Ah, the odd working of the markets. It’s often difficult to decouple the factors at work. For example, in the wake of the Fed’s unexpected 50 basis point Fed funds rate cut in September, long-dated Treasuries fell due to heightened inflation concerns. But last week, despite another rate cut and near $100 a barrel oil, Treasuries rallied due to worries about financial institutions triggered by the announcement of $8.4 billion of writedowns at Merrill and the possibility of large losses at other investment banks.
Another unanticipated development is hitting ten-year Treasury prices: the decline in mortgage refinancing. Normally, in a falling rate environment, home refinancings accelerate. That means mortgage securities investors get cash back faster than expected and typically park the proceeds in Treasuries until they find other reinvestment opportunities. Many mortgage investor also buy Treasuries on an anticipatory basis when interest rates fall, seeking to lock in returns before the mortgage borrowers refinance. As a Bloomberg story notes:
Hedging by owners of housing-related bonds surges to as much as 45 percent of that amount when yields drop by about a quarter percentage point, Rajadhyaksha [head of interest rate strategy in New York at Barclays Capital Inc.] said.
Now, however, borrowers aren’t refinancing. Many simply can’t, because the criteria have changed: banks are demanding better credit scores and lower loan to value ratios. And in some areas, a decline in home value also rules out a refi. Moreover, even though Treasury prices have fallen, spreads over Treasuries have widened, so the improvement in rates for fixed rate borrowers is not-compelling to non-existent.
Ten-year yields would be about 0.3 point lower if demand by consumers for loans was increasing, as is typical when borrowing costs fall, Rajadhyaksha said….
Because fewer houses are being refinanced, the average maturity, or duration, of bonds backed by loans is increasing. Barclays estimates the duration for the mortgage market has expanded to about six years from 4.4 years in September and 3.5 years in March.
Rising duration can be bad for holders of longer-maturity securities. The increase has the same interest-rate risk to investors as if the Treasury boosted the supply of 10-year notes by $911 billion, according to estimates by Barclays.
“This may be a unique situation in the mortgage market where rates are going down and mortgages are extending,” said Douglas Dachille, chief executive officer of New York-based First Principles Capital Management LLC, which oversees $3.5 billion.
Mortgage-bond investors typically buy Treasuries when rates fall and consumers refinance home loans, giving investors back their money sooner than anticipated and forcing them to reinvest in new securities at lower rates. Treasuries, meanwhile, usually rise in value.
Purchases of government debt by mortgage bondholders tend to lower yields by about half a percentage point during a rally, according to research by Frankfurt-based Deutsche Bank AG…..
This year is different because of the housing slump. Calabasas, California-based Countrywide Financial Corp., the biggest U.S. home lender, expects the constant rate of prepayments to slow to 12 percent from 18 percent, Chief Financial Officer Eric P. Sieracki said on a conference call with investors and analysts on Oct. 26.
“Traditionally, mortgage prepayments would be screamingly fast,” at current Treasury yields, said John Cerra, who manages $13 billion of bonds at TIAA-CREF, a retirement fund for teachers based in New York. There are no opportunities to refinance loans for “any but the best borrowers,” he said.
A drop in adjustable-rate mortgages is also adding to duration. The percentage of applications for loans with rates that change over time fell to 13 percent for the week of Aug. 31, the lowest since July 2003, from 23 percent the period ended Aug. 3, according to data compiled by the Mortgage Bankers Association.
About $120 billion of prime loans reset in a given year, of which half are converted to fixed-rate loans. That adds interest- rate risk equal to about $30 billion of 10-year Treasuries, said Mustafa Chowdhury, head of U.S. interest rate research in New York at Deutsche Bank.
`The risk,” said Chowdhury, who was a manager at housing finance company Freddie Mac in Mclean, Virginia, before heading interest-rate strategy for the German firm, is more toward “a sell-off than a rally.”