Friday, September 21, 2012

Spread between US mortgage rates and agency MBS yields hits a record as "transmission" remains an issue

The yield on the current 30y FNMA securities (3% coupon) has collapsed. As discussed earlier (see this post), fixed rate agency paper durations have shortened materially after the Fed's announcement because the markets are pricing in accelerated prepayments (mortgage refinancings). The 3% FNMA 30y bond (with pool average mortgage rate of 3.625%) now trades with the 5y treasury and the 3.5% paper trades with the 2y treasury (remember these are 30-year securities). Because of this sudden "roll" down the (relatively steep) curve and increased demand, the MBS yields have declined to record lows.

The national average 30-year mortgage rate however has stalled just above 3.5%.

Source: Bloomberg

The spread between the 30-year mortgage and the current coupon 30y FNMA security yield hit a new record high today. The previous record was set in 2008 when the so-called "transmission" first became an issue. Loan rates offered by banks remained significantly above where these loans could be financed via Fannie Mae for example. Low bond yields were not "transmitting" to the mortgage market. We are now faced with the same transmission problem once again.

Spread between the 30-year national average mortgage rate and
 the 30y FNMA current coupon yield
Part of the issue of course is that there will be a new set of FNMA securities issued shortly (the current FNMA security is already "outdated"). These new securities will have longer durations because they will include more new low-rate mortgages that are less likely to be refinanced in the near term. That means the new bonds may have a somewhat higher yield and less of a differential with the average mortgage rate.

Nevertheless this "transmission" from record low agency MBS yields to the residential mortgage market remains a problem. At this stage the national average mortgage rate should be materially below 3% - yet it isn't. At least part of the problem is the increased refinancing lag due to mortgage applications processing backlog.
FT: - A Freddie Mac mortgage rates survey last week found an average 30-year fixed-rate mortgage was 3.55 per cent compared with 3.92 per cent in January and more than 5 per cent at the start of 2010. Although the loan rate looks low, the spread between the mortgage rate for consumers and the yield on MBS is higher than it used to be.

They will have to wait for it, though. Banks acknowledge privately that the standard time between agreeing a loan and it closing has risen from about a month to as much as three months.
That means banks are not in a hurry to provide new loans and have little incentive to lower rates further (a company that receives more orders than it can handle is unlikely to lower prices.) Banks also stand to make more money by accumulating high rate mortgages and selling them at a premium. Financial shares have risen materially on the back of this development. In fact the longer this spread can be maintained, the more profitable banks will be this year. With the Fed buying so much MBS (see discussion), the "transmission" issue will likely be with us for some time, as waves of people attempt to refinance.

Over time mortgage rates should decline as the backlog is reduced and competition kicks in. Unfortunately low mortgage rates alone are unlikely to have a material impact on US economic growth and job creation (discussed here).
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