It's too late in the morning at this point to refer to this post as a "Day Ahead," so let's change course a bit and simply address the biggest burning question of the week: WHY ARE MORTGAGE RATES AND LENDER PRICING SO MUCH WORSE THAN WE FEEL LIKE THEY SHOULD BE RIGHT NOW?

This will be written with the intention of standing as a knowledge base article that can be provided to those seeking clarity on this issue in the future.  It will come up in the future--guaranteed--time and time again.

What exactly are we talking about?

MBS prices and lenders' mortgage rates have a tendency to improve much more slowly compared to the broader bond market during times of fast movement toward lower rates.  Volatility compounds the issue.

Why are we likely to see this time and again in the future?

This is not some unique, one-off occurrence.  Mortgage rates will always fall more slowly than, say, 10yr Treasury yields when longer-term interest rates are experiencing a rapid move lower because of their fundamental differences. 

What fundamental differences are those?

If you buy a 10yr Treasury, you KNOW that it will pay you x% of interest for exactly 10 years.  Nothing changes that.  If you buy a mortgage, you know it will pay you x% of interest for 30 years IF AND ONLY IF the borrower doesn't sell, refinance, die, get foreclosed on, etc.  Of these options, refinancing is by far the most volatile consideration, so we'll focus on that aspect from here on out (i.e. foreclosure rates are very small and "time in home before selling" is very stable on average.  These things are very easy for investors to account for when deciding how much to pay for a loan).

Why is refinance probability more volatile and harder for investors to account for?

Easy one!  Because investors can't predict the future of interest rates, and interest rate movement has a direct effect on someone's likelihood to refinance!

So why does that refi probability matter?

This is the crux of the issue.  When you buy a mortgage, or a pool of mortgages in the form of a mortgage-backed-security (MBS), you will typically pay more than the face value of the mortgage (aka "premium").  In exchange, you will collect enough interest over time to more than make up for that premium (hopefully!).  

Think about the last 2 sentences for a second.  You just paid $102,000 for someone's $100k loan thinking you'll be pocketing the interest for a few years (which would come to around $3k for the first year).  Great right?!  You will make $1k if they just stick around for 1 year!

But in a market with rapidly falling rates, they might refi in only a few months.  That means you might only pocket $1500.  You'd LOSE money by buying this mortgage!

The nitty gritty specific numbers in this scenario aren't important, but the concept is at the heart of how investors place value on mortgages and MBS.  

Is there some needlessly esoteric term that refers to this phenomenon, you know... so I can impress my friends when I talk about the mortgage market and rate movement?

You bet there is: NEGATIVE CONVEXITY!

Unless you have a strong background in finance or bond trading, don't worry about trying to understand this term.  It refers to a curve that plots the relationship between rate movement and the price of buying a bond.

In a regular bond, like a 10yr Treasury, the relationship between an investor's rate of return and the price paid for the bond is pretty linear.  But that's definitely NOT the case for a mortgage.  This all has to do with the borrower's ability to refinance if rates get lower or to avoid selling/refinancing if rates spike.

Can you say that in plain English?

If interest rates drop quickly, more mortgage borrowers will want to refinance.  If an investor paid a premium for their loans, the investor is more likely to lose money.  So investors preemptively offer lower prices when rates are falling rapidly.  Instead of paying $102k for a $100k loan at today's going rate, they might only pay $101k--as they assume the borrower won't stick around in that loan long enough to generate much more than $1k of interest payments. 

This is an oversimplified example with round numbers, but the concept is the important part.

SO AGAIN: lower rates = more refi risk = more risk for investors paying a premium for mortgages = excess downward pressure on mortgage prices (or MBS Prices).

And why do I care how much an investor pays for a mortgage?  Their problem, not mine, right?

Wrong...  The more an investor is willing to pay for your $100k loan at, say 4%, the less you have to pay.  You might realize those savings in terms of lower upfront costs or a lower interest rate.  

That might seem confusing at first glance because how can your rate be lower if the investor is paying for a 4% rate of return?  But the investor's rate of return is a function of your payment rate and the PRICE they pay for your loan.  So paying a lower price is the same as bumping the payment rate as far as they're concerned.

Point being: if investors suddenly worry more about you paying your loan off before they have a chance to collect much interest, they'll offer lower prices to buy your loan.  Mortgage lenders then have to charge you higher upfront costs if you want to keep your 4% rate, or you can simply keep the same upfront costs and opt for a higher rate.

