In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi examine why mortgage rates have drifted higher by breaking down the components of the spread between the average 30-year, fixed mortgage rate and the 10-year U.S. Treasury yield, explaining how each component is contributing to rising mortgage rates.

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Listen to the REconomy Podcast™ Episode 71:

“It's possible that the spread will decrease when the Fed finishes its monetary tightening, which could be in the coming months, and that will give investors some more certainty. And so the prepayment duration risk issue is less there. And, if the spread narrows, the mortgage rate will come down, even if the benchmark 10-year Treasury stays the same. But the duration risk will remain as many homeowners are so rate-locked into such lower mortgage rates. I mean, that's not going to go away. And it's less clear when the Fed may start lowering rates again. They may stop, but that's not to say that they will reduce them.”  – Mark Fleming, chief economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 71 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark, we're going to try something a little bit different to start the episode. Before we jump into our main topic, I want to talk about a headline that recently caught my attention.

Mark Fleming - Hi, Odeta. We talk a lot about the headlines that we read when we're doing our research for these podcasts as well as in general. So I'm intrigued. Which headline are you talking about?

Odeta Kushi - Nothing other than house prices?

Mark Fleming - Of course.

Odeta Kushi - I mean, it's like Fed, house prices, mortgage rates, you know, those are the main ones. But, specifically this headline was highlighting the year-over-year decline in house prices, which is true on a year-over-year basis. House price appreciation, according to the S&P Case Shiller HPI, officially turned negative in April and into May. But...?

Mark Fleming - Ah! There's more to it, then that. As with all headlines, the year-ago comparisons increasingly reference the house price peak of last summer. On a month-over-month basis, however, house prices have been re-accelerating for the past four months increasing 0.2% And 0.4% in February and March respectively. And 0.6% and 0.7% in April and May. It's as if we've gotten to the bottom of the roller coaster hill and we're heading up another one.

Odeta Kushi - That's right, the year-over-year comparison misleadingly suggests prices are falling, but that is all in the rearview mirror. House prices may have bottomed out. The short supply, along with continued demand for homeownership, is driving prices higher again. And that is actually a good transition to today's topic, which is inspired by a different headline. Can you guess which one that is?

Mark Fleming - Mortgage rates or the Fed? One of the two?

Odeta Kushi - Yep, there you go. A 50% chance of getting it right. It's mortgage rates. Mortgage rates in August 2023 hit their highest level since April 2002. The average 30-year, fixed-rate mortgage increased to 0.0%, er 7.09% in the week ending August 17, up from 6.96%.

Mark Fleming - That would have been a phenomenal mortgage rate. 

Odeta Kushi - Yeah, everyone lock in your 0% mortgage rate. Yeah, I'd be jumping into that. Now, the last time rates were over 7% was in November of last year. So, in this episode, we'll discuss mortgage rates and specifically why the spread between mortgage rates and treasuries remains elevated.

Mark Fleming - And remember that higher rates have a dual impact on the housing market. They obviously reduce affordability for buyers, but they also strengthen the rate lock-in effect and the lack of desire to sell for sellers. 

Odeta Kushi - Yeah, either way you look at it's not a good news headline. But forecasters for some time have been saying that mortgage rates were expected to head lower in the second half of the year. In fact, consensus forecasts in the industry still expect mortgage rates to come down to just over 6% by the end of the year.

Mark Fleming - I still think that's optimistic.

Odeta Kushi - I would agree, unfortunately. But it's also notoriously difficult to forecast mortgage rates because they're loosely benchmarked to the 10-year Treasury yield, which is often known as the risk-free benchmark for financial transactions worldwide. U.S. bonds backed by the full faith and credit of the U.S. government are widely considered the safest investments in the world. Global demand for U.S. Treasury bonds cause their price to go up and down and their yield to change with it. When the 10-year Treasury yield falls, mortgage rates follow suit and vice versa. And we know mortgage rates are tough to forecast because lots of things impact the global demand for U.S. Treasury bonds, economic events, geopolitical events, wars, inflation and more.

Mark Fleming - And collectively, that grab bag of things that we really don't know how to forecast is why rates picked up in mid-August. 

Odeta Kushi - That's right. 

Mark Fleming - The economy continues to perform better than expected, boosted by, of all things, consumer spending, investors were reacting to the Federal Reserve's meeting minutes, which indicated that members are still worried that inflation will stick around for longer than expected, aka not transitory. At any other time, that's good news. But wait, sorry, not the inflation part, but the consumer spending part is good news. But when fighting inflation, that's a different headline.

Odeta Kushi - So true. Investors are afraid that the Federal Reserve will need to keep rates higher for longer. That puts upward pressure on treasuries and mortgage rates followed suit. But the spread between mortgage rates and treasuries is still higher than average. Right?

