The ‘bubble' in the mortgage backed securities (MBS) markets blew up yesterday. So what happened? While there are a number of factors that affect mortgage rates, let's look at a few underlying causes of what happened yesterday.
The FNMA 30-Year 4.0% Coupon dropped 227 basis points (2-9/32) on 5/27/09 (blue line).
Since January 2009, the government's intervention in the MBS and bond markets has caused a tightening of the normal spread between MBS and the 10 year bond. (MBS trades at a higher rate than bonds because they are riskier, and there is a 'normal spread' between yields of bonds and MBSs.) As the 10 year bond continued to fall in price (and increase in yields) over the past few months, MBSs remained relatively stable - thanks to government intervention - and mortgage rates have stayed down. This caused a tightening of the 'normal spread' between bonds and MBSs. This was bound to unwind - which it did in a big way yesterday. After holding back while the 10 year note rate climbed (which it has been doing since January), prices of MBSs fell and their yields (and mortgage rates) jumped back to the level it was at before all this started - and that was back in December 2008. If you remember, the Feds announced back then that they will begin purchasing MBSs - as much as $600 billion worth - to help lower mortgage rates and keep them down to help revitalize the housing market.
Right now, the massive debt the government has piled on is about 79% of the gross domestic product (GDP). This has caused some to be concerned that the US may be poised to lose its AAA bond rating. Bill Gross, who is the co-chief investment officer of Pacific Investment Management Co., said the U.S. will eventually lose its AAA rating. (In Britain, their debt is 100% of their GDP which has caused them to lose their AAA rating).
Timothy Geithner, Secretary of the Treasury, stated just last week that he is committed to cutting the budget deficit as concerns about the deteriorating U.S. creditworthiness deepens. Unfortunately, it appears that Congress and the president have no intention of reducing the ballooning deficit - in fact, they intend to make it even worse. The Feds have been selling massive amounts of T-bills, notes and bonds to help finance all the stimulus packages, spending programs, and the bailouts of banks and financial institutions as well as others. The US is completely dependent on foreign investors (namely China and others) to fund our growing massive debt. And foreign investors are becoming leery of purchasing more and more of that debt.
Others are concerned about the impending inflation that may be looming as signs indicate that we may be nearing the end of the recession. And inflation is the nemesis of bonds and MBSs. Just the fear of inflation will drive up bond yields and mortgage rates. But we're not out of the woods yet. Without lower mortgage rates, the housing market will continue its downturn. If housing prices are not stabilized, then it's widely expected that the economy won't recover anytime soon.
Remember, the recovery of the housing market is the key to an economic recovery. And one of the keys to getting the housing sector back on track is to keep mortgage rates down. In order to keep rates down, the Feds needed to create an artificial demand for MBSs. (In the bond market, a higher demand leads to higher prices and lower yields and mortgage rates). With the Feds buying up to $1.25 trillion (that's with a ‘T') of MBSs and another $300 billion in Treasuries, many thought that that would do it.
However, the Treasury has also been selling massive amounts of T-bills, notes and bonds to help finance the growing national deficit. The market is now oversaturated with notes, bonds and T-bills - which in and of itself causes their prices to fall as there is no more demand for a growing supply. Less demand for bonds drives their prices down which in turn causes yields (and mortgage rates) to rise. The Feds simply can not continue to sell notes, bonds, and Treasuries without creating higher rates.
As of last Thursday, the Feds have purchased $481 billion in MBS since January. By creating an artificial demand for MBS, they have kept their prices up which in turn has helped keep mortgage interest rates down. However, mortgage rates cannot stay down in the face of increasing long term treasury rates. There is a ‘normal spread' between the 10 year bond and MBS - MBSs trade at a higher yield than bonds because they are riskier. Since January, the yield on the 10 year bond has been rising while the yield on MBS has been relatively stable. This has caused the spread between bonds and MBSs to narrow. As the spread between the yields of the 10 year bond and MBSs narrowed, traders were bound sell off the MBSs. Why? Basically, if you get the same rate of return for a relatively safe investment such as a 10 year bond and a riskier investment such as MBSs, you're going to drop (sell off) the riskier investment because there's not enough reward (higher yields) for the higher risk you're taking.
Our government now has a major problem. What are they going to do? Continue to buy more Treasuries? Continue to buy more MBSs? Continue with the bailouts? Continue with an ever increasing federal spending packages? If so, how will they finance it? Do they continue to sell more notes, bonds, and T-bills? If they do, who will continue to buy our mounting deficit? Will they finally address the massive deficit - or keep spending more?
All I can say is expect a significant increase in market volatility as prices of MBSs trade more in line with the bonds.
East Bridgewater, MA 02333
Lew Corcoran, ASP®, IAHSP, IAHSP-CB