Why Mortgage Rates Went Up After the Fed's Big Cut

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2:08Hello and welcome to another episode of the Odd Lots podcast. I'm Traci Alloway. And I'm Joe Weisenthal. Joe, have you noticed mortgage rates recently? Yeah, they've been up. In fact, we're recording this October 16th. Mortgage rates have been rising. And in the last couple of weeks, mortgage applications, according to new data out today, have been down. Refi applications have been down. And of course, it's all ironic because we got that rate cut. Yeah, that's right. So benchmark rates have been cut by 50 basis points. So we've moved to like 5 % from the 5.5 % on the upper bound. That happened on September 18th.

2:47But since then, as you point out, mortgage rates have actually gone up. So I think we've moved from like 6.6 % on the 30-year to something like 6.9 % as we're recording this. We were very close to 7 % last week. And just intuitively, that is not what you would expect to see happen when benchmark rates are getting cut. All right. I don't want to ever insult fellow colleague, or not colleagues, but other people in the media and actually have no basis for this. But in my mind, there are a bunch of explainers out there on the Internet is like, what do Fed rate cuts mean for you? And someone put a bullet in there that said, oh, they mean lower mortgage rates and stuff like that.

3:30And obviously, there's a connection between Fed rates and what people pay for a 30 year fixed rate mortgage or some other flavor of mortgage. But it's clearly not. There's reasons why it's not one to one. And there's nothing mechanical about the day the Fed cuts rates that suddenly borrowing costs for homeowners drop. Yeah, that's right. And this actually came up in our interview with Chicago Fed President Austin Goolsbee talking about what is the impact of rate cuts on the overall economy? And he talked about how everyone has a fixed rate mortgage now. And so that doesn't necessarily feed through.

4:05But I guess it does pose some existential questions for monetary policy transmission. Like if the benchmark rate was a person, it would be that guy like pointing at himself in the mirror, criticizing his own irrelevance, I guess. Anyway. That's interesting. I wasn't sure where we were going with that, but that's interesting. That's just what like springs to mind. You know what I don't get? I mean, I kind of get it because we've done episodes on mortgages, but like most mortgages in this country are backed by the U.S. government or Fannie and Freddie implicitly and now more or less explicitly, like, why can't we all just get mortgages at like the 10-year rate or the 30-year rate?

4:42You know, like, seriously, if the government can borrow at the 30-year rate and the government is backstopping it, why don't we just all get those same prices for a mortgage? I know there's reasons, but still, I'm not, I need to be reminded what they are. Okay, so this episode is going to be all about why Joe can't get a mortgage at 4 % at the 10-year rate. We are going to answer that question. And I'm very happy to say we do, in fact, to have the perfect guest for this episode. We're going to be speaking with Tom Graff. He is the CIO of Facet, which is a financial planning firm and currently has$4 billion under management.

5:16But perhaps more importantly for the subject, he was a bond portfolio manager for many, many years. And when he started out in finance, he was actually in mortgage bonds. So he's going to walk us through the sort of mortgage bond ecosystem and all the maths that goes into producing the final rate. I can't wait. I've followed Tom on Twitter for a long time, one of my favorite follows. So I'm really excited to actually be talking. Yeah, we finally got him on. Perfect guest for the perfect topic. Okay, Tom, thank you so much for coming on Oddbots. Thanks for having me, guys. Big fan of the show. Glad to finally be on.

5:52So I kind of alluded to it in the intro, but why don't you give us a rundown of your expertise? Why are we talking to you? Yeah, mortgage-backed securities. MBS. Yeah, so as you mentioned, my first job as an analyst, I was a mortgage bond analyst. So traded mortgages, analyzed mortgages, decided what went in the portfolio, that sort of thing. Then I graduated being a portfolio manager and I ran a general bond fund, but also ran a mortgage-specific fund, which was a five-star fund for a while. And now I'm at Facet. I'm the chief investment officer, so I oversee all things investment. But as a planning firm, we're on the other side now.

6:26We're helping people decide, well, it's now the right time to refinance. Now the right time to buy a house, that sort of thing. So I've kind of seen mortgages from all angles. And I've been at this 25 years. So I've seen a lot happen over that time. So we're going to really dive deep into this. But big picture, I actually, I don't want to get too much into the details on the podcast. But I actually have to refinance a mortgage in a couple of years. I could do it today, I guess, but I have to do it at some point. All right. government 30-year yields are 4.3%, 4.32 % as we're talking right now. I'll probably want to get a 30-year fixed.

