The Risk Of Higher Mortgage Rates

Mortgage rates again ticked higher Friday as the treasury market continued its sell off.  Most of the good news may already be priced into the treasury market that mortgage rates are based on.

Reasons why mortgage rates may increase:

1.  As the Fed’s efforts to stabilize the credit markets succeed, frightened money is moving out on the risk curve, selling treasuries and purchasing much higher yields on corporate debt, preferred and common stock and municipals.  To the extent that the Fed is calming the credit markets, their actions are  counterproductive to lower mortgage rates.

2.  The Fed’s announcement in late November of their intention to buy half a trillion dollars of mortgage backed securities is what kicked the mortgage rate decline into high gear.  Most of this may now be fully discounted.  The actual announcement of the purchase schedule of the MBS’s did nothing to lower rates.

3.  Without the backing of conventional mortgages by the government, mortgage rates would be much higher.   This can be seen from pricing in the jumbo fixed rate mortgage market where rates are as much as 2 to 3% higher since Fannie and Freddie do not purchase or guarantee these mortgages.  Many banks effectively do not offer jumbo mortgages since there is no secondary market for them.

4.  Continued massive government support of the mortgage market will be necessary since investor demand for mortgage securities is likely to remain low due to collapsing housing prices and the risk of mortgage debt being discharged by bankruptcy and loan modifications. How can an investor properly price a mortgage security where the asset value underlying the security is declining and also face the risk that the principal investment may be impaired by court decree?

5.  The question of how much financial support the government is able to continue to provide to subsidize mortgage rates becomes important, especially as bailout demands escalate.  There are reports today that the State governors are seeking $1 trillion in bailout support as their deficits grow.  Unless the funding ability of the US Treasury is infinite, price support for mortgages may be reduced.  The Fed is now expected to absorb virtually all of the new mortgage backed securities this year.  Meanwhile, the debt of the US Government continues to explode, possibly beyond the point where the debt can ever be repaid.  This scenario implies higher rates on all government backed debt.

Many investors expect the eventual outcome of the Fed’s quantitative easing campaign to result in much higher inflation.  Some very astute investment managers, who had correctly predicted the financial meltdown now view the treasury market as overpriced.

• Jeremy Grantham of GMO describes the 30 year treasury bond as “ridiculously” overpriced and effectively forecasting only a 1% annual rate for the next three decades.  Mr Grantham sees the scenario where there could easily be a large surge in inflation.
• Bob Rodriquez who runs the FPA New Income Fund and was up on the year in 2008 also sees a “massive bubble in treasurys”.  He is not buying treasurys since “We will not lend long term money to a borrower that capriciously erodes its balance sheet.”
• Peter Schiff of EuroPacific Capital also sees a substantial risk of massive inflation and sharply higher interest rates at some point.   Eventually foreign investors will refuse to buy US Government debt based on concerns about the US ability to repay its debts.

The above scenarios may not be imminent but they do become more probable as the US Government depletes the Treasury with endless bailouts, guarantees and borrowing.