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A puzzle in mortgage rates

rate conundrumEnlarge GraphMortgage rates are generally set by the TBA market which trades with the 10-year bond

Mortgage rates generally follow interest rates pretty closely. The most important security for mortgage originators is the To-Be-Announced (TBA) market. The TBA market is the basis for which your loan originator prices a loan. When they make a loan to you (as a borrower) your rate is par, give or take any points you are paying. Your originator will then sell it into a TBA. If you are quoted a 4% mortgage rate with no points, the lender will fund your loan and then sell it for whatever the current TBA price is. The difference between par pricing on the loan and the TBA price is their profit margin.

TBA prices generally follow movements in long-term interest rates, although they tend to be somewhat less sensitive to rates than the 10-year bond. As a rule of thumb, a 10 basis point jump in the 10-year corresponds to a 7 basis point increase in the TBA. Because the mortgage origination market is so competitive, mortgage rates tend to move in lockstep with TBAs, although competitive dynamics sometimes increase and decrease margins.

Mortgage rates spiked on Friday, May 31st in spite of a benign interest rate environment

The movement in mortgage rates over the past few days has a lot of market participants asking what is going on. The Bankrate 30-year fixed rate mortgage rate spiked by 20 basis points on Friday, May 31st, while the 10-year bond increased by only two basis points and the Fannie Mae TBA increased by only eight basis points. It first appeared to be a data error, but the pricing held on Monday and increased on Tuesday. Over this period, the 30-year mortgage rate has increased by 26 basis points, while the 10-year bond yield has increased by only 4 basis points. The Fannie Mae current coupon TBA sold off and yields did increase 22 basis points, but we didn’t see a dramatic sell off in Ginnies, and jumbos increased about 4 basis points. Since the Bankrate mortgage covers all products, the increase should have been a lot less.

Market participants are at a loss to explain what is going on. It may be that a large originator, like Wells Fargo, Bank of America, or JP Morgan, decided to pass on increased prices to their customers, which they have not passed on to their correspondent lenders. It could also be that the large originators are taking a bet on TBA pricing going forward. The odd part about it is that business is terrible for mortgage originators, given that we have seen the MBA mortgage applications index fall 19% in two weeks. The refi index is down 25%. Given the drop in applications, you would expect banks to become more aggressive on pricing.

Implications for mortgage REITs

The drop in Fannie Mae TBAs is large, even though it doesn’t explain the spike in mortgage rates. Agency mortgage REITs, like Annaly (NLY) and American Capital (AGNC), will certainly take mark-to-market losses on their portfolios of agency securities. The REITs that focus on adjustable rate mortgage backed securities, like Capstead (CMO) and Hatteras (HTS), should perform a little better. If the increase in rates sticks and origination margins increase, originators, like PennyMac (PMT), will benefit.