Rates Spike, Mortgage Markets “Utterly Unhinged”

by Alex Stenback on March 6, 2008

This was not a good week to be floating your interest rate.  From Bloomberg:

The markets have become "utterly unhinged,” William O’Donnell, a UBS AG government bond strategist in Stamford, Connecticut, wrote in a note to clients today. A lack of liquidity has “led to stunning air-pockets in price levels.”

Now, that is a pretty dramatic quote, but what does it mean for the average Joe?

For starters, it means that since last Friday, fixed mortgage rates have screamed higher – going from roughly 5.5% to 6.25% in a matter of days.  That type of move does not happen very often, and it was driven by two factors:

1. Inflation: Whether you are buying by the bushel, troy ounce, barrel, or pound, prices are up, in some cases historically so.  Inflation pushes rates higher. To understand why this happens, you have to think like an investor in mortgage backed securities, or mortgage bonds. 

Mortgage backed securities investors, like any good investor, look to maximize their return for a given level of risk; but the risk-reward proposition for bonds is different than stocks.  When you buy a stock, you run the risk that the price of a share may decline.  With bonds, you know what the return, or, properly, the yield will be, so the primary risk is inflation which has the effect of reducing the yield.

Still with us?  Here’s A grossly oversimplified example (that leaves out some important factors like prepayment risk and negative convexity):  Take a bond that will yield 6% to maturity.  In an environment of 2% inflation your return after inflation will be 4%.  You might be happy with that.  But if your yield is 6% and inflation is at 3.5%, your return would only be 2.5% and you’d probably look to invest these dollars somewhere else.

So it follows that in the presence of inflation, rates must rise to attract capital from investors.  After all, no capital from investors = no money for mortgages, so rates will always adjust to the level required to meet both the demand from the consumer level and present an acceptable risk-reward proposition for buyers of mortgage bonds. 

2.  Illiquidity, De-leveraging, and the Re-Pricing of Risk:  The credit markets are repricing risk in a big, big way.  Right now, the difference or "spread" between mortgage rates and treasury rates are at multi-decade highs.  This spread over treasuries  (treasury securities are considered zero risk because they are backed by the full faith and credit of Uncle Sam) is a reasonable proxy for how much risk the market thinks there is.  In other words, the market regards mortgage bonds as riskier – both because of inflation and the ongoing real estate unwind.

The repricing of risk also has a self feeding quality to it.  Hedge funds, money center banks, and other financial institutions are under tremendous pressure to raise and/or preserve capital right now, and are having to sell high quality assets in order to raise money – and just like any other market, when you have to sell because you need the cash now, you don’t get the best price, so as these high quality assets hit the market in volume, it puts additional downward pressure on prices.  Other investors have to mark their portfolios down to the new market price, which may cause them to sell still more high quality assets, pressuring prices lower still, and so on, and so on.

This looks bad enough that we’d expect the Fed to step in here – maybe not with an outright cut, but some sort of action to restore calm and support the credit markets.  More on this as it develops.

{ 1 comment… read it below or add one }

Nate March 9, 2008 at 4:33 pm

Looks like I chose a good time to work on the old resume.

The financial markets seem to have one of these crisis every few months these days. The fed will have to inject funds in an attempt to stabilize this one. Real stability in the form of an economic recovery doesn’t seem to be in the immediate future, we might be in for a very long summer.

Good luck to those trying to sell their homes, pressure is coming from all sides.

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