The US mortgage market is broken.

By Tracy Alloway and Joe Weisenthal

(Bloomberg) — To understand the highest mortgage rates in two decades, look to the intricacies of the market for bonds backed by home loans.

So says Guillermo Roditi Dominguez, managing director at New River Investments LLC. On the latest episode of the Odd Lots podcast, he describes how the surging cost of home loans can be traced to changes in the market for mortgage-backed securities, or MBS. The average rate on a 30-year fixed mortgage jumped above 7%, according to data released on Wednesday. That’s the highest since 2001.

Of course, mortgage rates are supposed to rise as the Federal Reserve hikes benchmark interest rates. That’s how tighter monetary policy works — by making the cost of credit more expensive. But the average borrowing cost on a 30-year fixed-rate mortgage now far exceeds the yield on equivalent US Treasuries, with the difference between the two at the highest level on record.

At issue is the changing nature of the market for mortgage bonds, and who’s buying them. Once the center of the housing bubble that burst in 2008, the vast majority of mortgage-backed securities come with guarantees from the US housing agencies, meaning investors aren’t necessarily worried about people paying back their loans. Yet their exposure to movements in US interest rates (known as “duration”) means they can still carry significant risks for investors.

“It’s not because people are afraid house prices are going to go down,” Dominguez says. “Mortgage-backed securities went from being effectively short-lived assets because we went through a pretty epic refinancing boom in 2020 and 2021, to all of a sudden rates going up very, very, very quickly — faster than anybody expected.”

Most buyers of MBS — which range from big banks to bond funds and the Fed itself —  understand there’s a risk of early repayment. People might refinance their home loans during periods of low interest rates, or simply move and sell their house. Dominguez estimates that some 17% of home-loan balances were extinguished in 2019, compared to 36% in 2020 and 2021 as the Fed pushed interest rates to historic lows.

Mortgage refi activity exploded in early 2020, when rates were cut to basically zero. 

In times of low rates, MBS investors who get their loan principal paid back early have to reinvest that money at potentially lower yields. But the transition from low rates to higher ones means that suddenly investors are left with longer-term assets, as borrowers hold onto the lower mortgage rates they locked-in previously. In times of higher interest rates, early repayments disappear and investors don’t have as much money to invest at higher yields.
That means many buyers are shying away from the mortgage market, which Dominguez describes as “broken,” even as spreads go higher. Adding to the pressure on mortgage rates is the fact that the Federal Reserve is now reducing its balance sheet after buying the debt as part of its emergency monetary easing.

“A mortgage-backed security is essentially similar to a covered call in equity terms,” Dominguez says. “And that means that you have all of the downside and, you know, very, very little of the upside and you trade that in for a little bit of extra coupon. And when rates were going down, everybody was upset about it because Treasury bonds were going up in price. People were making money there. If you held MBS, you got your money back and then when you went to buy new bonds, you bought them at a lower yield. And right now what we’re seeing is all of a sudden bond prices are going down, yields are going up and you’re not getting any cash flows so you don’t get to reinvest that money.”

But mortgage purchase and refi applications are showing a strongly negative trend as The Fed tightens.