BOTTOM LINE HERE: When investors pay lower prices, rates rise.

OK, but rates are still lower than they were a while ago, it's just that 10yr Treasury yields are a LOT lower.  Why?

THE OTHER BOTTOM LINE: Investor trepidation over refinance risk doesn't necessarily make mortgage prices reverse course if the overall rate market is improving.  It simply means that mortgage rates will not be able to fall as fast as Treasury yields.  To investors, the value of investing in mortgages is always thought of in RELATIVE terms to a risk-free benchmark like Treasuries.  In other words, they are asking themselves how much extra yield do they need to see in order to be compensated for the risk the you'll refinance faster than they currently expect?  That answer gets bigger and bigger as rates fall, but if Treasury yields are falling fast enough, mortgage rates can still move lower even as the gap between the two continues to expand. 

The following chart shows this happening like clockwork.  In each case, the vertical lines show long-term highs or lows in rates corresponding with long-term highs or lows in the gap between mortgages and Treasuries.  In other words, when rates drop quickly to longer-term lows, mortgages can't keep up (which is a bummer for consumers hoping for lower rates).  When rates spike quickly to long-term highs, mortgages still can't keep up (which is nice for consumers in that case, because it means rates aren't rising as quickly as Treasuries).

If this is confusing at first glance, spend some extra time looking at the chart and reading the previous paragraph.  30yr fixed mortgage rates are always higher than 10yr Treasury yields.  The higher the green line, the wider that gap is.

2019-8-9 NL1

I'm good with the explanation above, can you make it a bit more technical for me?

Really?  No one ever asks for that, but here you go: a chart of 10yr Treasury yield movement versus the chart of MBS prices (what investors are paying for groups of the most common mortgages).  The MBS prices have been inverted in this chart in order to show the correlation with 10yr yields (because prices and yields vary inversely for bonds and mortgages).

2019-8-9 open

What's the bottom line on the effects of all this?

First off, we should always expect rates to have a hard time keeping up with a massive, unexpected move lower in Treasury yields.  If the bond market can hold anywhere near current levels and especially if it can stabilize with less volatility around these levels, mortgage investors will get more and more comfortable making assumptions about borrowers' predisposition to refinance (thus throwing their value calculations out of whack).  That will allow mortgage rates to GRADUALLY move closer to Treasuries.

In addition to the ill effects from the big, fast drop in rates, VOLATILITY also makes it more expensive for mortgage lenders to conduct business.  It increases the costs they pay to ensure they can honor the rates being locked by consumers (and the costs to offset the money they lose when consumers break a lock agreement due to market volatility).  As such, as volatility decreases, lenders can tighten up margins between the rates they're offering and the rates implied by what investors are paying for mortgages.  

In other words, there has been a double whammy for mortgage rates' ability to keep pace with Treasuries:

  1. Investors offering relatively lower prices for mortgages/MBS due to a rapid drop in rates and the uncertainty about where we'll go from here.
  2. Lenders increasing margins to offset the increased costs associated with volatility.

Bottom line: it would actually be good for rates to hold steady right now, and to avoid any big swings from day to day.  In that scenario, 10yr yields could stay perfectly flat, and the average 30yr fixed rate could all another 0.125% to 0.25%.


MBS Pricing Snapshot
Pricing shown below is delayed, please note the timestamp at the bottom. Real time pricing is available via MBS Live.
MBS
FNMA 3.0
101-21 : +0-01
Treasuries
10 YR
1.7030 : -0.0120
Pricing as of 8/9/19 12:46PMEST

Today's Reprice Alerts and Updates
A recap of Alerts and Updates provided to MBS Live subscribers.
9:06AM  :  Slightly Stronger After Weak Producer Price Data

MBS Live Chat Highlights
A recap of featured comments from the Live Discussion on the MBS Live Dashboard.
Matthew Graham  :  "If I could beam one thought/truth into the heads of front-line originators, it would be that 2ndary is not out to get you. They're not some evil empire that is constantly attempting to profit by squeezing blood from your rocks. They're just trying to maintain balance in the force so they can stay in business. Their highest and best goal is the STABILITY of small profits as opposed to the MAXIMIZATION of profit."

Economic Calendar
Time Event Period Actual Forecast Prior
Friday, Aug 09
8:30 Core Producer Prices YY (%)* Jul +2.1 2.4 2.3
8:30 Producer Prices (%) Jul +0.2 0.2 0.1
8:30 Core Producer Prices MM (%)* Jul -0.1 0.2 0.3