Mark Fleming - That's right. We talked about this in Episode 64, but it bears repeating. Since 1972, the 30-year, fixed-rate mortgage has on average remained 170 basis points, or 1.7% percentage points, higher than the 10-year treasury bond yield. That spread, if you will, as of mid-August was 2.9 percentage points, or 290 basis points. In other words, mortgage rates are very high, abnormally high relative to the benchmark 10-year Treasury yield.

Odeta Kushi - And we did talk a lot about why mortgage rates are higher than treasuries in Episode 64. But what it really boils down to is that the spread between the 30-year, fixed-rate mortgage largely reflects the risks associated with investing in mortgage-backed securities, otherwise known as MBS. 

Mark Fleming - And this is where we get to this episode. What exactly are those risks? We can take it a step further. We break down the mortgage spread into three components, the primary spread, the secondary spread, and the demand-related effects. The first component of the spread, the primary, reflects the cost of mortgage issuance. Easy enough.

Odeta Kushi - The second component is what we covered in Episode 64. It's related to prepayment risk, and its impact on duration and credit risk.

Mark Fleming - And the third component is associated with the changes in demand for mortgage-related assets. So how badly do people want to buy mortgage-backed securities?

Odeta Kushi - I think it's worth going through each one of these, but the easiest is the last one you just mentioned. So I'm going to start with the easiest one.

Mark Fleming - You always take the easy ones.

Odeta Kushi - And I mean, that one is easy, because I think it's been in the headlines quite a bit over the last several years, right? The Federal Reserve over the pandemic was a large buyer of mortgage-backed securities in the secondary market, which generated demand that increased MBS prices and lowered yield for investors. This resulted in lower mortgage rates, strong demand for MBS bids up the price and reduces the return the MBS investor receives. So, the spread between the mortgage rate and the 10-year Treasury yield decreases. Now that the Fed has backed out as a buyer of MBS, there's less demand that has contributed to the reverse, an increase in that spread. So that component is pretty straightforward. What about the secondary component?

Mark Fleming - And this is what we talked about in episode 64. But we will repeat it here. One difference between U.S. Treasury bonds and mortgage-backed securities is that the U.S. Treasury doesn't pay any principal. Until the treasury bond matures, the investor gets paid interest for the term of the bond and then the principal value all at once when the bond finishes or ends. However, MBS work a little bit differently. Homeowners pay principal and interest every month and have the option of course to refinance their mortgage or sell their homes at any time and pay off the entire loan or the entire principle. That principle is passed through to the investor. And, in the event of a loan payoff, the investor receives the entire principal and stops receiving the interest payments associated with that paid off loan. It's as if the mortgage-backed security is shrinking over time. But the problem is that when you buy the MBS, you're not sure exactly how quickly that will happen. This is called prepayment risk. And when rates are changing quickly, and it's not exactly clear what the outlook is in the near term, it's really difficult to know how quickly or slowly that mortgage-backed security will shrink over time.

Odeta Kushi - So investors need to be essentially compensated for that risk relative to the risk-free alternative. Now the duration of the MBS is tied to this prepayment risk. The faster the prepayments, the more quickly the principal is paid back, and the shorter the duration of the MBS. The slower the prepayments, the longer the duration. The duration of an MBS tends to increase in a rising interest rate environment, as there's less incentive for borrowers to move or refinance. We're seeing that in today's market. 

Mark Fleming - You don't say? 

Odeta Kushi - Yeah, I mean, not a lot of refinances happening right now. The prepayment rate of the underlying mortgages typically slows down, which extends the life of the MBS and increases its duration. As a result, the spread between the mortgage rate and the 10-year Treasury yield may increase because the MBS investors require more compensation for the increased duration.

Mark Fleming - And then, of course, there's the related cousin of prepayment risk called credit risk. Credit risk is associated with the risk of a default on those mortgages. At any point, a borrower can fail to make a payment on the mortgage underlying an MBS. And all of a sudden that principal and interest isn't being passed through anymore. From the perspective of an investor in a mortgage-backed security, the implications of a default depend on whether the MBS is in an agency or non -agency. Agency MBS, which are the ones issued by the GSEs and FHA through Ginnie Mae, promise full and timely payment of principal and interest. So there's really no credit risk to the investor who buys agency MBS. Their focus is purely that prepayment duration risk issue. But, if not, then the investor also needs to be compensated in that secondary spread for the possibility that they won't get all the principal back.

Odeta Kushi - So, in other words, when a borrower defaults, the agency issuer pays the principal to the investor anyway. That basically ends up being a prepayment event for the MBS investor. However, for non-agency MBS, investors bear the credit losses from a default. Did I get that right?

