Here’s an interesting question: Why are interest rates on 30-year mortgages rising even as the Federal Reserve slashes interest rates and yields on Treasury Bonds fall?
MarektWatch had this to say about the current mortgage crisis:
The answer is that the mortgage market is short of roughly $1 trillion in capital, according to Paul Miller, an analyst at Friedman, Billings, Ramsey.
The modern mortgage market works with lots of leverage, or borrowed money. Investors, including hedge funds and mortgage real estate investment trusts, buy mortgage securities, but finance a lot of their purchases with this leverage.
FBR’s Miller estimates that $11 trillion of outstanding U.S. mortgage debt is supported with roughly $587 billion of equity. That’s a leverage ratio of 19 to one.
But last year’s subprime meltdown has undermined confidence in the home loans that back these mortgage securities. Now the banks that finance most of these leveraged mortgage investments have started to pull back and impose margin calls, demanding more cash or collateral to back their loans.
This has sparked a de-leveraging cycle in which some highly leveraged mortgage investors have to sell assets to meet margin calls. Forced selling pushes prices lower, sparking more margin calls, which in turn produces more selling and even lower prices.
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“The immediate impact is that [interest rates on] 30-year fixed-rate mortgages will have to increase relative to Treasuries,” FBR’s Miller wrote in a note to clients on Friday. “That is why we are experiencing pressure on mortgage rates despite the downward movement on the 10-year bonds.”
Rates on 30-year fixed mortgages usually follow the movement of 10-year Treasury bonds, but this relationship has broken down as de-leveraging in the financial system takes hold.
The difference, or spread, between yields on “agency” mortgage securities backed by Fannie and Freddie and those on Treasuries rose to a 23-year high this week, Miller noted.
“It is the leverage game playing havoc with the system,” he wrote.
There are two ways to resolve the problem. Either inject $1 trillion of new capital into the mortgage market, or allow prices of mortgage securities to fall (and interest rates on home loans to climb), Miller said.
The mortgage market won’t be able to raise $1 trillion, so prices have to fall, he warned.
“There is no quick fix here,” the analyst said. “It will take about six to 12 months for the pricing pressure to alleviate on these mortgage assets.”
“This will be painful, but it must be allowed to play out in an orderly fashion in order for the mortgage market to achieve equilibrium,” Miller concluded.
To that I would have to add that the markets have simply priced in a higher risk. No bank wants to take any chances with many being in an insolvent position. As the article said, there is no solution other than letting the market place sort things out. Any intervention or bailout plan will simply postpone the pain and not make it disappear.