How Markets affect Mortgage Interest Rates 

Mortgage Backed Securities (MBS) Basics

What is MBS?

Any time you see us write MBS, or anywhere else for that matter, we're always going to be referring to Mortgage Backed Securities. These are the securities of groups of similar mortgages, also known as "pools."  MBS function similarly to other bonds that have a purchase PRICE and pay the investor back in installments based on the YIELD.  The PRICE always refers to the cost of buying $100 of that particular bond. For instance, if the price of a bond is 101.00, then an investor would pay $101.00, and in exchange, would then own only $100.00 worth of that bond. So why pay more or less?


In a word: YIELD. Yield is the rate of return paid on that bond over time. There are multiple different types of bonds, and each bond has a certain yield that it pays. You will sometimes hear us refer to yield as "coupon" or "issue." As you might guess, the higher the yield, the more the buyer will make over time, so the more the buyer is willing to pay. For instance, if an MBS with a 3.0% yield costs $104.50, the investor pays $104.50 for the ability to collect 3.0% interest on $100.00.  Conversely, yields that are low enough may have prices under Par (100.00), meaning that investors could buy $100.00 worth of MBS at a discount.  Bottom line, the higher the coupon of MBS, the higher the price will generally be.


For this same reason, when considering only one coupon (you might find it easier to think of it as "if the coupon stays the same") and the price is going higher, then the yield for the investor goes lower (because they're paying a higher price for the same coupon yield).  This is what we mean when we say "as price goes up, yields go down," which is a different concept that "higher yielding coupons fetch higher prices."  This can be a bit of paradox for some, but if it doesn't make sense at first, try to separate the two different approaches mentioned above:


  1. In this case, we're looking at and/or considering the price/yield relationship of numerous MBS coupons, at one moment in time, and noticing that the higher the coupon, the higher the price.


  1. In this case, we're looking at one specific MBS coupon.  The coupon doesn't change, but the price does.  As the price moves higher and lower over time we're noticing that investors are paying more or less for the same coupon yield.  Thus if prices for a particular coupon are moving higher, yields are moving lower.


Keep in mind that the COUPON YIELD of a particular MBS only determines the rate of return of whatever principal amount remains in the MBS pool purchased by the investor.  Because the duration of a mortgage can vary (borrowers can sell, refinance, foreclose, etc..) the ACTUAL yield that an investor receives will depend on how quickly the loans in their MBS pools are retired.  Suppose you paid $104.00 for the right to collect interest on a $100.00 loan.  If the borrower pays you back before their first interest payment, now you've earned $100.00 for your $104.00 investment!!!  Not profitable!  You're realizing a MUCH lower yield than another investor whose borrowers keep their loan for several years. 


This is the "Prepayment Risk" that investors seek to avoid and it's the reason for the various "early pay-off" penalties charged to originators if loans are retired or refinanced within a certain time frame.


So MBS's are bonds! Where do they come from?

Grossly oversimplified and leaving out numerous items that are not germane to rate analysis, MBS are the bonds that mortgage loans are turned into when they are bought or sold. That's a tough one to grasp your first time around. I know it was for me.


Basically, Big Bank will write a check for your mortgage, say it's $100,000. Big Bank A then has a promissory note saying that you will pay them a certain interest rate over time (sound familiar?). But Big Bank A needs some more money to lend other people... Where to get it? I know! They can sell your mortgage note to someone else in the form of a bond! Hopefully, that investor is willing to pay something like $102,000 for the right to collect interest on your $100,000 loan. Big Bank A just made $2000, and the investor has something that will hopefully pay them interest over time. Remember price vs. yield? The higher your interest rate, the more the investor would be willing to pay Big Bank A. That's YSP Baby! And if the investor is only going to pay $97,000 for the loan, that means Big Bank has to pay them a discount to buy it, which was probably passed on to you on line 802 of the GFE! Now YSP starts to become clear I hope!


But there's a big problem! The investor doesn't want all of their risk riding on one loan, so we have to find a way to spread out the risk. Because even if you only have a 3% chance of defaulting, in the event that you do, the investor would lose his hat. So to spread out the risk, Big Bank A combines your loan with 10's to hundreds of other similar loans with similar rates and similar credit quality.


Then either by selling them directly to Fannie Mae and Freddie Mac or by utilizing Fannie and Freddies Protocols and doing it themselves, Big Bank A accomplished what is known as SECURITIZATION. Now the "pool" (collective of all the bundled loans which will now be in the millions of dollars) can be broken up into bond-sized chunks. Now instead of buying one loan for $100,000 dollars (give or take), and investor can buy a portion of 10's to hundred's of loans for the same amount of money, with the same rate of return, with the same risk of default. BUT NOW, if you apply the 3% rate of default, the investor only loses 3%! Brilliant! And it's a concept that has allowed a significantly larger amount of money to be available for home loans than ever before.

Why do MBS's matter to mortgage rates?

We just said that investors are paying 102% of the face value of a bond in certain cases right? So what happens if they are not interested at that price any more? No more liquidity for the mortgage market. So how do you combat this? In a nutshell, the market forces of supply and demand take care of it. If demand for a bond is low when the price is 102.00, then the sellers of the bonds may lower the price to 101.50 to ENTICE investors to start buying again. And what did we already say would happen to the YIELD when the price got lower for a particular issue? It goes UP because the same money the investor was going to spend, now buys more shares. So their rate of return per dollar spent (yield) goes up.


