Why Are Mortgage Rate Spreads So High Right Now?

In case you haven’t heard, the 30-year certainty is once again in excess of 7% by at least some accounts.

Mortgage rates have risen steadily over the past few weeks, after settling at around 6.5% in early May.

At the same time, the spread between the 30-year fixed and 10-year Treasury yields has widened to levels above historical norms.

There is always a premium on mortgages versus government bonds because the latter are guaranteed to pay back.

But the gap between the two is now nearly double the average, which begs the question, why?

Correlation Between Mortgage and 10-Year Treasury

First things first, let’s discuss why there is a correlation between the 30-year mortgage and the 10-year Treasury to begin with.

Without getting too complicated here, mortgage-backed securities (MBS) and 10-year Treasuries are common investors share.

After home loan funds, they are typically bundled and resold as mortgage-backed securities (MBS).

While these mortgages typically have 30-year loan terms, which is triple the time of 10-year bonds, they are often paid off much quicker.

This is due to a variety of factors, whether it’s a mortgage refinance, a home sale, or paying off the mortgage early.

Long story short, the average mortgage only lasts about a decade, making it a pretty good match duration-wise for the 10-year Treasury.

However, investors demand a premium for taking on the risk of a mortgage-backed security versus a government bond, as seen in fred graff Above.

The red line is the 10-year Treasury yield and the blue line is the average 30-year fixed rate.

This is represented by the risk spread, which has historically been around 170 basis points above the 10-year bond yield.

MBS investors earn higher returns because of things like payment defaults and foreclosures.

Mortgage rate spreads are almost twice their historical norm

Lately, investors have been demanding very high compensation for taking on the risk of MBS.

The current spread has widened to around 325 basis points over the 10-year yield.

This morning, the 10-year yield was hovering around 3.73%, while the 30-year fixed was hovering around 6.98%. mnd,

Simply put, MBS investors are required to pay almost twice the premium to take on the risk of a mortgage versus a government bond.

So instead of seeing a 30-year fixed rate of 5.5%, potential home buyers are facing mortgage rates in the high 6s and even 7% range.

Clearly this is reducing affordability and pushing a lot of potential buyers back on the fence.

This brings up the next logical question; Why is there so much spread now?

The increased risk aversion and uncertainty have increased the spread

There are several reasons why mortgage rate spreads are so high compared to Treasuries at this time.

But they all have to do with too much risk and uncertainty.

Remember, government bonds are guaranteed to be paid back. And their period is also off. If it is a 10-year bond, it is paid back in a decade.

In contrast, MBS are not guaranteed to be paid back, nor are their periods set in stone due to early repayment, home sale, default, etc.

While this uncertainty is always present, the recent banking crisis has made MBS investors even more perplexed.

If you recall, the banks that went (First Republic, for example) had term mismatches, where they held a lot of long-term debt at very low, fixed interest rates.

Meanwhile, depositors demanded higher yields on their cash, causing a liquidity problem when they pulled their money out en masse.

The underlying problem is that mortgage rates today are much higher than they were a year or two ago.

We’re talking interest rates at 6-7% versus rates in the 2-4% range earlier. This means that mortgages with lower rates are likely to last longer.

An extended tenure is great when interest rates are high, but clearly not a good thing when many savings accounts now offer 4-5% returns.

At the same time, there is an assumption that many of the new mortgages set at 6-7% will be relatively short-term.

So investors are not going to pay a premium for the underlying bond, only to be paid for it in a year when mortgage rates cool down to, say, 5%.

Overall MBS investors are demanding higher returns. And because the Fed is no longer a buyer of MBS, overall demand is down.

(picture: K,