Saturday, December 27, 2008

Why Mortgages Are Expensive Compared To Treasuries

Why are current interest rates on 30-year mortgages so high given that 10-year treasuries are so low? In effect, the current difference in the interest rate of 30-year mortgages and 10-year treasuries is more than double its normal and historical average. 30 yr mortgages are normally compared to 10 year treasuries because both the duration and the average life of a 30 year mortgage is closer to 10 years then 30 years, making the spread over 10 year more appropriate then 30 yr. It is currently about 3 percent or 300 basis points.

Mortgage spreads over treasuries contain at least two components. One is the risk of default, including the risk that the collateral for the mortgage, i.e. the house will decrease in value below that of the mortgage amount.

The other is the cost of an implied option right that gives the mortgagor the ability to prepay the mortgage before the 30 years through sale, refinancing or through additional principal payments. The cost of the option is borne by the mortgagor through a higher spread since it is the mortgagor who owns and pays for the right to prepay.

The two work in opposite direction. The longer one expects to continue to pay a mortgage, the greater the risk of default and the higher the spread. The increase term increases the likelihood that the mortgagor will encounter economic difficulties, such as a job loss, unexpected large medical or other expenses, or a significant decrease in home value, etc. In the first 15 years of a mortgage, about 70 percent of the principal remains and after 20 years, almost half the mortgage principal remains.

The longer one initially expects to reside in the home and pay the mortgage, the less one is willing to pay for the option that gives right to prepay in the early years and this will decrease the spread.

The above average spread of mortgage rates over treasuries can mean either of two things. It can mean that the average life of new 30-year mortgages will be significantly less than 10 years and people are willing to pay a premium in the spread for the right to do so. It can also mean just the opposite, that people are expecting to stay in their homes way beyond ten years and that the average life of a mortgage will be significantly more than 10 years with a higher chance of default that historical average spreads suggest.

Both a longer term with a higher chance of default and a willingness to pay a premium for the right to prepay early for a shorter term will increase mortgage spreads above historical averages over treasuries. People who have worked in mortgage finance computing option adjusted spreads for mortgages could probably compute which effect is the dominate one in the current environment.

Any action the government takes to attempt to decrease the current mortgage spread must either decrease the risk of default on longer-term mortgages or decrease the cost of the likelihood of early payment of mortgages without interfering with people’s ability to refinance or move.

In either case, guaranteeing the GSEs debt with the full faith and credit of the US or having Treasury borrow on their behalf as Nobel prize winning economist Paul Krugman recommends in his December 26, 2008, NY Times article will not do the trick. His solution most likely will not impact the underlying factors that make up the mortgage spread over treasuries.

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