The real reason mortgage rates are falling at a record pace

(Much of what follows is adapted from yesterday’s coverage, but with additional graphics and examples. As for the brass pushpins, if you got the message yesterday, today’s version is more of the same.)

Mortgage rates have been all over the map recently, both in terms of movement and variation between lenders. The disconnects are so important that they require further explanation.

Let’s quantify “big”. Best-case scenario rates for a conventional 30-year fixed are down about half a point from last week on average and more than a point below mid-June highs.

It’s a exceptionally fast drop! In fact, it’s a little faster than the decline seen in the 10-year Treasury yield, a frequently used benchmark for mortgage rates.

This makes it even more exceptional because the 10-year almost always moves faster than mortgage rates when they fall. Here’s an example of the last time rates fell from a long-term high:

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So why are things different this time around, and what about the ultra steep drop over the past few days?

A word of warning: answering these questions requires a guided tour of some high-level concepts involving the bond market. If everything is a little confused, that’s normal. We’ll wrap up the more esoteric stuff in the six steps below. These provide the basis for understanding what is going on.

Step 1: Mortgage rates are based primarily on mortgage-backed securities or MBS. As lenders issue mortgages, these mortgages can be “turned into” MBS and sold to investors who want to earn interest on the mortgage debt.

2nd step: MBS have a coupon – which is the official rate paid by a bond. Other bonds, such as the 10-year Treasury note, also have coupons.

Step 3: MBS have a price. Same story for a 10-year Treasury bond. This is the price an investor pays to own $100 of that bond. A prize can be above or below $100. If I pay more than $100 for a bond with a hypothetical 4% coupon, I technically earn less than a 4% rate of return because I paid more up front. Coupons are periodically set in stone, and the bond market moves by changing the price it pays for that coupon. The combination of price and coupon allows investors to know the actual yield associated with a bond. So when you see 10-year yields moving everywhere every day, the coupon has never changed. Just the price.

Step 4: Unlike treasury bills, which only change coupons once per quarter, MBS coupons are offered in half point increments (i.e. 4.0, 4.5, 5.0 , etc.) and are always available for investors to buy/sell.

Step 5: In other words, investors have CHOICES to MAKE when it comes to which MBS to buy. Investor demand for a given coupon can wax and wane for several reasons. Generally though, when investors think the broader rates market has plateaued or rates will continue to fall, they prefer to buy the lowest possible MBS coupons. As demand increases, these lower coupons increase in value faster.

Step 6: Mortgage lenders have choices to make when it comes to picking an MBS coupon in which to place their recently contracted loans. There are limits here. Any given MBS coupon is limited to mortgage rates that are between 0.25% and 1.125% above that coupon. For example, a 4.0 coupon MBS is like a bucket that can only hold mortgages with rates from 4.25% to 5.125%.

Here’s how all of the above has been going lately:

Falling rates and increased demand for refinancing can hurt investors’ returns.

Investors buying MBS note that rates probably peaked in June and have since fallen. Negative economic data added to that momentum this week. If rates continue to fall, mortgage borrowers who recently closed will begin to refinance, effectively paying off investors too soon, before investors have had a chance to earn much interest. In other words, early rollovers cost investors money.

Investors are trying to get a head start by buying low coupon MBS (which are less likely to be prepaid due to falling rates). This increases the value of these coupons.

Why do you care about a lower MBS coupon that increases in value?

You may care more than you think. Mortgage lenders base their rates on several factors, but the MBS coupon price associated with those rates is the biggest consideration because most lenders turn your loan into MBS in order to sell it to investors.

Sounds simple enough, but again, MBS coupons can hold rates in the range of 0.25% to 1.125% above the coupon (remember 1.125%…we’ll use that in a bit) . Thus, a mortgage lender has a choice to make. Any loan they close can be inserted into one of two MBS coupons.

Lenders also like to make money.

We talked about how investors are changing their buying habits to make more money. This directly leads lenders to change their selling habits to make more money! Let’s use a concrete example from this week to get us out of the rabbit hole:

  • Rates were in the mid to upper 5% range last week.
  • A rate of 5.75% is too high for an MBS coupon of 4.5.
  • A rate of 5.625% is NOT too high for a coupon of 4.5 (4.5 + 1.125 = 5.625)
  • Investor demand caused MBS prices to rise to 4.5 coupons above normal from prices at 5.0 coupons.
  • This meant that lenders selling MBS were actually making more money selling a 5.625% loan than a 5.75% loan!
  • Note: Rate is always factored into the profit equation. In other words, with a sufficiently high rate, a coupon of 5.0 can be more profitable than a coupon of 4.5, but not before increasing the rate by at least 0.25%. Here’s an example comparing rates, coupons, and relative prices from a lender who makes more money by giving you 5.625% instead of 5.875:

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Moving down to the next MBS intersection, we find a similar scenario with 5.125% and 5.375%.

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Perhaps more important than 5.125 being about as profitable as 5.375 for your lender is the fact that there is only 0.79 of price separating 5.875% and 5.125% (103.13 – 102.34).

A 0.79 improvement in the price of MBS is very significant, but it’s the kind of thing that happens once in a while in a single day, and quite often over 48-hour periods.

This means that 2 good days in the bond market could cause the 30-year fixed rate to fall by 0.75%, a relatively unknown amount for such a short period of time.

A note on points: The much lower than normal profitability gap between certain rates can be paid up front in the form of “points”. Using the example above, a lender makes the same amount of money by giving you a rate of 5.875% without points or 5.125% with 0.79 points.

What is better? It’s up to the borrower. It would take about 17 months to recoup that extra upfront cost through savings on monthly payments, and rates could easily drop enough by then that it would make much more sense to refinance. The comparison is not the point (no pun intended).

The fact is that ‘points’ are more widespread and more valuable than normal – a fact that helps us reconcile the seemingly large differences between lenders as well as rate quotes that may seem too low to be true at first glance. Thanks to the dots, there were plenty of 30-year fixed rate quotes at 4.625% on Friday afternoon this week.

Other news this week:

Many of the links below contain the full story of many of the biggest developments of the week, but to be sure, Thursday morning’s GDP data was the biggest market driver of the week for rates. We also heard from Powell and the Fed on Wednesday and although the Fed raised rates again by 0.75%, markets had long since priced it in.

Powell pushed the Fed off the path of clearly telegraphed rate hikes. Market participants debated whether or not this was supportive of rates, but the best takeaway is likely that the Fed will be guided by upcoming data when deciding the size of September’s rate hike. This assessment is well in line with the relative calm in bond markets for an afternoon Fed announcement.

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