Daily Commentary
By Larry Baer, Market Alert
Update:
I regret it has taken longer than I would have liked to get this update to you - but I feel confident you understand it has been a very quick day around here. The question I've heard most consistently throughout the day is, "What the heck happened to our mortgage market?"
The following may seem an unusual way to answer your question, but bear with me just a little bit. I think I can provide a clear answer to this question - without burying those with less credit market experience in a bunch of technical credit market mumbo-jumbo. Those with a more developed knowledge of credit market function will find an explanation in the last three paragraphs of this section of my update
By Larry Baer, Market Alert
Update:
I regret it has taken longer than I would have liked to get this update to you - but I feel confident you understand it has been a very quick day around here. The question I've heard most consistently throughout the day is, "What the heck happened to our mortgage market?"
The following may seem an unusual way to answer your question, but bear with me just a little bit. I think I can provide a clear answer to this question - without burying those with less credit market experience in a bunch of technical credit market mumbo-jumbo. Those with a more developed knowledge of credit market function will find an explanation in the last three paragraphs of this section of my update
Let's assume you have invested your hard-earned money in a $1,000 certificate of deposit that will pay interest of 4.5% annually on your principal. You have willingly made the investment for 2-years with the full knowledge you can't get your principal back until the end of that period of time. For the sake of this example - let's further assume the institution holding your money has the right to extend your commitment time beyond 2-years if interest rates in general rise -- but they are under no obligation to pay you one penny more in terms of your interest rate.
Hmmm, now this last particular feature could be a problem - but only if interest rates rise. As long as interest rates in general stay below 4.5% you'll get your principal back in 2-years -- and you will have made what you deem to be an acceptable return on your money given the risks associated with the transaction. So far - so good, right? The extension risk associated with your new certificate of deposit keeps waking you up at night - you generally like the transaction structure -- but you would be much more comfortable with it if you could find a way to offset the institution's ability to keep your money for a longer period of time than 2-years in a rising interest rate environment.
All you need to do is find a way to profit from failing prices and rising rates in the credit market - and you will have successfully developed a method to offset the majority of any loss you might incur on your certificate of deposit should interest rates in general begin to rise. You ask around and learn that there is indeed a way to "hedge" the extension risk of your certificate of deposit. When interest rates are rising (a bad thing in terms of your extension risk) the prices of private and government CD's are falling. To your delight you discover that in the credit market it is possible to sell an asset you don't currently own - and if the price of that asset falls -- you can buy the asset back and keep the profit. In the business they call it going "short" (see ** below for more detailed explanation). A model using the yield on the 2-year Treasury note is developed as your baseline index to enable you to anticipate future interest rate movement. According to your model, should the yield on the 2-year Treasury note move above 3.61% -- the probabilities are high that interest rates in general will begin rising - and that is a condition that prompts you to spring into action to offset the extension risk related to your 4.5% certificate of deposit. For reasons that go beyond the scope of this example you choose to sell the 2-year Treasury note "short" as a hedge against financial damage you might suffer as a result of rising interest rates. You determine that the extension risk on your CD can largely be offset by the gains you make on the "short sale" of the 2-year Treasury note (as interest rise -- prices fall). Should interest rates settle down and you decide you don't need your CD hedge anymore -- all you have to do is buy the 2-year Treasury note back at the market price - and you're done - until perhaps you find it necessary to put the hedge on again at some later date. No fuss . no muss.
Actuarial experience shows that as mortgage interest rates rise -- borrowers with low note rates become increasing less likely to sell their homes, refinance or in any other way pay off their mortgage early. This tendency is known as extension risk in the mortgage industry - and it was at the core of today's hard sell-off in the mortgage market. Mortgage investors (actual long-term holders of mortgage-backed securities like insurance companies, hedge funds, mutual funds, big money center banks, foreign sovereign governments and others) deemed it necessary to hedge the extension risk of their mortgage-backed security portfolios as the yield on the 10-year Treasury note moved above 3.61% earlier today. The majority of these market participants chose to "short-sale" the 10-year Treasury note - a process that pushed the yield of the Treasury note even higher - and yet models to trigger additional mortgage portfolio extension risk hedges. As the afternoon progressed some investors decided rather than attempting to hedge their extension risk under fast market conditions- they would simply sell their mortgage-backed securities outright. The ensuing snowball effect of these two strategies resulted in the very ugly numbers in the mortgage market at the end of the day.
Looking ahead - if a retracement rally is going to develop in the mortgage market tomorrow - in my opinion it will likely begin in earnest after the close of the Treasury's $26 billion 7-year note auction at 2:00 p.m. ET.
**Here's a quick overview of how "selling-short" works:
Let's say the price of an asset you sold "short" at $2.00 falls to $1.65.
You, the "short" seller, can choose to buy the asset back at the current market price of $1.65 -- and pocket a marketing gain of 35 cents. If you decide to hold off with your buy order -- and the price of the asset you sold "short" falls further to $1.05 - you, the "short" seller, have a marketing gain of 95 cents. But what if the price of the asset you sold at $2.00 moves higher rather than lower you ask? The answer is painfully straightforward - you will incur a marketing loss for every penny higher price moves before you jump into the market place and buy-back the asset you sold "short". In a "short" sell transaction -- no matter which way the price of the asset goes - ultimately, in order to close the transaction, the asset is going to have to be purchased. This may be way more than you wanted to know - but I hope you see it is actually a significant part of the answer to your original question.
Commentary: The mood in the credit markets is ugly this morning as the Treasury Department lines up to dump $35 billion of 5-year notes on investors already staggering under the weight of the government's massive borrowing spree. The Fed is active in the market as a buyer again today - with authorization to spend up to $300 billion to support steady to fractionally lower rates for consumers and businesses. The objective is noble - but the financial firepower is weak. Compared to the $2.5 trillion dollars of supply from Uncle Sam scheduled to wash through the credit market before the end of the government's fiscal year in September - the Fed appears to be engaged in an almost meaningless effort to drain the ocean with a teaspoon. Credit market investors are in a particularly bad humor this morning as General Motors bondholders have rejected the latest restructuring offer from the company's management. The likelihood that the government will soon be called upon to inject "massive" amounts of capital into the automaker simply compounds credit market concerns about the size of future government borrowing. The "so what" factor here from a mortgage perspective is straightforward - increased debt obligations flushing into the credit market from the government will push Treasury prices lower - and in our world when prices fall - interest rates rise.
This morning's release of the April Existing Home Sales figure was almost completely overshadowed by investor nervousness surrounding today's 5-year Treasury note auction and growing anxiety about tomorrow's bigger hurdle of $26 billion in the form of 7-year notes The National Association of Realtors said purchases increased 2.9% on an annualized basis last month. Distressed sales accounted for 45% of all transactions. The inventory of homes for sale increased 8.7% as more homes were listed during the popular spring selling season.
In a related, but separate report the Mortgage Bankers of America said their seasonally adjusted index of loan applications to purchase or refinance a home fell by 14% during the week ended May 22nd. The refinance component of the index fell by 14% while the purchase component gained 1.0%.
THE MARKET IS ALWAYS RIGHT! YOU AND I ARE SOME OF THE TIME.
