May 25, 2022

Mortgage Investors Pay Big Price for a Small Yield

Investors trying to eke out a small return on their savings are finding out that buying mortgage-backed securities (MBS) can yield big losses when rates increase.  It is doubtful that most investors in MBS appreciated the risk involved in buying long duration assets, regardless of the collateral behind it.

The zero-rate policy of the Federal Reserve has resulted in yield hunt by conservative investors looking for a yield higher than the near zero rates offered by banks and money market funds.

Investors buying MBS were probably seduced by the fact that they are guaranteed by various U.S. government agencies such as Fannie Mae, Freddie Mac and Ginnie Mae.  The government agencies guarantee payment of interest and principal but unfortunately, the value of MBS can and will fluctuate in value depending on changes in interest rates.  For example, a popular Vanguard MBS ETF has an average duration of almost 6 years.  Duration measures interest rate risk and in this case, a 1% increase in interest rates with result in a 6% decline in the value of the ETF.

A MBS ETF as part of a laddered bond portfolio makes sense but could turn out to be a disaster if increase rates continue to increase, especially if the investor has to liquidate a position.  Since the high reached in August 2021, the Vanguard MBS ETF has decline in value by over 10%, a really big loss for someone who thought they were investing in a relatively safe security. With the ETF currently paying a yield of 1.83% if would take almost six years to recoup losses if interest rates remain stable.

The biggest loser of all in the MBS market may turn out to be the U.S. taxpayer since the Federal Reserve currently holds almost $2 trillion of mortgage-backed assets.  The Fed has been furiously purchasing MBS in an effort to keep interest rates low in the mortgage market.

With inflation continuing to accelerate, MBS along with other long dated debt securities will continue to drop in value.


Home Equity Line of Credit (HELOC) is a Better Option than a Mortgage Refinance

Savings – A Lost American Virtue

In an uncertain world it is important that everyone has at least six months’ worth of savings available.  It might not be possible to save this much for the average person.  The best option to establish a readily available and reasonably priced source of funds is to take out a home equity line of credit (HELOC).

Here are some of the basic things to know about a HELOC.

A home equity line of credit (HELOC) can provide emergency funds at a fraction of the cost of a credit card advance or personal loan and there are no monthly fees.

A HELOC is a mortgage on your home which means that you are using the collateral in your home as security for the loan.  If the borrower already has a first mortgage, then the HELOC would be a second mortgage lien.

The application process with a bank is very easy and usually there are no upfront costs. The borrower may be responsible for paying the fees associated with setting up the HELOC if the line of credit is cancelled within five years. Keep in mind that the bank must incur costs for underwriting, credit report fees, processing, title search, appraisal and closing costs. A HELOC is a much lower cost option for obtaining cash than doing a fee laden cash out refinance of a first mortgage.

The application process is similar but less stringent than applying for a first mortgage. The borrower’s income is verified, and the credit score must meet the bank’s standards. Most banks will lend up to 80% or more of the home’s value minus any first mortgage balance.  At the time of application, the borrower puts in a request for a specified loan amount.

Once the HELOC is approved, the borrower is given a check book to access the approved credit line.  There is no requirement to borrow any funds.  The money is quickly available when needed which can be a lifeline in the case of job loss or unexpected expenses.

The interest rate of a HELOC is variable and is typically based on the prime rate or other short-term index plus a specified margin.  The rate and payment on any advances will therefore change monthly. Interest rates on personal loans and credit cards can easily be more than triple the rate on a HELOC.

The monthly payment on a HELOC is interest only which keeps the payment low. Borrowers have the option of paying more than the minimum payment due and can pay off the loan in full at any time.  The interest on a HELOC is tax deductible which lowers the cost of the loan.

The biggest risk of a HELOC is that if a default occurs, the bank may initiate a foreclosure proceeding.  If you are comfortable with the concept of using your home equity as collateral, a HELOC is the lowest cost and most flexible option for borrowing money.

The Pros and Cons of an Adjustable-Rate Mortgages (ARM)

A mortgage payment is usually the biggest monthly expense for most people.  Since an adjustable-rate mortgage (ARM) will always start off with a lower rate than a fixed rate mortgage, it is useful to understand the pros and cons of an ARM.  Depending on the trends of future interest rates, an ARM can be a money saver or a money pit.

The interest rate on an ARM can change over the life of the loan at various time intervals depending on the type of mortgage product you select.  An ARM product is more challenging to understand than a fixed rate mortgage so dealing with a knowledgeable mortgage loan officer is essential.  The rate on an ARM is the sum of an index rate plus a fixed margin.  The index rate will vary but the fixed margin will not.  Most banks use a short-term index rate such as the yield on a one year Treasury bill.  The index rate plus the margin is called the fully indexed rate.  The ARM will never have a rate less than the fixed margin.  For example, if the fixed margin is 3% and the yield on the one year treasury is 0%, the ARM will have a rate of 3%.

