Mortgage-Backed Securities Losing their Stigma - What we can learn from the current Mortgage - Treasury Spread

Mortgage and Lending with Province Mortgage Associates - NMLS #2861

Is there a light at the end of the tunnel? Investors may be suggesting so with the recent surge in the Dow Jones Industrial Average from its March low below 7000 to a recent peak over 8700. Still, some doubt should exist considering the recent economic data hasn't so much indicated the United States economy is getting better, rather that the economy is worsening at a slower pace. Still there is one area, very close to the epicenter of the economy's troubles, that suggests recent changes are achieving their desired results.

In the 18 months leading up to December, 2008, the spread between 30-year mortgage rates and the benchmark 10-year treasury note rose steadily, reaching a peak at over 3%. This was a period of unprecedented worry over asset quality, as years of declining credit standards were exposed in massive defaults, especially among sub-prime adjustable rate mortgages. These loans had been given at lower standards for credit history or income documentation, and often at higher loan-to-value ratios than conventional mortgages.

As this played out, mortgage lenders introduced a seemingly endless series of guideline updates intended to improve the quality of newly originated mortgages, ranging from adding "declining markets" requirements, and increasing required down payments, to outright program elimination. In addition, mortgage vendors, such as mortgage insurance companies, have tightened their requirements, further reducing mortgage availability. While one result of this is that more borrowers are being turned down for mortgages, the market is recognizing these efforts, and the result can be seen in the current Mortgage - Treasury Spread.

As of June 11th, 2009, the Mortgage - Treasury spread stood at 1.73%, meaning investors required a rate 1.73% higher to justify investing in riskier mortgage assets rather than safer US government securities. The 10-week moving average fell to 1.68%, approaching the historical equilibrium around 1.5% that had stood until the watershed revelations of July, 2007.

Chart of 2009 Mortgage Treasury Spread

The spread briefly reached 1.24% at the end of May, as a surge in Treasury rates had not yet caught up to mortgage pricing.

Several factors preclude the spread returning to the 1.5% level permanently, although it is possible it could settle near this level. The 1.5% level came about in part due to a massive increase in the quantity of assets seeking investments; mortgages replaced stock and treasury investments due to stock volatility and low returns on treasuries. The current economic crisis has erased much of the wealth associated with that period, permanently affecting demand. Addtionally, stocks have presented attractive opportunities of late. However, Treasuries are becoming less desirable compared to other assets due to their increased supply.

In coming months, it is important to be mindful of housing statistics, in particular, to gauge the success of the economic turnaround. Existing Home Sales figures will provide insight into the absorbtion of properties, especially foreclosed properties, into the market. Of particular note is data regarding the supply of existing homes. Until this supply subsides, home-price stabilization cannot be expected to occur. Also important is employment data, as another wave of foreclosures could easily follow from the 6 million or more jobs already lost since the beginning of the recession. If this happens, the Mortgage-Treasury Spread could easily widen. While inflation will be a significant focus of the Federal Reserve, it is not expected to meaningfully impact the Mortgage-Treasury Spread, as inflation impacts both types almost equally. Of note, though is one recent article suggesting that the Fed is facilitating Treasury purchases by buying mortgage-backed securities. This could be dangerous if the Fed is unable to continue and other buyers remain unwilling to participate in the market.

One final thought that has seen little press lately, but likely will in the near future, is the question of duration for new mortgage-backed securities. Duration of a financial asset is the average amount of time in which the investor will receive the proceeds of the investment, and provides a measure of the risk faced on that investment as interest rates change. Essentially, the longer the asset's duration, the greater the risk it faces in a rising rate environment. While most mortgages have either a 15- or 30-year term, their duration is much shorter due to the amortized nature of the loans, and due to natural events such as refinancing or home sale which cause loans to be prepaid.

Several factors in the current environment are likely to cause a shift in expected mortgage duration. Specifically, recent home-price depreciation will extend duration, as homeowners will be less likely to sell or refinance should they have insufficient equity. Second, newly written mortgages at historically low interest rates are less likely to be refinanced in the future, which had been a significant historical factor in shorter mortgage duration. Offsetting these is a possible cultural shift towards debt aversion which may lead homeowners to pay down existing debt more rapidly.

Mortgage risk relative to Treasury risk has decreased significantly in the last 6 months, however, the outlook for the market is still not as clear as investors would like it to be. The continued recovery could be threatened, should market factors impact demand for home purchases. Perhaps the most important news will come shortly, with the Federal Reserve's June meeting. For now, while it is clear that mortgage risk has normalized, whether it will stabilize at this level is anyone's guess.


Dan Hartman is a Senior Mortgage Advisor with Province Mortgage Associates, and also serves as an Adjunct Professor of Finance at the University of New Haven and Roger Williams University. Dan can be reached by commenting on this article, or by phone at (401) 263-8655.


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Lester Wilkins
Blue Water Home Loans NMLS# 166527 - Port Huron, MI

Great blog.  I wish the future of MBS and our industry was clearer.  It has been an adventure that is for sure.