7:01Why can't I just borrow at 4.32 % if the government is already backstopping it? Well, so the key difference between a mortgage bond and a treasury bond is that in the United States, virtually all mortgages and all the ones that Fannie Mae and Freddie Mac back can be refinanced at any time without any penalty. Can I just promise not to? No, I guess because I could always sell the house or something like that. Yeah, you can't do that, Joe. And so from an investor perspective, right, what that means is if interest rates rise, no one refinances. Everyone just stays where they are. Witness all the people kind of stuck in two and a half, three percent mortgages right now, right?

7:35And so those mortgages just stay outstanding and they might stay outstanding for 30 years for all we know, right? Whereas if interest rates fall, you kind of don't get any of the benefits. So if I buy a 30-year treasury and interest rates drop, I could make 10, 15, 20 percent price appreciation as that happens. But in a mortgage bond, if interest rates fall, everybody just refinances. I just get all my money back at par. I'm no better off. And so you got to get paid for that. What we'll get into it, but what's called negative convexity. You've got to get paid for that risk. And that's why there's a spread between mortgage bonds and treasury bonds.

8:08That was perfect. I get it now. So who is actually buying mortgage bonds? Because I think this is going to feed into the discussion of like the spread, the yield difference between the 10 year and something like the 30 year mortgage rate. Who's buying? Yeah. So it's kind of everybody that plays in the bond market, but particularly those that play in the high, high quality part. So as you mentioned, Joe, this whole market is more or less government backed. And so kind of the same buyers who are buying a lot of treasury bonds are probably buying a lot of mortgage bonds. So that particularly goes to banks and financial institutions.

8:41They get favorable capital treatment versus corporate bonds or something else. So it's kind of the highest yielding thing they can buy that has good capital treatment. And then money managers are certainly buying, particularly ones that are focused on kind of a general bond benchmark. It's about 30 % of the Bloomberg aggregate. And then you also have a lot of mortgage REITs. So it's an asset that's easy to leverage. And so there's a lot of players there as well. Tracy, I heard a rumor. Uh-oh. And I can't say any, I'm going to be very vague about this, But I recently heard a rumor that there was some sort of a meeting and there were a lot of economists there.

9:18And I can't say any more details about what it was, but that actually there is still a widespread misconception, even among professionals who should know this perception that banks have gotten out of the mortgage space. That after 2008, 2009, it all sort of went to what people call non-bank lenders or other asset managers, et cetera. But banks, according to what you're saying, are still huge holders of mortgages. And then I guess what's going on with bank balance sheets, et cetera, really do matter. Joe, that is so cryptic. You make it sound like you were at Bilderberg or something, like some big top secret meeting.

9:51I'm not going to say anymore. This was third hand. Well, so to answer your question, I'm not insulting anyone. No one can hear this as, oh, this was me. But I'll tell you the meeting. I don't know what. Yeah, no one knows. With no comment on what Joe might be getting into in his off hours. Yeah, look, I think banks have always been big players. Now, the degree to which they buy depends on a lot of things. So what else could they do with that capital? Is there more efficient ways to use that capital? And in particular, right now, the fact that the yield curve is so flat does make it a little tricky, right?

10:23So banks, their whole game is get in capital at deposit rates, right? And you guys have done a couple shows on how deposit rates have been rising. And then buy something, you know, whether it's lending or securities that yield more. And the closer those are, the less that makes sense. And mortgages, there's higher yielding things they could do. So making a normal commercial and industrial loan is going to have a higher yield. And so I think in a flatter curve, just a little trickier for banks to be big buyers. But still, in the scheme of things, there's still big players in the mortgage market for sure.

10:53So talk to us about what goes into producing a mortgage rate. So if I want to buy a house and I go to a bank and I ask for a mortgage, what are the individual factors that go into the number that eventually gets quoted back to me. Okay. Yeah. So let's assume for sake of argument, this is a loan that conforms to Fannie and Freddie standards because that's the ones we're talking about here. Okay. So assuming that, right, your bank has to pay Fannie or Freddie a guarantee fee. Okay. So that is the G fee. The G fee. Exactly. And that is based on your credit situation. So how much you're putting down what your credit score is, that sort of thing.

