Why Such High Mortgage Rates?

Annualized existing home sales in the US have recently been running as low as 3.7M per year, the worst level since 1993. And that is despite the population of the United States being about 70M people more now than it was in 1993. The obvious explanation is that mortgage rates are at levels we have not seen since 2000 as high mortgage rates deter buyers due to the higher mortgage payment stream. But, high mortgage rates also deter sellers because they will need a place to live after selling their home, so immediately after a sale the seller becomes a reluctant buyer too.

One reason mortgage rates are high is that Treasury rates are high (on a relative basis). However, mortgage rates are unusually high relative to Treasury rates. The mortgage spread measures the difference between the 30-year mortgage rate and the 10-year Treasury rate.¹ The mortgage spread has averaged about 180 basis points (bps) between 1990 and the start of the Covid pandemic. However, since early 2022 when mortgage rates started climbing in the US (due to the Fed beginning its policy pivot and raising the Fed Funds rate), the mortgage spread has averaged around 310 bps. So, when home buyers in late 2023 were facing mortgage rates of 8.1%, the rate should have been 6.8% if the historical average mortgage spread of 1.8% had held.²

To understand why mortgage spreads have been unusually high, we need to break down the components of a mortgage rate.

A mortgage rate is composed of three pieces:

1. The corresponding maturity Treasury rate

2. The credit spread — compensation to the lender for the possibility of the borrower defaulting

3. The prepayment spread — compensation to the lender for allowing the borrower the option to prepay the mortgage anytime during its life.

The mortgage spread is represented by components 2 & 3 in this breakdown of mortgage rates. From 2021 onwards the credit spread, component 2, has been at record low levels. This is true for companies, but it has also been true for consumers. Consumer delinquency rates on all loans ranging from unsecured credit card loans to secured auto loans dropped to historic lows due to the “easy” money being doled out by the government during the pandemic period. So the component of the mortgage spread that is compensation for credit spreads has been relatively low.³

With the credit spread ruled out, that necessarily implies the prepayment spread has been at historically high levels and the cause of mortgage rates being so high. The prepayment spread emanates from the option that a mortgage borrower has to prepay the mortgage at any time. If we consider a mortgage as a bond that is issued by a borrower to a lender, the prepayment option allows the borrower to purchase the bond back from the lender at par value, or the principle amount of the bond.⁴ So the prepayment option is essentially a call option on the value of the bond,⁵ and the strike price of the call option is the par value of the bond. The value of this option has been at historically high levels since the start of 2022, thereby causing the mortgage spread to be high.

What is causing the value of the prepayment option to be unusually high? A call option is highly sensitive to the volatility of the underlying instrument (mortgage rates in this case) that it is written on.⁶ If we start by looking at equity implied volatility as captured by the VIX, we get a mixed picture on volatility. The average implied volatility prior to the pandemic was 16%. During 2022 and the first quarter of 2023, the average implied volatility was 18%. But from early 2023 onwards, the average has been 13%. Therefore, at first look, it doesn’t seem like the volatility of markets is having a big impact on the value of the prepayment option.

Since mortgages are just a type of fixed income instrument, we should look at fixed income market volatility rather than equity market volatility. A widely used measure for fixed income volatility is the Merrill Lynch Option Volatility Estimate (MOVE) index. The MOVE index measures the implied volatility of Treasury futures. Essentially the MOVE index is to fixed income as the VIX index is to equities. For the ten years prior to the pandemic the index averaged about 70. If we get away from the effects of the Great Financial Crisis of 2008 and look at the eight years prior to the pandemic, the index has averaged approximately 59. However, since the start of 2022, the index has averaged about 123. So, unlike what we have seen in the equity markets, the volatility in the fixed income markets has increased substantially — doubled according to the MOVE index.

So, we have our culprit: the substantial increase in the mortgage spread over the last two years has occurred because fixed income market volatility has been unusually high for the last two years. Prepayment of mortgages hurts mortgage lenders because they are forced to reinvest the prepayment proceeds into lower rate mortgages (because a prepayment usually occurs as mortgage rates decrease and existing mortgage borrowers refinance their mortgages). When interest rate volatility is high, there is a higher probability of interest rates going downward and therefore a higher probability of prepayments occurring. Mortgage lenders realize this and charge a premium for bearing the higher probability of prepayment, thereby increasing the mortgage spread.

Why has bond market volatility been so high whereas equity market volatility has been so low? Generally, one reason why volatility will increase in a market is that liquidity in that market decreases. The Treasury markets have been becoming less liquid since 2007 because banks (especially those serving as primary Treasury dealers) have been participating less in the markets due to capital regulations. For example, the main reason for the funding crisis (and subsequent repo rate spike) in late 2019 was the lack of liquidity in the Treasury markets (in combination with low bank reserve balances). Treasury liquidity improved considerably when the Federal Reserve began Quantitative Easing (QE) in early 2020. But in 2022 the Fed ended QE and began Quantitative Tightening (QT), which resulted in a plunge in Treasury market liquidity. The deterioration in liquidity has continued to today, and the resulting volatility increase along with its impact on all fixed income markets, particularly the mortgage markets, has been the most visible result to consumers and investors.

Footnotes

[1] The 10-year Treasury is typically used for this measure instead of the 30-year Treasury simply because the 10-year has higher liquidity. However, the 10-year rate and the 30-year rate are almost perfectly correlated, so when looking at the change in spreads through time, it makes little difference whether one is using the 10-year or 30-year rate.

[2] And with the 10-year rate at 3.8% at the start of August 2024, the 30-year mortgage rate should be at 5.6% instead of the 6.7% that is widely available from mortgage lenders.

[3] A way to quantify this is to look at corporate credit spreads. Average credit spreads for BBB-rated bonds were about 2.1% for the 10 years prior to the pandemic. In October of 2023, when mortgage rates were above 8.0%, the BBB credit spread was 1.5%, well below the historical average spread.

[4] Unlike a typical corporate or Treasury bond, the par value on a typical mortgage decreases through time due to the fact that principal is paid back throughout the life of the mortgage rather than at the end as a bullet payment.

[5] Or conversely a put option on mortgage rates because interest rates move inversely with bond prices.

[6] The value of an option is also highly sensitive to the ratio of the market value of the mortgage to the par value, i.e., the “moneyness” of the mortgage. However, the vast majority of new mortgages are issued at par value, and this has been the case for a long time. So, on the day of inception, the market value of the vast majority of mortgages issued has been equal to the par value, i.e., the mortgages’ moneyness are all fairly close to “at the money” or a ratio of 1. Therefore, with little variation either cross-sectionally or time series in the moneyness of mortgages, we can rule out moneyness of the prepayment option as the cause of the unusually high value of the option.