Sunday, September 27, 2009

Grab that cheap mortgage before the pary ends

The stars have aligned to bring down mortgage rates to levels (even for jumbo mortgages) that may not be here for long.

source: Bloomberg ( mortgage rate and jumbo rate (orange) national average)

The US consumers who are able to refinance will find money in their pocket. Those who want to buy a new home, go for it - prices are down and you can't beat a 30-year mortgage rate at around 5%. That's a 3-4% 30-year loan on an after-tax basis, courtesy of the US government. Some may argue that house prices are going lower, and in some areas they will be. But by trying to time the exact bottom in the housing market, you may miss the great American 30-year mortgage party. Here are some reasons for this "generosity" from your local bank and why the party may not last:

1. The Fed has purchased $689 billion of mortgage backed securities plus $127 billion of agency paper. The supposed target for the program is $1.25 trillion, but it is possible they will slow down the purchases. The Fed is getting nervous about the quantitative easing, which has recently moved into full swing.

Demand for mortgage securities from the Fed lowers the financing rate for mortgages, making bankers set a lower rate and still have the ability to make their fees. The chart below shows the narrowing spread between a 5% mortgage bond from Fannie Mae and the 10-year treasury note (part of the reason for the drop is also the reduced volatility in interest rates - discussed below). Going forward, that spread may not keep on tightening the way it has.

Source: Bloomberg

2. Related to the point above, the government has been providing unprecedented support for Fannie and Freddie. Once the agencies stop bleeding profusely, there isn't going to be much political will to help them other than to keep them from collapsing. Chase for example keeps a large slug of mortgages they originate, where as Wells Fargo tends to sell more to the agencies (to deal with Wachovia's portfolio). If the agencies start controlling their balance sheet growth, the mortgage rates may be impacted.

3. Interest rate volatility has dropped significantly. Because interest rates impact the prepayment option embedded in long-term mortgages, high volatility in rates makes that option more valuable. When a bank gives you a mortgage, it in fact sells you the option to prepay your mortgage early. That option impacts the pricing of mortgage backed securities, therefore impacting mortgage rates. The chart below shows historical 30-day volatility in 10-year note futures.

As the chart below shows, that lower volatility reduces the value of the prepayment option, making the mortgage cheaper. If you believe low volatility is here to stay, than there is plenty of time to grab that mortgage. But not many professionals would bet on that.

source: Kalotay's paper (attached)

30-year mortgages at close to 5% are an excellent (and a safe) choice, but before you refinance or select your mortgage however, please read Kalotay's paper blow (Financial Analysis of Consumer Mortgage Decisions primer). He does a superb job in analyzing under what circumstances refinancing makes sense and what types of mortgages work best. When it comes to mortgage analytics, Andrew is one of the best in the business.


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