I get an email every morning from a wholesale lender I've never met or closed a loan with, telling me about his take on the market.  Specifically, today's email stated that treasury notes had slipped on investors renewed interest in a potentially rising stock market.

That's all very well and good, but I've lately decreased my focus on treasuries, specifically the 10-year treasury in my mortgage rate forecasts.  Lately, movements in treasury rates have had very little to do with movements in mortgage rates.  I believe this is because investors have devalued mortgage securities, thereby raising their required rate of return, as the subprime mortgage crisis has played out. 

This was further exacerbated this week as Freddie Mac's stock lost 29% of its value on Tuesday after reporting a huge loss and asset write-down.  Freddie's assets are largely mortgages and mortgage backed securities.  What happens to the percentage yield when you reduce the value of a mortgage?  As my finance students at UNH and Roger Williams University will tell you, it's annual rate of return must go up. 

So this week, we saw the highest spread between the 10-year treasury rate and Freddie's 30-year fixed Primary Market Mortgage Survey that I have seen since I started tracking this information, at 2.17%.  That means that mortgage borrowers are paying 2.17% more per year than the US Government is on its debt.  Since June of this year when the truth about the subprime situation became apparent, that average spread has risen from 1.5% to a current, rising, level over 1.9%.  10-year treasury yields are approaching the psychologically important 4.0% boundary.  The last time they dipped below 4%, 30-year fixed mortgage rates averaged 5.53%.  Today, they stand at 6.20% on average.

In Finance, my students learn that the required rate for any bond or note is as follows:

R = r* + IP + LP + DRP + MRP

where

R is the interest rate that will be paid on the investment

r* is the real risk-free rate

IP is a premium to compensate investors for effects of inflation

LP is a premium to compensate investors for effects of owning an investment that may be difficult to liquidate

DRP compensates for the risk of default by the borrower

MRP compensates for the risk of lower interest rates at maturity

Analyzing the current mortgage situation on this basis, I believe the increase in spreads to treasuries we have seen recently is due to an increase in the Default Risk Premium, DRP, being demanded by investors for investing in mortgages, an investment where the borrower is much more likely to default than the federal government.  Up until recently, homeowners' ability to pay has been improved by their ability to refinance due to rising property values.  This is no longer an option for many homeowners, increasing the risk they may default.

I believe that in the short term, it as almost inevitable that this spread will continue to grow, however, I believe it is unlikely to exceed 2.25% on average, because of the security that mortgage investors have in the property, and in the more strict underwriting guidelines governing newly written mortgages.  Whether it will ever return to the 1.5% level it seemed happy at so many years before remains to be seen, however, the spread will certainly improve at some point.  It will be another 2-3 years before all of the most questionable ARM loans hit their reset point, and I wouldn't be surprised to see this situation continue until then.