As mortgage rates spike, a market distortion appears

As mortgage rates spike, a market distortion appears

Posted: 05 Sep 2013 08:15 PM PDT

Mortgage rates hit another high today, touching levels not seen since early 2011. We have now experienced an almost 150bp spike (over 40% relative increase) from the lows in a matter of a few months.

Something highly unusual is happening in the mortgage market however. Recently jumbo (see definition) mortgage rates have been lower than conforming rates. This is one of those market dislocations that most would have never thought possible. Yet here we are.

Source: MND

Jumbo mortgages have generally been considered riskier by banks simply because they typically can not offload them to Fannie and Freddie as they can and do with conforming mortgages. Therefore banks would charge a premium for having to tie up balance sheet.

What's driving this distortion? As the Fed prepares to reduce its purchases (which include MBS), agency MBS bonds are selling off. The latest price decline in fact has been quite sharp.

Price of 30yr Fannie MBS with 4% coupon (source: MND)

Conforming mortgages are priced based on a spread to these bonds, and therefore very much tied to the MBS market fluctuations. As the MBS market sold of, conventional mortgage rates spiked. Jumbo loans on the other hand are not financed with MBS. Flush with deposits, banks have access to extraordinarily cheap capital and are seeking to earn more interest income. Seeing stability in high-end property values in certain areas, they are more willing to take additional risk these days. Of course jumbo mortgage applicants better have top credit scores, high incomes and high down payment to qualify for these loans - a set of requirements which is often even more stringent than the conventional mortgage applicants. With willingness to deploy some balance sheet and competition for wealthier clients, banks are charging less for these loans.

Qualified applicants who are now on the borderline between a conventional and a jumbo mortgage will be incentivized to buy a larger property in order to get a lower rate. Lenders in effect are charging the same borrower less for borrowing more money. High-end properties will therefore benefit from this effect at the expense of lower-priced homes. This is yet another market distortion created through government-based housing finance, with securities in this market dominated by the Fed.