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Illustration by Joel Arbaje
US homeowners are among the unexpected beneficiaries of fears of a slowdown in global growth that are contributing to a fall in mortgage interest rates. A wave of mortgage refinancing aimed at reducing interest charges will increase household cash flow and support consumption.
Investors should, however, pay attention to how refinancing, Federal Reserve policy and the technical characteristics of the bond market could interact to generate increased volatility in bond yields.
At 3.6%, the interest rate of a typical 30-year fixed mortgage is now at its lowest level in nearly three years. From the beginning of 2017 to the end of June, mortgage rates averaged 4.3% on average. As late as November, new borrowers had to pay 5% to borrow a house.
The precipitous fall is expected to have a significant impact on refinancing activities. US households have mortgage debt of about $ 9.4 trillion, of which just over half is in the form of conventional mortgages that meet the standards established by
Fannie Mae
and
Freddie Mac
.
More than 90% of these 30 year mortgages have an interest rate higher than the current market rate.
All of these borrowers will not refinance – the prepayment of a mortgage loan by another causes problems and closing costs – but many of them will likely do so. The low estimate comes from analysts at Black Knight, a mortgage research company, who estimate that about 10 million mortgages would be eligible for refinancing, based on the current market rate (3.6%), interest rates. interest on existing mortgages (at least 4.25%), credit score (greater than 720) and loan / value ratio (below 80%). If market rates were to fall to 3.4%, Black Knight estimates that the number of potential refinancing candidates would increase to 13 million. Mortgage rates of 3%, which would represent a sharp drop from current levels, would result in 20 million applicants for status rei.
The methodology of Black Knight is conservative. Evercore ISI analysts performed the same simulation, but excluding credit score and LTV ratio. In their view, today's low interest rates mean that close to 31 million mortgages could be refinanced. Strategists at
Goldman Sachs
think that nearly 70% of all 30-year-old conventional mortgagors – about 36 million borrowers – are currently "in the money" to refinance, although they will not all do it.
The economic impact would be perceptible in one or the other of these scenarios. According to Freddie Mac, households that refinanced from April to June, when mortgage rates averaged 4 percent, had already saved about $ 140 a month, or about $ 1,700 a year. For comparison, the typical American homeowner with a mortgage spends $ 5,300 a year on groceries. Evercore estimates that the average borrower could save about $ 4,560 a year by refinancing it in a new mortgage at 3.5%.
All of this could have a significant impact on the bond market, as yield changes and mortgage refinancing activities are growing in their own right. The reason is that mortgage bonds have an unusual link with interest rate risk. Given that borrowers are replacing existing mortgages with new ones as soon as they choose to refinance or move, the term of a mortgage bond tends to shorten when interest rates fall and get longer when they increase. (This means that mortgages have a "negative convexity".)
An investor seeking to obtain a consistent exposure to interest rate risk must therefore hedge any mortgage position by buying and selling interest rate swaps. When rates fall and advance payments increase, bond investors tend to buy additional exposure to long-term interest rates. This tends to lower mortgage rates.
Once the wave of refinancing is over, investors will deleverage and eventually move to the sale of swaps, which will cause a surge in long-term rates. The classic example is that of the summer of 2003, when the 30-year mortgage rate jumped by 1.1 point in about six weeks. This dynamic may have also exacerbated the "cone crisis" of mid-2013.
This time, the Fed could amplify the vortex of convexity. The central bank began to reduce the size of its $ 1.8 trillion mortgage bond portfolio in October 2017. Its plan was to let bonds mature and reinvest capital in the US Treasury debt, where "gradually" meant less than $ 20 billion in principal and month payments. Any payments in excess of this $ 20 billion threshold would be reinvested in new mortgage bonds.
The recent rate cuts and the related refinancing boom have forced the Fed to return to the mortgage market in an unexpected way. The Federal Reserve Bank of New York, which is responsible for all transactions, will purchase $ 5.3 billion of new mortgage bonds from August 14 to September 13 – from zero until mid-April to the end of April. mid-May.
Additional purchases by the Fed could narrow the gap between mortgage bonds and the swaps used to cover them. This could further reduce mortgage interest rates, encourage increased refinancing and further reduce long – term interest rates, until the process reverses.
If you have a mortgage, you may want to get the refi documentation now.
Write to Matthew C. Klein at [email protected]
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