Why Interest Rates On Mortgages Are So Higher Than Treasuries And When Will They Come Back Down

Mortgage interest rates are much higher than usual compared to long-term Treasury bills. Mortgage industry experts wonder if spreads will return to normal, meaning mortgage rates will be lower as long as Treasury rates remain stable. It will probably happen, but not in 2023.

The spread was wide by historical standards. Before the pandemic, the average spread across all readily available data is 1.69 percentage points. For example, in February 2019, the 10-year Treasury note paid a yield of 2.68%. The average 30-year fixed-rate mortgage costs homeowners 4.37%, the difference being right at the long-term average of 1.69%. Most of the time, the difference is between 1.5% and 2.0%.

Homebuyers approach a mortgage originator, usually a mortgage broker or bank, who sets the interest rate. The originator then sells the loan, usually to a government-funded organization, such as Fannie Mae or Freddie Mac. Like any intermediary, the mortgage lender is compensated for this service. The offeror is paid cash equivalent to the value of the interest rate increase. For example, in the first week of 2020, the average mortgage rate was 3.72%. The average interest rate Fannie Mae pays to investors is 2.61%. What happened to the difference between these two rates, the 1.11% gap? This amount paid to the originator of the mortgage for his services. This payment can be considered the retail mortgage spread. 

Of course, if Fanny or Freddie sells a series of mortgages to investors, the interest rate will depend on supply and demand. Investors often view mortgages as inferior products compared to Treasury bills. Both are considered safe, but the US Treasury will continue to pay interest for the life of the bond. However, homeowners can refinance when mortgage rates drop. A refinancing option means that homeowners can refinance when interest rates drop. Investors no longer own old mortgages with high interest rates. Instead, investors now have cash to reinvest at new lower interest rates. Investors don't like it.

Investors also have a problem with rising interest rates. They were stuck with old low interest mortgages that no one could pay off quickly. They were desperate to get their money back and buy a new high-yield mortgage, but that never happened.

The ability to refinance a homeowner's mortgage makes mortgage-backed securities a disadvantage as an investment option. Therefore, investors will buy them only if they offer a premium over US Treasury yields. This is the wholesale mortgage gap.

Total spread is the sum of retail and wholesale spreads at any point in time. Headline spreads rose slightly in the first half of 2020 as the Federal Reserve cut interest rates and the government implemented stimulus measures. Homeowners refinance their mortgages to take advantage of lower interest rates. Condo residents are starting to buy homes thanks to cash in their bank accounts and low mortgage rates. A mortgage newbie was overwhelmed with the business. We can't handle all the mortgage refinances people want. At least not anytime soon. Added staff and trained new employees, resulting in improved profit margins. Retail spreads widened significantly, while wholesale spreads widened slightly. This was documented by William Emmons of the Federal Reserve Bank of St. Louis.

Large spreads between mortgage rates and government bonds in early 2023 are likely due to wholesale levels. Fixed income traders cite interest rate volatility as an important factor. Keep in mind that rising interest rates mean fewer upfront payments, which is what mortgage-backed security owners want most. Lower interest rates mean that mortgage-backed security holders get most of their upfront payments when they least need them. Therefore, the prospect of interest rates moving in either direction is keeping investors away from mortgage-backed securities. At the individual level, spreads are expected to widen given the interest rate risk of mortgage lenders. Borrowers receive interest rate offers, but walk away when interest rates drop, abandoning the first lender. But when interest rates rise, that borrower keeps the quota on the originator. Both spreads widen in a more volatile interest rate environment.

Over the past 52 weeks, mortgage rate volatility (measured as the standard deviation of the absolute value of the weekly interest rate change) has doubled compared to his previous 52 weeks. When will these wide spreads normalize again? Whether or not interest rates stabilize is critical. That's after the Federal Reserve completed its tightening and then returned to a stable path for interest rates going forward. It seems that further tightening is imminent from March 2023. And maybe in 2024, the Fed will cut rates to reopen the economy. If interest rates reach levels that last for many years, spreads will tighten.

If you're looking to buy a home given the cost of a mortgage, or if you're a new homeowner looking to refinance, the actual mortgage rate will either start easing as the Fed starts or it will ease. It may decline prematurely in anticipation. Mortgage rates will fall even if spreads remain wide. If spreads tighten, it will put more downward pressure on mortgage rates. Mortgage interest rates will therefore likely decline gradually over the next two years, starting in early 2024.