The Week Ahead in the Capital Markets

November 3, 2008

Interest rates are low and getting lower. The Fed dropped overnight funds to 1.00%, and the futures market is calling – with 80% likelihood – for the Fed to cut rates to 0.50% before the end of November. The economy is weak and getting weaker. Global equities shed nearly $10 trillion of value in October alone. Commodities fell more in October than they had in any month since 1960. Crude oil is 55% off of its highs. Gold is down 30%. Deflation, not inflation, is the immediate concern (just hold on – $3 trillion of government spending will give us lots of inflation to worry about once the economy gets going again). The economy is struggling with the specter of the worst recession since the 1930s. The consumer is failing, and analysts predict that GDP will drop at a 3% annual rate for the next several calendar quarters. Recession plus deflation equals low interest rates.

So where is the mortgage refinance boom? “Woe is me,” cries the loan officer, “I have seen nary a loan in days.” The plight of the mortgage banker is rooted in one simple concept: at 3.26%, the spread between mortgage and Treasury yields remains stubbornly, historically, dramatically wide. The spread is 1.00% wider than it was two months ago, and 1.75% wider than its long-term historical average. Mortgage rates are hovering near their highest levels of the past twelve months.

Many inter-related factors widen the difference between mortgage and Treasury yields, and can be summed up in two words: risk and volatility.

First, risk. Wide swap spreads push mortgage yields higher. “Swap” is a generic term that relates to the exchange of floating for fixed interest rates, and usually refers to LIBOR (swaps can get really complicated and sometimes involve different currencies, corporate exposures, and interest rate indexes). A five-year swap rate, therefore, is the market’s estimation of short-term LIBOR rates over the next five years.

LIBOR is a good measure of risk in the global financial system – and here’s a shocker: risk and LIBOR have been very high lately. Investors in mortgage securities receive funding based on LIBOR. When LIBOR rises, investors push mortgage yields higher to compensate.

Second, volatility.  Because borrowers can refinance their mortgages, mortgage securities contain prepayment risk.  When rates drop, borrowers refinance out of high rates, and investors lose yield.  When rates rise, borrowers stay put, and investors get stuck with low-yield securities.  Treasury securities do not have risk of prepayment.  The difference between mortgage and Treasury yields therefore reflects prepayment risk.  When interest rates are very volatile, like they have been lately, the uncertainty and cost of prepayment risk rises.  Investors demand relatively higher mortgage yields for taking prepayment risk.

Supply and demand issues also drive mortgage yields (general investor aversion to mortgages and attractive yields on competing investments have hurt mortgage securities), but the overriding issues are risk and volatility. When risk in the global financial system subsides, and interest rates become less volatile, mortgage spreads will drop. Tight spreads can’t come too soon for the health of the banking and housing markets – a gradual decline through the first half 2009 is our best guess.

AN INSIDER’S VIEW FROM THE CAPITAL MARKETS COOPERATIVE TRADING DESK:

“When spreads contract (and hopefully Treasury yields stay low), how big will the refinance boom be? At a 5.25% 30-year mortgage rate, including the effects of housing price declines and tight credit guidelines, $2.5 trillion of mortgages are eligible for refinance. Add some modest purchase activity, and we’re talking about a very active market. At 5.75%, a respectable $1.5 trillion is available. At today’s rates (~6.50%), only $400 billion is eligible for refinance and purchase activity is anemic. That is why mortgage bankers are crying the blues.

Help your friendly neighborhood mortgage banker and buy a mortgage fund today. There is a silver lining to wide mortgage spreads: mortgage securities are a great investment play. Relative to Treasury yields, outright purchases of Ginnie, Fannie, or Freddie securities offer one of the better risk/reward trade-offs ever. It may not be such a bad idea to borrow at Fed Funds rates (1.00% or less) and buy agency securities (yields are close to 6.00%). Your risk is that rates rise, but you get paid near-6.00% yields for your trouble, and your principal is backed by the full faith and credit of the U.S. government. In related news, banks have enjoyed watching the yield curve steepen. The spread between two-year and ten-year Treasury yields has soared to 2.47%, at least 1.00% steeper than six weeks ago. ” (CMC traders price, hedge, and sell $billions of mortgages for their clients, and offer a front-line perspective on the markets.)

Barack Obama gets a half-hour on TV. Big deal. I’ve done 470 of these things. Where’s my presidency? – Stephen Colbert

Thanks for your business and have a good week. – Tom Millon

About Capital Markets Cooperative
Capital Markets Cooperative (CMC) provides mortgage bankers with the economies of scale and the expertise to reduce risk and maximize profit in the secondary market. Regarded as the premiere secondary marketing specialist in the industry, CMC has worked with financial institutions nationwide to break traditional barriers in capital markets and take performance and profits to the next level. To date, CMC executives have managed more than $500 billion of mortgage volume. CMC board members are Tom Millon, Jeff Harry, and Harold Koegler.

For more information about Capital Markets Cooperative, visit www.capmkts.org or call 904.543.0052 or e-mail info@capmkts.org. This e-mail is not a solicitation or investment advice of any kind. You may change your e-mail address, or if this e-mail has reached you in error, or you do not wish to continue receiving it, please let us know by replying to tmillon@capmkts.org.