Mortgage Rates: Thinking About the Unthinkable
Market participants now say there is greater likelihood of U.S. Treasury yields turning negative (a possibility once considered unthinkable) after recent trade talks. This makes many wonder why, if our 10-year or 30-year treasuries go to yielding 0 percent, a 30-year mortgage rate will not be 0 percent? And why are mortgage rates higher than a 10-year or 30-year Treasury yield?
Well, the short answer is who would you rather loan money to: yourself, or the U.S. government? All jokes aside, 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 for default and for early prepayment. Those two factors mean investors need to be compensated at a higher yield for the increased risk.
It’s important for lenders to know how Treasury yields could ever go negative. Well, economically things could always get worse from where they currently are! Negative yields are common in Japan and Europe and are supported by central bank policies. In fact, Denmark is due to start offering 20-year fixed-rate loans that charge no interest, after offering negative 10-year loans. 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.
In theory, zero or negative rates should contribute 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. Further, during deflationary periods, wouldn’t financial asset values decline, e.g., stock prices, negatively affect down payment affordability? Thus, some form of expansionary monetary policy and cutting the central bank’s interest rate may stimulate borrowing and lending, but negative interest rates are usually a last-ditch effort. Rates below zero will reduce the costs to borrow for companies and households, and retail banks may choose to internalize the costs associated with negative interest rates for fear that, otherwise, they will have to move their deposits into cash.
The recent movement in Treasury yields has many lenders scratching their heads as to why mortgage rates really have not dropped in tandem. After all, rates dropped as the 10-year first broke below 2 percent, but haven’t changed much since. 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. 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 our client’s borrowers can through refinancing. And when a borrower refinances and the loan pays off prematurely, mortgage lenders and servicers are on the hook.
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 the premium, resulting in price compression. (“Why should I pay you more for a 4.5 percent 30-year Fannie loan than a 4.25 percent 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.
In the primary markets, 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 shoot back up, pipelines will be filled with illiquid coupons that are hard for investors to value. How much would you pay for a 2.50 percent 30-year Freddie Mac loan? So there is a big premium for uncertainty.
The real driver behind the fact that the rates are not moving in sympathy with the 10-year’s yield is capacity. Many of STRATMOR’s clients came into 2019 trying to shed capacity and then rates rallied and everyone is trying to build it but we are now in a 100 percent full documentation world: HARP is gone, and there are no streamline refinances any longer. Lenders have 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 streamline refinance paper around but with Dodd Frank it is all 100 percent underwritten and verified to be eligible for delivery to the GSEs.
No one has a crystal ball. It is especially difficult given that one presidential tweet can move bond and equity markets dramatically. The trend, however, is toward lower rates, and lenders are acting accordingly. Some are adding capacity by hiring. Others are “playing it safe” and adding limited capacity and waiting for some of the uncertainties to dissipate. And prudent capital markets staffs are continuing with their daily hedging regime.