric that is watched is the difference between the 2-year and 10-year Treasury yields.

Recessions have not happened without an inversion, so likely it will be a predictor of a future recession. The timing, however, is unknown. It could take up to two years, and plenty of unforeseen things can happen in the interim. As the Federal Reserve embarks on a cycle of quantitative tightening, there are fears that it will reduce consumer spending and business activity as the central bank battles the highest inflation rates in a generation.

But before brokers start sounding the “recession alarm,” some economists will tell you that there's reason to believe that this time around, yield curve inversion may not be as good of an indicator as it has been in the past, particularly given the enormous amount of quantitative easing undertaken by global central banks. Regardless of what the yield curve suggests, MLOs are doing the best they can helping clients with their financing needs.