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CAPITAL
By DAVID WESSEL
U.S. Appetite for Refinancing
Contributes to Bond Volatility
Americans believe they have an inalienable right to life, liberty and the refinancing of their mortgages.
With mortgage rates low and the value of American homes rising, refinancing is running 80% above levels seen when mortgage rates took a big dip four years ago.
This is great for homeowners. And by cutting monthly mortgage payments and allowing consumers to turn the swelling equity in their homes into cash, it has been vital to the consumer spending that is keeping the U.S. economy growing. It's a tribute to the marvels of modern finance and the agility of Fannie Mae and Freddie Mac, the behemoths created by the government to make home-buying easier.
But indirectly, the blessing of easy refinancing may be driving interest rates in the bond market to extremes in ways that could make the U.S. economy less stable.
Here's how: For homeowners, a fixed-rate mortgage usually comes with a cool feature: If rates go up, you keep the old mortgage. If rates go down, you trade it in.
But the folks who lend money don't like this deal. We're talking Fannie, Freddie, banks, Wall Street houses and others who borrow money from one place and use it to buy big pools of mortgages. Their profits come from borrowing money at, say, 6.5% and lending it to homeowners at 7.5%. When a homeowner pays off a 7.5% loan and takes out a 6% mortgage instead, that profit can turn to a loss. Big players are still stuck with paying out 6.5%, but can't find a safe way to earn that much on their cash.
So they buy insurance. And -- here's the key -- the insurance often consists, in one form or another, of buying U.S. Treasury securities. (The value of a Treasury bond rises when interest rates fall. The profit on Treasuries offsets the losses caused by homeowners who take advantage of those lower rates to pay off mortgages early.) The big players may not buy Treasury debt directly, but they make side bets on financial markets, called "derivatives," from dealers who buy Treasuries to cover the risk.
The insurance isn't perfect. It's hard to predict what homeowners will do. Over the past 10 years, they've become quicker to refinance; many are now serial refinancers. So when rates fall a lot, as they have, the big financial institutions may need extra insurance, even if only temporarily. That means more demand for Treasuries, which pushes market interest rates lower. And the lower rates go, the more refinancing, and the more need for the big institutions to buy insurance, and so on.
Bond traders say that is a factor in what's happening today. The bond market is gyrating, and 10-year U.S. Treasury notes are paying 3.749%, lower than they've been since 1958.
Interest rates, of course, are supposed to fall when an economy is weak. That is supposed to help turn an economy around. But it's not just jitters about the economy or deflation that seem to be driving rates. The peculiar dynamics of the mortgage business may be giving interest rates an extra shove. And similar dynamics could give interest rates an extra upward shove when the bond market turns around; unwinding the insurance policies will mean someone is selling Treasuries. In short, homeowners, Fannie, Freddie and big investors all doing the logical thing may accentuate the swings in the bond market. And that could accentuate swings in an economy that relies so much on borrowing at rates tethered to the rates the bond market sets on U.S. Treasuries.
Peter Fisher, the U.S. Treasury under secretary for domestic finance, points out in speeches that we have invented a system that passes a lot of volatility to financial markets because we like stabilizing things like employment and household income. Better wild swings in bond prices than wild swings in your monthly mortgage payment or your wages. Not all investors like volatility, though. So now, just as there are markets for stocks, bonds and mortgages, there are new markets for volatility. "It seems to me," he lectured bond dealers in June, "that we all have been a little slow to question some of the assumptions on which our current understanding of the 'volatility market' are based." In other words, even the big players don't fully understand what's going on. Gulp!
All financial markets are more volatile these days, not just bonds. But there's no mistaking the growing impact of the mortgage business on the way the bond market sets the long-term interest rates that affect investor portfolios, the federal budget deficit and the willingness of companies to borrow to invest.
Back in the 1970s, most mortgages ended up on the books of savings and loans. Refinancing was often a hassle. Today, competition in the mortgage market has made refinancing easier. According to Fannie Mae, 75% of all mortgages are held by investors who have borrowed money to buy them, which means little moves in markets can cause big reactions. The Bond Market Association says there are $4.5 trillion in mortgage-related securities today. That's 15% bigger than the market for corporate bonds and 50% bigger than the market for U.S. Treasuries.
In 1994, the Federal Reserve raised short-term interest rates a little, and the bond market raised long-term interest rates a lot, partly because of the gyrations in the market for mortgage securities. Since then, the size of that market has more than doubled.
Look out.
Write to David Wessel at capital@wsj.com |
