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Solving a Puzzle Behind Today’s High Mortgage Rates

The spread between mortgage rates and Treasuries is similar to the wide spreads that were experienced during the 2007-09 financial crisis.

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Jim Watson/AFP via Getty Images

About the author: Laurie Goodman is an Institute fellow at the Urban Institute. She founded and was previously director of the Housing Finance Policy Center at Urban.

Mortgage rates have been a puzzle to many investors: They have gone up far more than Treasury rates over the course of 2022. In particular, through Dec. 15, the 10-year Treasury rate has increased from 1.43% to 3.59%, or 216 basis points, while the mortgage rate has increased from 3.11% to 6.31%, or 320 basis points.

One can think of the mortgage rate as comprising two parts: the 10-year Treasury rate and the mortgage/Treasury spread. This year, while interest rates have risen, courtesy of Federal Reserve rate increases, the mortgage/Treasury spread has expanded even more dramatically, from 168 basis points at the end of 2021 to 272 basis points as of Dec. 15. The current mortgage/Treasury spread is 93 basis points wider than the 179-basis-point average for the almost 22-year-period since 2000. In fact, this spread is wider than it was during the Covid panic in March 2020, and very similar to the wide spreads that were experienced during the Great Financial Crisis of 2007-09. 

The high level of the mortgage/Treasury spread is due in part to interest-rate volatility. Mortgages are known as “negatively convex” instruments. Their duration extends when rates rise, as the opportunities for borrowers to refinance are more limited; their duration contracts when rates fall, as borrowers take advantage of lower rates to refinance. When rates rise, mortgages lengthen, increasing an investor’s exposure to this asset class as prices are declining. Money managers find they are too long their mortgage exposure, and sell to lighten up. Simultaneously, mortgage originators, who sell forward as borrowers lock in their mortgage rates, find that, as rates rise, they need to increase their forward sales as a higher proportion of mortgages will close. (Borrowers have locked the lower rates and are more incentivized to close the loan, as they will be unable to match the rate). These actions cause more selling, driving the mortgage spread wider. This drives mortgage rates up faster. As rates fall, these effects reverse.

We can measure interest-rate volatility using the MOVE Index (short for Merrill Lynch Option Volatility Estimate). This is a measure of the yield volatility implied by prices of 1-month over-the-counter options on 2-year, 5-year, and 10-year Treasury notes. The MOVE index is as high as it was during the Covid panic in March 2020, albeit much lower than the Great Financial Crisis. This index is highly correlated with mortgage spreads.

Interest-rate volatility explains why mortgage spreads are wide, but it doesn’t explain why mortgage spreads are comparable to those during the Great Financial Crisis, since the MOVE index is considerably lower than it was then. The difference between now and then is that some of the traditional buyers of mortgage-backed securities have stepped back from the mortgage market.

Before and during the Great Financial Crisis, the
Fannie Mae
and
Freddie Mac
portfolios essentially served as shock absorbers, buying mortgage-backed securities, or MBS, when spreads were wide, selling when they narrowed. In 2009-2010, the combined portfolios were over $1.5 trillion. In the wake of the Great Financial Crisis, Fannie and Freddie have been mandated to reduce their portfolio size. The two portfolios together are now under $200 billion. Meanwhile, the Federal Reserve was a fairly consistent buyer of MBS after the financial crisis, as part of its quantitative easing strategy. But as of June 2022, the Fed began to allow its portfolio to run off. In September 2022, it increased the amount of MBS it would allow to run off to $35 billion a month. And commercial banks have stepped back from MBS buying as rates have risen. They presumably don’t want to show further mark-to-market losses on holdings in their investment portfolio.

The result: We would have expected mortgage spreads to widen due to interest-rate volatility. This effect has been amplified by the loss of the actors that have historically acted as mortgage-spread stabilizers.   

What lies ahead? The 10-year Treasury rate is well below both the federal-funds rate and the 2-year Treasury rate. The Federal Reserve has said it will continue to raise rates next year. By contrast, the market view, reflected in the 10-year note, is that, while there will be several modest increases early in the year, the Fed is likely to be cutting rates later next year as the U.S. economy slips into a recession. However, the Fed has vowed to fight inflation; numerous Fed officials have said that they see inflation as a larger concern than a possible recession. If the market is wrong on the number and magnitude of the Fed’s rate increases, the 10-year rate has some room to move higher next year.

The mortgage spread is likely to contract, as the path of Fed policy becomes more deterministic. That is, as the high level of volatility subsides, market participants are likely to focus on the fact that the volume of new MBS is down considerably. This “scarcity” value should push spreads tighter.

Overall, next year we would expect to see a reversal of the mortgage-spread widening we saw in 2022. If Treasury rates increase considerably, we would expect a more modest increase in mortgage rates. Or, if the mortgage-Treasury spread contracts enough, we could conceivably see mortgage rates declining as Treasury rates increase.

Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to ideas@barrons.com.

Credit: marketwatch.com

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