Why mortgage rates are weird

September 5, 2013

This time last year, Peter Eavis came out with a pair of columns asking the question: why were mortgage rates so high? Back then, the typical 30-year mortgage cost 3.55% — more than 140bp above prevailing mortgage-bond rates. Given that banks normally lend out at only about 75bp above mortgage-bond rates, said Eavis, mortgage rates should by right have been much lower.

Eavis was pessimistic that market competition would drive rates down: “mortgage rates may not decline substantially from here,” he said, adding that “the 2.8 percent mortgage may never materialize”. Little did he know that he was writing at the very low point for mortgage rates — they have spiked over the course of the past year, and today, reports Nick Timiraos, they’re at 4.73%.

Using Eavis’s benchmark, we’re still pretty much in the same place as we were a year ago: that 4.73% rate is about 130bp more than the yield on Fannie Mae’s current-coupon mortgage bonds. It could be lower, it should be lower, but at least the spread isn’t continuing to widen.*

But in one way, today’s rate is even crazier than the 3.55% rate a year ago. As Timiraos says, this marks the first time ever that the typical 30-year mortgage rate, which comes with the blessing of a government guarantee, is higher than the typical rate on unguaranteed “jumbo” loans. Even in a world of crazy spreads, this is pretty bonkers:

Before the housing bubble burst six years ago, jumbo mortgages over the past two decades typically had rates at least 0.25 percentage point above conforming loans, but that widened sharply after 2007, reaching a peak of 1.8 percentage points in 2008, according to HSH.com, a financial publisher. The rate difference between the two stood at 0.5 percentage point as recently as last November.

Timiraos tries to explain this rationally: if banks hold jumbo loans on their balance sheets, he says, that means the price of the loan isn’t “set by bond markets”. To which I say, pull the other one. Of course the price is set by bond markets. Or, says Timiraos, maybe this whole thing can be explained by looking at the cross-selling opportunities represented by jumbo borrowers: if they come for the mortgage, they’ll stay for the investment advice! Or something. Again, this is highly unpersuasive, especially since there’s no indication that cross-selling abilities have suddenly blossomed in the past year or so.

The real story here, I think, is not about banks at all; rather, it’s about the government, which is desperately trying to extricate itself from its current position as the ultimate source of just about all mortgage finance. In the absence of a formal plan of how to do this, it’s trying a market-based approach: make mortgages expensive, and maybe the banks will take the hint and start offering private-label mortgages at lower, more competitive rates. As Timiraos says, part of the reason mortgage rates are so high is the fees that Fannie and Freddie are slapping on to every loan they buy from lenders.

In a way, that’s what we’re seeing in the jumbo market — when you don’t have to deal with Frannie, rates are lower than when you do. But if the government hopes that expensive mortgages will cause the private sector to stop dealing with Frannie, it should prepare itself for disappointment. As I said in March, whatever Frannie pays for mortgages will simply become the market price for mortgages. The government is just too big not to be the marginal price setter: it speaks volumes that mortgage rates are lower than the government is paying only in the one area where the government isn’t competing.

All of which is to say that if the government wants to shrink Frannie, it’s going to have to do more than tack on a bunch of fees and leave the rest to the market. Five years after the crisis, we’re still waiting for a plan, however, and there’s no indication that we’re going to get one any time soon. Which means that the government is going to remain the dominant monopoly in housing finance for the foreseeable future.

*Update: I’ve now managed to pull the chart: this is the 30-year mortgage rate, minus the yield on the 30-year current-coupon bond from Fannie Mae. As you can see, it has actually tightened in back towards its historical level over the past year: the excess profits that Eavis was complaining about a year ago seem to have largely disappeared.


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