Compared to the interest rate on long-term federal bonds, the mortgage interest rate is now running significantly higher than normal. Professionals in the mortgage sector ponder if the spread will return to normal, which would mean lower mortgage rates as long as treasury interest rates stay constant. It most likely won’t occur until after 2023.
By historical standards, the dispersion is substantial. The average spread across all available data before the pandemic was 1.69 percentage points. For instance, 10-year Treasury bonds paid 2.68% interest in February 2019. The typical 30-year fixed rate mortgage cost the homeowner 4.37%, The difference was just at the long-term average of 1.69%. The spread typically falls between 1.5% and 2.0%.
The prospective homeowner visits a mortgage originator, often a bank or a broker, who provides an interest rate quotation. The mortgage originator gets compensated for this service, just like any intermediary. The value of raising the interest rate is compensated to the originator in cash. For instance, the typical mortgage interest rate was 3.72% for the first week of 2020. The typical interest rate that Fannie Mae offered to investors was 2.61%. What happened to the 1.11% disparity between those two interest rates? It covered the mortgage originator’s fees.
The Interest Rate
Naturally, the interest rate is determined by supply and demand when Fannie or Freddie sells a package of mortgages to investors. Both are regarded as secure, but the U.S. Treasury will continue to pay interest for the duration of the bond. Yet when mortgage rates decline, homeowners have the choice to refinance. Homeowners who have the choice to refinance do so when interest rates decline. An outdated mortgage with a high-interest rate is no longer owned by the investors. Instead, because of the new, low-interest rates, investors now have cash that they must reinvest. This is disliked by investors.
Investors face difficulties when interest rates rise. Old, low-interest mortgages that nobody will pay off early are forcing them to stay in debt. It is not possible for them to get their money back and purchase some of the new, high-interest mortgages. Mortgage-backed securities are a less desirable investment alternative since homeowners can refinance their mortgages. Investors won’t purchase them, then, unless they provide a premium above the interest rates on Treasury bonds. The wholesale mortgage spread looks like that.
The total spread is the product of the retail spread and the wholesale spread at any given time. In the first half of 2020, while the Federal Reserve was lowering interest rates and the government distributed stimulus payments, the total gap grew considerably. To benefit from the decreased interest rates, homeowners refinance their mortgages. Apartment dwellers began house hunting thanks to money in their bank accounts and cheap mortgage rates. The brokers were overloaded with work. They couldn’t, at least not immediately away, manage all of the mortgage refinancing requests from the public. They increased their profit margins while hiring more people and training them. The wholesale margin barely changed, whereas the retail spread increased significantly. This was demonstrated by William Emmons of the Federal Reserve Bank of St. Louis.
The wholesale level appears to be the cause of the significant overall difference between mortgage rates and government bonds in early 2023. Bond dealers point to interest rate volatility as the main cause. Keep in mind that owners of mortgage-backed securities receive far fewer prepayments than they would want. Owners of mortgage-backed securities now get the majority of prepayments when they least expect it due to falling interest rates. Investors steer clear of mortgage-backed securities as a result of the possibility of interest rate fluctuations in either direction.
Due to the mortgage originator’s interest rate risk, some spread widening would be anticipated at the retail level. After receiving an interest rate quote, the borrower decides not to proceed if rates drop, leaving the initial originator helpless. Yet, that borrower holds the originator to the quote if interest rates increase. Both spreads rise as interest rates are more erratic. Mortgage rate volatility increased during the previous 52 weeks compared to the 52 weeks before that (measured as the standard deviation of the absolute value of the weekly rate change).
Stability of Interest Rates
When will this large spread become normal? The point at which interest rates stabilize will be crucial. When the Federal Reserve has completed its tightening, it will next begin to relax back towards a steady path for future interest rates. It appears that there will be more tightening as of March 2023. And the Fed will eventually lower rates to stimulate the economy, probably in 2024. The spread will decrease as soon as rates reach a level where they can stay consistent for years.
As the Fed begins to ease, or maybe even sooner in anticipation of such easing, the real mortgage rate will drop for potential house buyers evaluating their anticipated mortgage expenditure or for new homeowners wanting to refinance. The spread would decrease even if it remained high. When the spread narrows, the downward pressure on mortgage rates will increase. The rates will thus decrease, most likely gradually beginning in early 2024 and lasting for around two years.
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