The typical ARM rate will change yearly. The date of the first-rate change on an ARM depends on the type of ARM that the borrower initially selected. The four most common ARMs are the 3/1 ARM, the 5/1 ARM, the 7/1 ARM, and the 10/1 ARM.  These ARM products are called hybrid ARMS since they have a fixed rate for the time specified and afterwards convert to an adjustable rate which can change once a year.  For example, the 3/1 ARM will have a fixed rate for three years and the rate might change starting in year four.  The starting rate on loans with a longer initial fixed interest rate will start off higher.  For example, the rate on a 5/1 ARM might start off one percentage point lower than the start rate on a 10/1 ARM.

ARM products have lifetime and yearly rate caps.  Although the rate change on an ARM can be substantial over the life of the loan, lenders have a cap on the yearly rate increase to avoid payment shock to borrowers, but the lifetime rate increase can result in much higher payments.  Most ARMs cannot increase by more than 2 percent after the initial fixed rate period and the lifetime rate is usually capped at 5 percent above the start rate.  For example, in a worst case basis a borrower with a 5/1 ARM at a 2.75% start rate might see an increase to 4.75% in year six, 6.75% in year seven, and reach the lifetime cap of 7.75% in year eight.

The risk involved with an ARM should be carefully considered.  An initial interest rate that is lower than a 30-year fixed rate is a bet that future interest rates will not dramatically increase.  This has been the case for the past 14 years and the ARM borrower automatically shifted to a lower rate without the large expenses involved in a refinance.  However, even if rates do increase in the future, savings from a low start rate could more than offset higher rates in later years.

No one can predict future interest rates but in a declining or stable interest rate environment, ARM borrowers will save money over time compared to a fixed rate mortgage which almost always has a higher rate than the start rate of an ARM.

An ARM will make sense for a borrower who expects to sell his home within 10 years which is the average number of years a person lives in his home before selling it.

Mortgage Rates At 10% a Real Possibility If Inflation Can’t Be Reduced

Mortgage Rates Explode to 12 Year High

This year has seen one of the most explosive mortgage rates increases in history.  In a matter of a few short months the 30-year fixed rate mortgage has almost doubled from the high 2’s to over 5%. There have been previous periods of time during which rates rose substantially but 2022 has been a vertical move up that is rarely seen.

30-year fixed mortgage

Why rates have risen so quickly is no mystery.  After months of Federal Reserve talk of “transitory inflation” it has become clear that inflation is here to stay and likely to get worse before it gets better. The Fed must increase rates significantly to have any chance of reducing the inflation rate since current rates are far below the rate of inflation.

This from the WSJ:

During the 1980s, when Paul Volcker’s Fed was desperate to avoid a repeat of the inflation of the 1970s, interest rates were on average more than 4 percentage points higher than inflation. Leave aside the fact that at the moment the Fed Funds target rate is an extraordinary 7 percentage points below inflation; markets aren’t bracing for the Fed to be truly hawkish in the long run. Investors still think there’s no need, since in the long run inflation pressures will abate.

This is probably a mistake. The inflationary pressures from Covid and war will surely go away eventually. But self-fulfilling consumer and business expectations of inflation are rising, and a bunch of longer-term inflationary pressures are on the way. These include the retreat of globalization, massive spending to shift away from fossil fuels, more military spending, governments willing to run loose fiscal policy, and a starting point of an overheated economy and supercheap money.

If interest rates continue to rise, we may be looking at another housing bust similar to what we saw in 2018.

The Zero Sum Game Of Lower Interest Rates And Why Mortgage Rates Will Rise

The Federal Reserve has forced long term interest rates to historic lows in a desperate attempt to “stimulate” both the housing market and the economy in general.  The results have been mixed but the benefits of lower rates to borrowers are undeniable.  Lower rates reduce the cost of large debt burdens carried by many Americans and increases the spending power of those able to refinance.

Exactly how much lower the Fed intends to repress mortgage rates is anyone’s guess but as interest continue to decline, the overall benefits diminish.  Here’s three reasons why the Fed may wind up discovering that the economic benefits of further rate cuts will be muted at best, self defeating at worst.

1.  Lower rates are becoming a zero sum game for the economy as lower rates for borrowers translates into lower income for savers.  Every loan is also an asset of someone else and lower interest rates have merely been a mechanism for transferring wealth from savers to debtors.  Every retiree who prudently saved with the expectation of receiving interest income on their savings have been brutalized by the Fed’s financial repression. Even more infuriating to some savers is the fact that many debtors who took on irresponsible amounts of debt are now actually profiting from various government programs (see Foreclosure Settlement Q&A – A Victory For The Irresponsible).