11:33But it's all algorithmic. So they're just typing into a computer, Fannie and Freddie's kicking back, here's the rate, right? Then they're also going to think to themselves, okay, well, where can I sell this mortgage, right? What price am I going to get when I sell it in the open market? And that depends mostly on just what the general price is for the going rate for mortgages. But it might depend a little on your situation. So we can get into how certain kinds of mortgages command a bit more of a premium in the market than others. And that will go into the rate you're going to get quoted. And so every night the bank's mortgage desk is sort of plugging in, hey, for more, it's like this, we'll offer this rate for more like that.

12:09We'll offer this rate. And all these factors are going into that. So when your loan officer is typing this into his computer, that's what's spitting out, right? Actually, let's back up. What makes a mortgage conforming versus nonconforming? The biggest thing is the price. So the price relative to used to be a hard number, but now Fannie and Freddie do it relative to your sort of MSA or your area. So wait, above a certain price, can you go into that a little further? Above a certain price, Fannie and Freddie just won't back. Yeah, they're just not backing it. And that has to do with their mandate from Congress to be about affordable housing.

12:41Got it.

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14:16And by a number, I mean kind of any number. You can have a dozen mortgages in a pool. you could have 100 ,000 mortgages in a pool. And so, but they'll pull them together. What they're gonna try to do is just get best execution like any other trade that you do in any other market, all right? And the way they're gonna get best execution is by grouping the loans together that command a premium, all right? So let me give a, for instance, that is apropos to Joe's refinancing situation. If you're in New York, if you have a pool that's all New York loans, that's gonna get a premium. And the reason is because in New York, this transfer tax makes refinancing more expensive for a New Yorker.

14:54So New York loans refinance slower than all the other loans. And so what we call that in the mortgage business, call protection. So if for every basis point decline in rates, a New York loan is going to pay a little slower, and that tends to be advantageous to the investor. So they're going to take all, if they've got 30 New York loans and 30 Oklahoma loans, they're not going to pull them together because that would waste their money. They're going to put all the New York loans in one loan and get a premium for those and just sell all of the Oklahoma ones at the kind of generic rate. That's interesting.

15:25So if I'm a buyer, I pay a little bit more for New York loans because of that less sensitivity to the refi. You know, I was thinking, so again, I'm not trying to get too into my personal finances, but I remember around 2023 and mortgage rates hit 8%. And a lot of things that people were saying, including like mortgage brokers who call you on the phone or whatever, right after you enter into some website, like, oh, don't worry about the high rates. You just refinance in a few years. And I, you know, I'm very EMH brain. So I'm thinking like, well, if everyone is already planning on refinancing in a few years, then there probably isn't going to be the great refinance opportunity because not everyone can just take that free lunch.

16:07You know, when it was 8 % and everyone's like, yeah, I'm just going to refinance though in a few years. So it'll be fine. Does that sort of like factor into the math of how much premium the buyer demand. Yeah, I think it really did. And let me give a very specific example. So right now, the spread between the 10-year treasury and the mortgage rate is relatively large. And I'm talking about the investor rate. I'm talking about the actual borrow rate you get at the bank, right? And so there's a lot of discussion as to why is that, right? And it's been pretty sticky. It's stayed unusually wide for a couple of years now.

16:41And I think one of the reasons is what I would call severe negative convexity. So negative convexity is this idea I said earlier where, boy, if interest rates rise, I don't really get any benefit from buying mortgages. But if interest rates fall, I don't get any upside either. So that's this idea of negative convexity. Well, if you have everybody laser focused on refi opportunities, maybe the kinds of people who never check on interest rates, but all of a sudden they're like, I'm checking And every day, I want to know the moment if they're laser focused on that and the moment they have any opportunity, they're going to be right on it.

17:15Right. Well, that's a different kind of negative convexity. I'm going to take my bond that I own is going to refi faster than it might otherwise in a time that people may or may not be paying attention. Right. So as an investor, you just mentioned your efficient markets build. Yeah. As an investor, I'm not unaware of that. Right. I'm thinking, boy, these things are going to pay like a bat out of hell. the moment interest rates drop even a little. And I need to get paid a little more for that. Tracy, by the way, you and listeners right now should go to Google Trends and look for a search of the word.

