Today’s long-awaited jobs report came out much stronger than expected. A stronger outcome would almost certainly cause (relative) carnage in the mortgage market, and that is definitely what we are witnessing. The caveat is that while interest rates are still significantly lower than they were a few months ago, the average lender is now back to where they were in mid-August. Additionally, this is one of the largest single-day increases ever seen as the average 30-year fixed rate rose from 6.26 to 6.53.
Fluctuations of more than 0.25% in a single day are extremely rare, but the fundamental structure of the mortgage bond market allows them to occur. For those who want to know more about them, please refer to the following link.
Whether a mortgage lender lends out its own cash reserves or temporary cash from a loan facility, the chunks of cash that are transferred to escrow at closing come with a cost. For most mortgage lenders, day-to-day changes in these costs are determined by the trading of mortgage-backed securities (MBS).
MBS are similar to bonds such as U.S. Treasuries in that investors pay a lump sum of cash and earn interest over time. They differ in several important ways. The most important difference is that the “borrower” of a U.S. Treasury (i.e., the U.S. government) cannot exit the transaction by returning the investor’s principal. You must continue making payments as long as you agree.
On the other hand, a mortgage borrower can terminate the mortgage underlying the mortgage-backed security, such as by selling/refinancing. This introduces an element of uncertainty for investors, which quickly becomes important.
Another key difference with MBS is that they are offered in 0.5% increments and only apply to a specific range of mortgage interest rates that fall into each 0.5% bucket. What makes the problem even more confusing is that there is overlap between the buckets. For example, rates from 6.75 to 7.125 might apply to two different buckets.
Bucket selection is important. This corresponds to the general rates within that bucket, and certain ranges of rates exhibit different behavior depending on what is happening with the rate trends. The simplest example is that if interest rates are trending downward, buckets with higher interest rates are more likely to refinance.
Is owning and refinancing a mortgage good or bad for an investor? There is no single right answer, but it depends on the price the investor paid at the time of purchase. Investors often have high interest rates but don’t want to refinance their mortgages when interest rates are starting to fall.
Now let’s combine all this with the above example of 6.75 to 7.125 rates with two MBS buckets to choose from. One of those buckets contains the lower average rate. That bucket is less susceptible to the risk that the borrower will refinance if interest rates start to fall. Therefore, investors may be willing to pay more money for lower buckets and, conversely, avoid higher buckets in comparison. At this point, it’s important to note that mortgage lenders determine the price based on the amount the investor pays for the loan.
The net effect is that the highest allowable interest rate in the lower of the two buckets is actually more profitable for the mortgage lender than the lowest allowable interest rate in the higher of the two buckets.
This week we bring you real-life examples from real lenders. If the interest rate is 6.625%, the lender can make about 10% more profit and therefore reduce the initial cost by about 0.2% of the loan amount. On a $400,000 loan, that’s an $800 difference. In other words, if you choose a 6.75% loan, you will pay higher upfront costs.
The reason we dive so deep behind the curtain is to explain why interest rates can suddenly rise sharply, or rise or fall more quickly than expected. The structure described above means that there are certain rates that are disproportionately economically efficient. If rates drop enough to approach the next lowest 0.5% MBS bucket, it becomes increasingly reasonable to pursue the highest rate in that bucket, even if it means paying a little more upfront.
Depending on the underlying methodology of a particular mortgage rate index, this can allow for more rapid movement within a given interest rate range, and significantly faster movement on days when the next lower bucket suddenly becomes a viable option. A big drop is possible (or a big rally is possible on days when that lower bucket doesn’t exist). (as long as possible).
