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Blog Details
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What Went Wrong Wednesday?
By
Roger Arnold
On
5/28/2009
Topics:
Convexity,Mortgage Rates
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Part 1: Convexity
Treasury yields spiked yesterday along with yields on mortgage related bond issues and mortgage rates.
Technically speaking the spike Wednesday was driven by what is referred to in mortgage bond parlance as convexity.
I will discuss convexity in more detail at a later time. In short however it refers to moves in treasury yields related to duration matching.
In the mortgage business firms funding mortgages borrow on one side of their balance sheet and lend out on the other side. The goal is to borrow money for your mortgage business to fund loans for exactly as long as the borrower from you will hold the mortgage you have provided to them.
If you think the average length of time the mortgagor (borrower) will keep the mortgage you have provided them is 5 years then you, the mortgagee (lender) want to borrow the money to fund that mortgage also for 5 years; i.e. duration matching.
If rates fall quickly and prepayments by way of refinances shorten the term your mortgage business will hold mortgages then mortgage companies buy treasuries and drive treasury yields lower.
If, on the other hand, treasury yields unexpectedly rise rapidly and refinance activity abruptly slows then mortgage companies must sell treasuries, which drives treasury yields higher.
Don’t worry of it doesn’t make sense for now. I will review with more clarity at our next get together.
Wednesday was a convexity driven day; i.e. a scramble by mortgage lenders to rebalance their balance sheet to achieve duration matching of their portfolios; not a beginning of a continuing spike in mortgage rates and treasury yields.
The big question is why this happened.
In March, at the bottom of the recent stock market depths the Chairman of the Federal Reserve, Ben Bernanke, indicated the feds willingness to force lower mortgage rates into the market to support housing.
The FED does this by way of what is called quantitative easing. QE, in short, is when the FED “prints” money and then uses it to buy up US Treasuries that are circulating in the public markets.
As the FED buys up the treasuries the yields fall and mortgage rates are dragged, forced down.
The markets perception of what the Fed was targeting was a ~4.5% 30 year fixed rate mortgage in the near term.
Although the FED never indicated an exact mortgage rate it was targeting it also did not dissuade the markets from this perception.
The markets overall and the bond markets and mortgage business’s specifically took the FED at its “word” and prepared their business’s financials for such activity.
Then the Treasury yields started to steadily increase. Nobody worried about it at first because mortgage rates remained stable as confidence came back into the markets and spreads began to fall; i.e. even though treasury yields were rising, mortgage rates weren’t.
This is because the markets were convinced that the FED would step in to control the rise in Treasury yields by way of QE when treasury yields exceeded ~3%.
This expectation by the markets also went unchecked by the FED. The FED instead allowed the markets to believe they were there to back stop any risk of rising mortgage rates.
As, over the past few weeks however, treasury yields began to rise above 3% with no indication from the FED that they would step in to stop the increase mortgage lenders began to get worried.
That worry finally burst on Wednesday as the bond markets and mortgage businesses became convinced that the FED would not step in to control Treasury yields from rising further, and a panic to cover ensued; i.e. a “convexity run”.
So, why did the FED turn its back on its implied promise to the markets?
…to be continued
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