17:48No, seriously, it's a great chart. Someone had showed me this a few weeks ago. Guessing line goes up. Look at the word, do a Google Trends search for the word refinancing. And you will see a big spike on September 18th because it was, you know, not everyone's always paying attention to raids, but there's like one day this year where the Fed actually made some pretty significant news that sort of broke through the bubble. And you can see how suddenly there were a bunch of people paying attention to rates. Ironically, they didn't get any real benefits automatically, but you can see how people don't pay attention.

18:19And then there's a day when someday they weren't. The futility of doing Google research. Everyone wants to refi on that specific date and they can't get a lower rate. Anyway, Tom, I wanted to ask, what is the ideal environment to be buying mortgages in? Because I think back to the years after 2008 when interest rates were really low, and I remember big investors in MBS, they always complained, you know, they didn't want to get prepaid because then they would have all this extra money that they would have to reinvest at lower rates. But now we're in the higher rate environment and they're also complaining.

18:56So, like, what is the ideal here? Yeah. So one way to think about mortgage investing is, and I'm going to play on another odd lots theme here. Please. It's a little like doing a covered call strategy in a stock. All right. So what I've kind of done is I bought a bond and I've also sold an option to the borrower. And that option is to call my bond away. Right. And it's just like if I buy Microsoft and I sell an option to for someone to buy Microsoft from me. It's exactly the same trade. And if you think about that trade, right, what you want is for Microsoft to do nothing. Because if it goes down, I've lost money.

19:35If it goes up, I get called away. Right. But if it does nothing, I just collect that premium and I still have my stock. Right. So what you want is for interest rates to stay very steady. OK. And nobody really gets to refinance. But I don't suffer the downside that I suffer if interest rates rise. And so mortgages, it's a tough, it can be a tough total return bond. So like if you think about someone trying to trade it and play interest rates moving around, that's not that great. What it is, is a good income bond. So I buy it, just collect this income. If interest rates can stay steady, it can be a great bond to own.

20:10This is why people call them pass-throughs, right? Well, yeah, passive. The other thing people say is it can be a good defensive bond. So So if you think that corporate bonds are going to suffer because there's going to be a recession, a lot of times people will rotate into mortgage bonds because there's still yield there and they're not as sensitive to that part of the cycle. Usually when that happens, interest rates drop a lot and you're not getting that upside. And so I don't know. It's a tough space. It's a tough space. Do Americans under refinance? I mean, there must be some population that doesn't pay attention.

20:41So I'm looking at mortgage rates in 2010. At one point, December 31st, 2010, they're at 4.99%. They had gotten as low in 2016 at 3.3%. You know, I imagine in your covered call strategy, anyone engaging in these things are very sophisticated and you call it right away. Is there an advantage for mortgage buyers sort of taking advantage of the fact that the counterparty to this trade is not watching rates all day? No, for sure that is true. So there's a concept in mortgage trading called burnout, OK, and this is the idea that at a certain point, everyone who's going to refinance has refinanced. Yeah.

21:19So if we rewind to 2020, 2021, rent rates were really low, you'd still see 5 % mortgages outstanding. And you'd be like, well, why? What are they doing? Like, get on it. Right. And not paying attention to interest rates. Right. Now, sometimes they're just not paying attention. Sometimes they may maybe something's happened with their credit and they can't get a lower rate at this point, which you can get a ton of detail on what the mortgage conditions are. were when the borrower initiated the mortgage, but you don't know that much about where they are in their life now, right? You just really only know what happened when they applied.

21:51So you can get that. You can also get people who are thinking about just paying off the loan and they don't want to restart the clock. So if I've been in this house for 10 years and you're like, I know I get a lower rate, but then I got to reset the clock. Maybe a 15 year more, you could do a 15 year original, but maybe that monthly P &I is too much for me. So there's a lot of reasons. There's something nice about just paying off a mortgage and having it done. And that's a personal preference. Some people, that's what they want to do. Some people think that's a bad financial idea, but I think it's up to you.

22:16But anyway, that certainly happens, right? And so it's not all just not paying attention, but it's not not. There's an element of that for sure.

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