Those pricing adjustments from 102.00 to 101.50 should look familiar. They move in exactly the same proportion to YSP. Although Big Bank A has to pull profit off that for themselves, THE PRICES OF MBS ALWAYS MOVE IN DIRECT PROPORTION TO THE PRICES (YSP IF POSITIVE, DISCOUNT IF NEGATIVE) OF THE MORTGAGES FROM WHICH THEY ARE DERIVED.


That is why we want to follow MBS instead of any other treasury or index in order to gauge the direction of the market. If investors are wanting to buy more MBS, then the prices are going to go up (Price vs. Demand function). Higher prices mean that Big Bank A makes more on a given coupon, which means they can originate a loan for your clients with either a slightly lower interest rate or a slightly higher YSP. Your choice!


So that is the theme of any mortgage market analysis. We want to assess the movements of MBS prices (which change by the second), in conjunction with the macroeconomic climate, in order to determine which way they might be headed and what future events can have an impact.


For instance, inflation data being negative hurts bonds because bonds return a fixed income. So if inflation has devalued the dollar over time, the bond is not really worth as much as when it first was purchased. So high inflation makes investors seek higher yields in order to get on that boat. Another popular correlation is that a booming economy draws money out of bonds and into more rapidly appreciating stocks. This causes bond owners to lower the price to entice buyers which raises mortgage rates. That is why, if you look at a historical chart of recessions and interest rates, you will almost always see recessions coincide with low rates.


Beyond that, there's only a little more you need to know when reading my analysis.


First of all, there are several coupon rates ranging from 4.5%-7.5%. Right now, we primarily track the 5.5% coupon and the 6.0% coupon as most of the trades are taking place in that range, giving us a higher sample size and thus more reliable data. We will always report on the bond coupons that are closest to PAR for this reason (par meaning a cost of 100.00).


Bonds move in 32nds. So 101-32 would actually be 102-00. And 101-16 would actually be 101.50 in decimal form. So when you see prices improve by 16/32nds, that means that at some point in the future, lenders have the ability to improve the YSP on rate sheets by .500. NOW, in this day and age, lenders are not quick to pass on a price improvement to its full effect. They want to see the market hold its gains for a bit. However, if the market worsens, they will hedge their positions by taking even more away from you than they have lost on price. This is just smart business, and it's a balancing act between lenders to see who reprices and by how much. I will oftentimes refer to 32nds as TICKS. So if I say "we're down 6 ticks on the 5.5," that would mean that the 5.5% coupon MBS has declined in price by 6/32nds from yesterday's close. Lot less typing my way!


Tight or Wide. Bond investors have a choice between MBS and other types of bonds. The benchmark competitor is the US 10 year treasury. MBS price relative to treasury price is important because even if mortgage prices go up on the day, if treasury prices go up a whole lot more, the MBS will still be the better investment all other things being equal. Because there is a significantly higher amount of risk in MBS than in treasuries, the MBS prices will ALWAYS be lower than treasury prices for a similar coupon amount. So when prices rise on MBS and "close the gap" on treasuries, we say "MBS are trading tighter." You might also hear "tighter to the curve," meaning the yield curve. Wide is simply the opposite.


Graphs. Hopefully the graphs I've been posting make much more sense now. They are simply tracking the curve of the price of a particular coupon throughout the day. As the curve gets higher, rates have the potential to go lower and vice versa. There is a school of thought known as "technical analysis," which some think is crazy voodoo, while others think it is gospel. Basically, technical analysis throws all economic analysis out the window and simply focuses on the numbers, what they have done in the past, their propensity to "obey" certain trends, their resistance to certain price floors or ceilings, etc... I am a fence-sitter when it comes to Technicals. I will comment on them, but always keep in mind that technical analysis must be considered in conjunction with the rapidly changing economic climate. 


So for instance, if I say "there is a price floor today that has been established at 99-16," that means that bond prices have resisted going below the horizontal line on the graph at the 99-16 mark. If bonds then were to break through that floor and go lower, it could indicate a potential increase in pressure to sell, which would hurt rates. Hope that makes sense.


A couple final thoughts...


Lenders release rates at different times. They have different mentalities when it comes to pricing. I comment on MBS, not on particular lenders. What your lender does can vary greatly from what is available to them on MBS markets, especially if they are overworked or underfunded.


Other services may tell you what you want to hear and some may take pride in their strong stance on lock recommendations. The bad news for you and them is that lock recommendations can only ever be accurate enough to help you if you are talking about a VERY short time horizon. So I will present you with the raw data, give you my personal analysis of it, present you with the potential outcomes from impending data, and suggest that you apply your own lens to the facts. The exception is that we are all pretty accurate when it comes to reprice alerts. Just make sure to keep track of who gets to you quickest and cheapest.


If you've read this far, it means you are more dedicated to understanding the mortgage market than 90% of your peers. It is very rewarding when a client chooses you because of your understanding of the subject. It is even more rewarding when you see a .500 YSP reprice 30 minutes before it hits on a $400,000 loan! So if you're not in the boat already, I invite you to come track the mortgage market with me, learn from the data, share your thoughts about how what I am doing can be improved, and we can both continue to improve together by delivering a higher level of quality to our readers. Thanks!


Article from Mortgage News Daily

Find us on social