Jun 15, 2009 07:09 AM #1
Joe Pryor
The Virtual Real Estate Team - Oklahoma City, OK
REALTORĀ® - Oklahoma Investment Properties

Okay, you are pretty danged smart on this, so I just looked at the future through my Eight Ball fortune teller, and it says, it isn't over and don't get too optimistic yet. Brilliant post.

Jun 15, 2009 08:48 AM #2
Rich Cotton
Rich Cotton The Waterfront Specialist EXiT Preferred Realty - Chesapeake City, MD
Waterfront Specialist Cecil and Kent Counties MD

Very well written and informative. I just hope you are right and the housing market stabilizes soon. We all need a break from all the "fall throughs" and stress this downturn has generated! 

Jun 15, 2009 09:57 AM #3
Terry Iwaniw
Avalar Atlantic Properties - Sicklerville, NJ
Realtor - S NJ

Thanks for the great information.  Really learned a lot.

Jun 15, 2009 11:04 AM #4
John Jones
Briggs Freeman Sotheby's International Realty - Dallas, TX

great article, Dan.  And thanks for the link to the NPR info.  They consistently provide the best info and programs that help explain the financial crisis in terms that are easy to understand and very comprehensive and thorough. 

There's no doubt that printing money has some effect on not only this spread, but also the fact that rates are extremely low right now.  It will be very interesting to see how the Fed expiriment in quantitative easing works over the long run and what issues it may cause in the future.  at some point, we're going to have to borrow money to buy some new ink for all these printing presses :)

Jun 15, 2009 11:44 AM #5
Russ Ravary ~ Metro Detroit Realtor call (248) 310-6239
Real Estate One - Commerce, MI
Michigan homes for sale ~

Yes mortgages are getting better but not if home values continue to drop and there are more foreclosures

Jun 15, 2009 01:47 PM #6
Mike Henderson
Your complete source for buying HUD homes - Littleton, CO
HUD Home Hub - 303-949-5848

Great analysis.  People don't pay enough attention to the spread.  I agree with you that it will settle at  a margin greater than 1.5%.

Jun 15, 2009 03:31 PM #7
Louie Flores
South West Home Inspections LLC - Hemet, CA

That is great information thanks

Jun 15, 2009 03:39 PM #8
Jerry Current
HBC Realtors - Pasadena, CA

Dan, You should work for Barry Habib at the Mortgage Market Guide.  This is some great analysis and information.  Thanks.

Jun 15, 2009 04:06 PM #9
Christine Donovan
Donovan Blatt Realty - Costa Mesa, CA
Broker/Attorney 714-319-9751 DRE01267479 - Costa M

A very nice analysis on a subject that is likely not clear to most people in and out of the industry.

Jun 15, 2009 04:34 PM #10
Dan Hartman
Province Mortgage Associates - NMLS #2861 - Providence, RI

Thanks everyone for your feedback.

Rich, I couldn't agree with you more on the "fall throughs" - a greater degree of predictability would help immensely in this market in easing homebuyer fears.

John, that is the next big worry - can we keep pumping out money where the ink is still wet? It has already hit treasury rates, and could impact mortgages before too long.

Russ, mortgages are getting better, but only in comparison with other instruments like treasuries. As you said, foreclosures are still a big risk.

Again, thanks to everyone for reading. I appreciate your thoughts.


Jun 15, 2009 11:42 PM #11
Gene Riemenschneider
Home Point Real Estate - Brentwood, CA
Turning Houses into Homes

Very interesting.  Maybe there is some good news in the middle of all this mess.

Jun 16, 2009 03:14 AM #12
Dan Magstadt
Paramount Residential Mortgage Group, Inc - Lake City, FL

Great info Dan!! I see you're a true expert in the mortgage business with a good understanding of the markets!

Jun 16, 2009 03:21 AM #13
Shari Kay Hunter

Dan: I'm proud of you! It's great to hear from such a smart loan officer. I don't think we could be replaced by chimps this year, at least it would take really smart chimps. At one point, there seemed to be a belief that loan officers could be replaced by on-line purchasing of financing. That did not seem to go very well. What do you see as the future of our industry? How might we provide the best service to the real estate community in these troubled times? Thanks again for your analysis and ideas. Shari

Jun 16, 2009 07:43 AM #14
Barry Habib

Dan give me a call so we can talk about you getting a job!

Jun 16, 2009 12:21 PM #15
Lyn Sims
RE/MAX Suburban - Schaumburg, IL
Schaumburg IL Area Real Estate


Jun 17, 2009 02:02 AM #16
Michael Barrow
Keller Williams Realty - San Diego Metro - San Diego, CA
Realtor, San Diego CA Real Estate

Very well written post!  Thanks for all the great info!

Jun 17, 2009 10:40 AM #17
Vince Perna
Dunes Properties of Charleston - Folly Beach, SC
Folly Beach, SC

Very informative info.  I believe the peak was an over-reaction and we are beginning to settle back in.  When we return to smart lending, the demand for homes will return.  This is when we will see improvements in the housing situation.  Lets hope it is sooner rather than later.

Jun 18, 2009 06:19 AM #18
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