September 2, 2019 BARRON’S 27
THEECONOMY n ByMatthewC.Klein
Cheap Mortgages Have Downside, Too
Refinancingsraisehouseholdincomebutmakebondyieldsmorevolatileforinvestors
U.S. homeowners are
among the unexpected
beneficiaries of fears of
slowing global growth
thatarecontributingtoa
plunge in mortgage in-
terest rates. A wave of
mortgage refinancing to lock in lower in-
terestcostswillboosthouseholdcashflow
and support consumption.
Investors,however,shouldbecarefulof
the ways that refinancing, Federal Re-
servepolicy,andthetechnicalfeaturesof
the bond market could interact to gener-
ate additional volatility in bond yields.
At3.6%,theinterestrateonthetypical
30-yearfixedmortgageisnowatitslowest
levelinnearlythreeyears.Fromthestart
of2017throughtheendofJune,mortgage
ratesaveragedabout4.3%.Asrecentlyas
November,newborrowershadtopay5%
to borrow for a house.
Theprecipitousdropshouldhaveabig
impactonrefinancingactivity.U.S.house-
holdsoweroughly$9.4trillion inmortgage
debt, and a bit more than half of that
takestheformofconventionalhomeloans
that conform to standards set by Fannie
Mae and FreddieMac .Morethan90%of
those30-yearmortgageshaveaninterest
rate above the current market rate.
Not all of those borrowers will refi-
nance—prepaying one mortgage and re-
placingitwithanothercomeswithhassles
andclosingcosts—butmanyprobablywill.
The low estimate comes from analysts at
Black Knight, a mortgage research firm,
whothinkthatabout10millionmortgages
wouldbecandidatesforrefinancing,based
on today’s market rate (3.6%), interest
rates on existing mortgages (at least
4.25%),creditscore(above720),andloan-
to-valueratios(below80%).Shouldmarket
ratesdropto3.4%,BlackKnightestimates
that the number of potential refinancing
candidateswouldjumpto13million.Mort-
gage rates of 3%, which would represent
asharpdeclinefromcurrentlevels,would
translate into 20 million refi candidates.
BlackKnight’smethodologyisconser-
vative. Analysts at Evercore ISI ran the
same simulation but excluded the credit
score and LTV ratio. By their reckoning,
today’s low interest rates mean that as
manyas31millionmortgagescouldbeup
for refinancing. Strategists at Goldman
Sachs thinkthatabout70%ofall30-year
conventionalmortgagors—about36million
borrowers—arecurrently“inthemoney”
to refinance, although not all will.
The economic impact would be notice-
ableunderanyofthesescenarios.Accord-
ingtoFreddieMac,householdsthatrefi-
nanced in April through June, when
mortgageratesaveraged4%,alreadyhave
saved about $140 each month, or roughly
$1,700ayear.Forperspective,thetypical
U.S.homeownerwithamortgagespends
$5,300ayearongroceries.Evercoreesti-
mates that the average borrower could
saveabout$4,560annuallybyrefinancing
into a new mortgage at 3.5%.
Allofthiscouldhaveasubstantialim-
pactonthebondmarket,becausechanges
in yields and mortgage refi activity are
self-reinforcing. The reason is that mort-
gage bonds have an unusual relationship
with interest-rate risk. Since borrowers
replaceexistingmortgageswithnewones
whenever they choose to refinance or
move, the duration of a mortgage bond
tends to shorten when interest rates fall
andlengthenwhentheyrise.(Thismeans
thatmortgageshave“negativeconvexity.”)
An investor trying to get a consistent
amount of exposure to interest-rate risk
thereforemusthedgeanymortgageposi-
tion by buying and selling interest-rate
swaps. When rates fall and prepayments
rise,bondinvestorstendtobuyadditional
exposuretolong-terminterestrates.That
tends to push mortgage rates lower.
Once the refinancing wave ends, how-
ever, investors will unwind their hedges
and eventually switch to selling swaps,
causingaspikeinlonger-termrates.The
classic example is the summer of 2003,
when the 30-year mortgage rate jumped
by 1.1 percentage points in about six
weeks.Thisdynamicmayalsohaveexac-
erbatedthe“tapertantrum”ofmid-2013.
Thistime,theFedcouldendupampli-
fying the convexity vortex. The central
bank started reducing the size of its $1.8
trillionmortgagebondportfolioinOctober
- Its plan was to let maturing bonds
roll off gradually and reinvest the princi-
palinU.S.Treasurydebt,where“gradu-
ally”meantlessthan$20billioninprinci-
pal payments a month. Any payments
above that $20 billion threshold would be
reinvested in new mortgage bonds.
Therecentdropinratesandtheasso-
ciatedrefiboomhaveforcedtheFedback
intothemortgagemarketinawaythatit
hadn’texpected.AccordingtotheFederal
Reserve Bank of New York, which is re-
sponsible for doing all of the trading, it
willbebuying$5.3billionofnewmortgage
bondsfromAug.14throughSept.13—up
from essentially zero as recently as mid-
April to mid-May.
The Fed’s additional purchases could
compress the spread between mortgage
bondsandtheswapsusedtohedgethem.
Thatcouldlowermortgageinterestrates
evenmore,encouragingmorerefinancing
andpushinglong-terminterestrateseven
lower—until the process reverses.
Ifyouhaveamortgage,youmaywant
to get the refi paperwork in now.
0
5
10
15
20
Jan '18 Mar '18 May '18 Jul '18 Sep '18 Nov '18 Jan '19 Mar '19 May '19 Jul '19 Sep '1 9
FasterPrepaymentsMeansMoreFed
PurchasesofMortgageBonds
Scheduled reinvestments of maturing principal into new mortgages, USD billions per month
Source: Freddie Mac
TheInterestRateontheTypical30-yearMortgageIs
SignificantlyBelowtheRecentAverage
30-year fixed average conventional mortgage rate
3.0%
3.5%
4.0%
4.5%
5.0%
5.5%
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: Freddie Mac