Mark Fleming - That's right. All right. So prepayment and duration risk all fall under the secondary component of the spread. That secondary market component is the reason for the bulk of the increase in the overall mortgage spreads since the beginning of 2022. So everyone's sort of realizing there's either the credit or prepayment risk. There's more of that out there. The last, but certainly not least, though, is the primary component, which has historically been more stable, but the trend over the last decade has been ever-growing higher.

Odeta Kushi - Well, we're through the wonkiest part of this conversation, which is great news. The primary component is essentially just the cost of issuing a mortgage and it includes things like the annual G fee and upfront G fee, which is also known as the low-level price adjustment or LLPA, the servicing fee and the lender revenue at the time of the loan sale, or the lender gain on sale. Okay, I just heard myself. I don't think we're through the wonkiest part.

Mark Fleming - I was gonna say that that sounds like the wonkiest part.

Odeta Kushi - Yeah, I just heard myself say it out loud. I'm like, oh, no. 

Mark Fleming - G Fee, LLPA, gain on sale. That's a lot of mortgage lingo. Odeta, can you please describe it in less technical or wonky terms?

Odeta Kushi - Yeah, that's a good point.

Mark Fleming - Ooh, a little more mortgage points, humor, I see. I see.

Odeta Kushi - I just had to sneak one in there. So the mortgage rate paid by a borrower is split every month to pay the loan servicer for doing all the work, like collecting monthly payments and making disbursements. It's also making interest payments to the MBS investor. And, of course, you've got to pay the GSE. And any remaining part of the borrower's interest payment is oftentimes converted to a one-time source of revenue to the lender as part of selling the loan. That's what we call a gain on sale.

Mark Fleming - So the basic equation for a mortgage rate would be mortgage rate equals MBS rate, plus servicing fee, plus GSE G fees, plus lender gain on sale.

Odeta Kushi - I totally forgot we had math in the second conversation when I made the commitment that the wonky part is over.

Mark Fleming - It's only addition. It's pure addition.

Odeta Kushi - Exactly. So it's like third grade math. That's okay. So, can these be quantified?

Mark Fleming - Well, thank you for asking. There's actually a paper from Jaclene Begley and Mark Palim entitled, "Mortgage costs as a share of housing costs, placing the cost of credit in a broader context." And this paper quantifies and breaks down these individual cost components. Definitely worth the read. But obviously not something we're going to go into great detail here. And because we've already done the wonkiest part of this podcast episode.

Odeta Kushi - As I keep promising. Okay, so we've gone through all of the factors that make up the spread. I think the secondary component has been the largest contributor to the abnormally high spread most recently, but there has been a longer term trend in the growth of the primary spread. But what do you expect will happen with the mortgage spread in the future?

Mark Fleming - Well, it's possible that the spread will decrease when the Fed finishes its monetary tightening, which could be in the coming months, and that will give investors some more certainty. And so the prepayment duration risk issue is less there. And, if the spread narrows, the mortgage rate will come down. Even if the benchmark 10-year Treasury stays the same. But the duration risk will remain as many homeowners are so rate-locked into such lower mortgage rates. I mean, that's not going to go away. And it's less clear when the Fed may start lowering rates again. They may stop, but that's not to say that they will reduce them. And what is the "just-right" -- I'm air-quoting here -- the just-right level for rates in this economy. So will the spread return to its historic norm of 1.7 percentage points? Or could it be something higher?

Odeta Kushi - I thought for a second there, you're gonna take us in direction of the neutral rate. And I'm like, we just promised the wonky part was over.

Mark Fleming - No wonky. That's another episode.

Odeta Kushi - That actually would be a great episode. Very interesting. So one source of certainty is helpful, but the Fed is unlikely to become an MBS buyer again, and arguably slower prepayment rates and longer duration are here to stay as you just said, Mark. We recently published a blog post, which walks through different rates, scenarios and the implications for affordability. So you can check that out on our website at  firstam.com/economics. But one of the points we make in that blog is that it's likely mortgage rates continue to hover in the 6.5% to 7.5% percent range for the remainder of the year, due to the reasons we just mentioned, which means affordability will remain a challenge for many buyers.

Mark Fleming - And, while we did say at the outset that forecasting rates is somewhat of a fool's errand. This may possibly be the new normal.

Odeta Kushi - A new normal, but really an old normal, right? Because the historical average of mortgage rates is between 7.5% to 8%. So... 

Mark Fleming - Maybe even a little bit better.

Odeta Kushi - Maybe a little bit better than the historic norm. We're gonna end on that very positive note. All right. Well, that's it for today's episode. Thank you for joining us on this episode of The REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And, as always, if you can't wait for the next episode, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2023 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.