With 30 year mortgages at 3.5% I have wondered what will happen in 5, 10 years when interest rates are likely to rise back to historocal rates of inflation. Are banks hedging with interest rate swaps? What will they do if the rates go to 5% which isnt historically high?
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Agency RMBS: If rates go up a couple of things will happen: 1) existing agency RMBS will be marked down and banks or MBS portfolio managers will have realized/unrealized losses, 2) refi activity and prepayment speeds will slow down.
A slowdown in prepayments can be viewed as a negative because you want to reinvest that 3% money in a 5% market, but it is more than offset by the positive of realizing a lower premium amortization expense (given that agency RMBS paper typically trades at a premium, for example 104, you amortize that 4 dollar premium over the life of that security). Slower prepays = lower premium amortization expenses.
In terms of hedging, banks would use swaps to hedge against a rise in interest expenses associated with rising rates on short-term borrowings (borrowings that are funding MBS portfolios).
Non-agency RMBS: I think something like over 95% of RMBS issuance is agency right now, not a lot of action in the non-agency market. Very few deals happen right now (under 5 this year), and they are all jumbo, super senior/AAA, super high quality RMBS. In 5-10 years, as GSEs are being scaled back (probably a 5-7 year process and a post-election event), private capital should return to the mortgage market and this will be a positive for banks.
As for the existing non-agency RMBS, when rates rise, it will probably be due to a recovery in the housing sector and the broader economy in general. Better economic conditions = better credit performance from non-agency RMBS, as these securities have credit risk. This should also increase principal repayments (given better delinquency rates), and in turn would allow banks to record higher discount accretion (the opposite of premium amortization when you buy MBS at a premium) as well as take that money and reinvest it into higher yielding MBS. In addition to private capital filling in the gap the GSEs will leave wide open, both should be a positive for banks.
In either case, a rise in interest rates will not create "the next mortgage crisis."
^ You, sir, are awesome.
Flake, nice post but I disagree in one respect--I don't see the GSEs or gov't programs getting scaled down or pushed out by private lending materially in the next decade. I'm managing a mortgage banking branch and private capital wants absolutely nothing to do with mortgages unless they are gov't insured or meeting the standards of the GSEs, particularly since Congress in 2008 under the SAFE Act basically eliminated the meat of the profitability. Because of new regulations points are no longer charged by most lenders, and this was the source of the huge profit windfalls for lenders. Frankly, mortgage lending is just not that profitable anymore except for the very best lenders. And the paper lenders want is gov't paper--FHA, VA, USDA. Anything carrying gov't guarantees because they just don't earn enough money for the risk to be worth it. Subprime lending is effectively disallowed, and again this was one of the primary sources of private lending and MBS. I just don't see subprime lending coming back on any meaningful scale ever again, sort of like the savings and loans banks.
As an aside, I keep hearing how our clients are asking for these 3.5% 30-year mortgage rates. They don't exist as of Friday. The absolute BEST I've seen is 4.0% on a 30-year gov't product--absolute best unless it's a special deal from a builder that owns a mortgage company. You may see 3.5% 15-year rates, but 30-year rates at 3.5% note just doesn't exist unless the lender is charging you some extraordinarily high closing costs.
You're right, maybe I am a little optimistic with my timeline, but I still think it will be based on who takes the seat in the election. GSEs will be scaled down in one way or another and there will be incentives built in to attract that private capital. 5-7 years post-2012 is still a long time away and it will be a very gradual process. No one will pull the plug on the GSEs and the unstable housing market in one move. Besides, I think 2 out of the 3 options that were proposed earlier this year had a government "backstop" element to them. Don't forget that replacing the GSEs with some other entity altogether is also on the table.
Good comments on the mortgage rates. What are your thoughts on capacity? Let's say the government pushes further with the revised HARP program for example, do the big guys have the capacity to handle that much more of the refi volume (which are elevated already) or will they just start raising mortgage rates?
Banks better adjust their duration hedging. With a shitty housing market and super low rates, combined with high credit standards, refi's will be limited going forward. Can't remember exactly, but I think the average duration of a 30 year mortgage is like 7-10 years historically because of sales or refinancing. I'd imagine that being much higher.
I'm more concerned with the US debt.
Most of it is short term debt (same thing as an ARM).
When interest rates go up, how will the governement pay for the debt (interest+principal)?
o and all the banks that were saved during '08 will fail again.
This economy is on life support. The only thing keeping it 'alive' are those 0% interest rates, but at what price.
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