A significant number of retirees that I know have been forced to drastically curtail their spending in order to make ends meet while others have been forced to draw down their savings.  The increased spending power of borrowers has been negated by the reduced spending power of savers.  This fact seems to elude Professor Bernanke who hasn’t been able to figure out why lower rates have not ignited the economy.

2.  Many consumer who would like to incur more debt are often turned down by the banks since their debt levels are already too high.  Those who can borrow often times chose to deleverage instead, considering the fragile state of the economy.  Anyone saving for a future financial goal (college tuition, home down payment, retirement, etc) is forced to reduce consumption and increase savings due to  near zero interest rates.  The Federal Reserve has destroyed Americans most powerful wealth building technique – the power of compound interest.  A 5% yield on savings will double your money in about 14.4 years while a 1% yield will double your money in 72 years – and that’s before taxes and inflation.

3.  As mortgage rates decline into uncharted territory, the mathematical benefit of lower rates diminishes.  As can be seen in the chart below the absolute dollar amount of monthly savings as well as the percentage decrease in the monthly payment diminish as rates race to zero.

Benefits of a refinance on a $200,000 mortgage diminish as rates decline

% Rate Mo Payment Mo Savings % Reduction Yearly Savings
6.00% $1,199.00
3.00%    $843.00 $356.00 29.70% $4,272.00
1.50%    $690.00 $153.00 18.10% $1,836.00
0.75%    $621.00  $69.00 10.00%    $828.00

Closing costs at lower rates also become problematic, making it impossible to recapture fees within a reasonable period of time.  With closing costs of $8,000 on a $200,000 mortgage refinance, it would take a decade to recoup closing costs.

Many astute analysts have made elaborate and compelling arguments that interest rates can only go lower.  From a contrary point of view, I believe that a future rise in interest rates is a high probability event.  This is the opposite of my prediction in March 2009 when I surmised that mortgage rates would decline to 3.5% – see 30 Year Fixed Rate of 3.5% Likely.

The Chart of the Day has a long term chart of the 10 year treasury and notes that the recent sharp decline in interest rates “has brought the 10-year Treasury bond yield right up against resistance of its 26-year downtrend channel.”


Fed Struggles To Lower Mortgage Rates

Fed Determined To Lower Mortgage Rates With Unconventional Methods

Mortgage rates started dropping late last year after the Federal Reserve announced that it would be purchasing mortgage backed securities (MBS) in an effort to lower mortgage rates.  As recently as January 13th, Fed Chairman Bernanke again attempted to talk down mortgage rates in his speech at the London School of Economics by discussing the potential purchase by the Fed of longer dated treasury securities.  Bernanke noted that “In determining whether to proceed with such purchases, the committee will focus on their potential to improve conditions in private credit markets, such as mortgage markets.”

Shortly after Bernanke’s London speech, Charles Evans, Chicago Fed Chief, reiterated the Fed’s determination to lower rates by stating that “With the United States in the midst of a serious recession, it could be useful to purchase significant quantities of longer term securities such as agency debt, agency mortgage backed securities and treasury securities.  We stand ready to grow our balance sheet even more should conditions warrant.  At the current time, the biggest concern is deflation and the Fed can worry about inflation later.”

Given the Fed’s determination to lower mortgage rates, why have mortgage rates jumped 75 basis points over the past week?

Most of the Fed’s current and potential purchases of MSB and long dated treasuries may already be substantially discounted by the market.  The larger question is does the Fed have the resources to force mortgage rates lower given the competing demands for funding by virtually every major sector of the economy? Although mortgage rates have declined , they have not dropped to the extent necessary to give homeowners truly significant savings, especially after the recent run up in rates.

The Fed views lower mortgage rates as crucial in stabilizing a collapsing housing market.  However, if the Fed could have brought mortgage rates down to 2%, they would have, which implies constraints on their ability to manage rates.  These constraints are becoming visible on the Fed’s ballooning balance sheet.  The world is discovering that there are limits on the ability of Governments to bail out every sector of the economy.  (See  Insolvent Banking System Eludes Government Containment.)

Lower mortgage rates may become a sideshow to the larger issue of the solvency of nations, with Britain being the latest example . (Gordon Brown Brings Britain To The Edge Of Bankruptcy) The demands on the British treasury to rescue the entire banking system and economy are so large that the British pound has crashed and the very solvency of Britain is now being questioned.  This unfolding financial disaster in Britain puts a serious dent in the theory that Governments have unlimited financial resources.  The implications for the US Treasury, by extension, are ominous.