The Scoop on Mortgage Pricing
by Barry Habib

From the first day an originator enters the mortgage business, they are often asked to comment on the direction of mortgage rates.  Additionally, they are often asked what factors will determine the interest rate or price.  Surprisingly, even originators with many years experience have difficulty getting their arms around this subject.  Let’s take a closer look at some of the facts, myths and keys to the mortgage rate puzzle…you might just be surprised.

First, let’s discuss what does not affect mortgage pricing.  Many individuals in the mortgage industry look at the US 10-year Treasury note as a guide to the direction of mortgage rates and pricing.  The fact is - the US 10-year Treasury note has nothing to do with daily mortgage pricing.  It does however, have a lot to do with price hedging after a loan closes. 

The US 30-year Treasury bond has been in the news lately because e it will be re-issues in February of 2006.  Notice the important difference between “bonds” and “notes”.  Maturities that are greater than one year up to ten years are known as “notes”.  Maturities greater than ten years are called a “bond” and maturities less than one year are called a “bill”.  Once again, US Treasury bonds, notes or bills do not have any direct relationship to mortgage pricing.  Treasuries are backed by the full faith and credit of the US Government, while Mortgages are secured by the underlying Real Estate value. 

Is the 10-year Note really a mortgage benchmark?

Why all the confusion?  I have heard it over and over; people in the financial media presenting information on the bond markets continually make erroneous assumptions about the relationship of mortgage interest rates with US Treasury bond and note prices.  This happens because these financial reporters may understand the bond markets in general but they are not mortgage experts and do not fully understand how mortgage interest rates are determined.  For example, the bond market reporters mistakenly tie mortgage rates to the performance of the US 10-year Treasury note on a routine basis.  You see this happen on CNBC all the time.  In reality, mortgage interest rates and the intra-day re-pricing that occur are determined from the performance of mortgage-backed securities (MBS) or mortgage bonds, not US 10-year Treasury notes.

So why do so many mortgage originators look at the wrong security?  The information on MBS is not easily available.  Moreover, in order to get live, real time pricing of MBS you must subscribe to a quote service like http://www.mortgagemarketguide.com.  Following actual MBS prices will allow you to make much better decisions on locking because you will know what your daily price sheets will look like before you get them.

Living in two separate worlds  

Clients and Loan Originators live in the “lock the rate” world.  Customers want the best rate and we want to help them while getting a fair profit.   

Once a mortgage is closed, it must be sold.  Quite often, loans are sold to Fannie Mae or Freddie Mac, who then turn them into MBS to be sold to the public through the securities markets.  As the daily pricing is bid higher or lower in the open securities market, your rate sheet reflects the exact price changes that occur. 

Therefore, we are concerned with the price of MBS, which directly impacts our rate sheet. 

After the loan closes, the wholesale lender or servicing entity must sell it to Fannie, Freddie, etc. so it can be securitized for sale to the public.  But many times, that loan will need post closing documentation before it can be moved off the wholesale lenders books.  This adds some large risks because the market is moving during this period.  Lenders live in the “after the closing” world. 

Sure if the market improves, the lender will make a lot of extra money.  But what if the market significantly worsens?  The lender can be exposed to huge losses.  A great way to protect themselves from losses would be to find a way to make money when the MBS market significantly worsens.  Additionally, they would need to do this at an affordable cost.  Unfortunately, there is no such way to do this with MBS, but you can do this with US 10-year T-notes.  A lender can buy a security that trades like a stock, which emulates the yield of the US 10-year Treasury note (Symbol:  TNX).  Affordable call options can be purchased to generate profits when yields rise.  While this will not exactly follow the movement of the MBS market, it gives that lender a way to affordably protect their pipeline from significant price worsening in the market. 

This type of insurance is called “hedging” and is why you may often hear comments that mortgage rates are pegged to the US 10-yr T-note.  In their “after the closing” world, the 10-year does play a major role, but in our “lock the rate” world, the US 10-year T-Note has no bearing on our pricing - we must only follow the pricing of Mortgage Bonds.