Yield Curve Likely to Keep Hedging Costs High

A bevy of year-end economic outlooks suggest that mortgage hedging managers are heading into another challenging year. Most economists expect the yield curve between long-term and short-term interest rates to remain relatively flat - and perhaps even inverted at times - at least in the early part of 2007.

And so far, the prognosticators appear to be right. In early January, 30-year mortgages were running at about a 6.20% average, according to Freddie Mac's weekly rate survey. The 10-year Treasury, meanwhile, stood at about 4.65%.

Even more tellingly, the two-year Treasury in early January was trading at yields that exceeded not only the yield on 10-year Treasuries but also on 30-year Treasuries. Economists are divided about what this means. In the past, an inverted yield curve was often seen as a sign of a nascent recession. But some economists are skeptical of the notion that this hypothesis still holds true, arguing that circumstances are different. For one thing, strong foreign demand for U.S. long-term debt has helped keep demand growing for U.S. treasuries (and mortgage-backed securities). And economic reports in early January pointed toward continued growth, with both wages and job creation showing strength. In fact, the job and wage numbers seemed to spark renewed fears about inflation, dousing any hope that the Federal Reserve Board might lower short-term interest rates any time soon.

What does that mean for those executives trying to hedge a mortgage servicing portfolio?

For one thing, it means the cost of hedging will remain relatively high and the results relatively unpredictable. Hedging strategies generally do not assume an inverted yield curve.

That does not make it easy for mortgage servicers to manage the high level of portfolio runoff they are seeing now. Long-term mortgage rates dropped by about 50 basis points in the third quarter of last year, and they have remained low during the fourth quarter and into the new year. As a result, refinancing remains high, running just shy of 50% of mortgage loan applications in early January, according to the weekly mortgage application survey conducted by the Mortgage Bankers Association.

A couple of factors should help slow down the refinancing mania this time. For one thing, the average coupon rate on outstanding loans has dropped sharply since the big refinancing boom of 2003 got underway. According to UBS, the average weighted average coupon on mortgage loans outstanding has fallen by about 100 basis points since the end of 2002. In short, fewer loans are "in the money" to get a lower interest rate by trading in for a new loan at today's rates.

Falling home price appreciation also may dampen refinancing. With home price gains slowing down across the board and stagnating in some markets, homeowners may be less tempted to "cash out" equity, as they did during the boom years in home price appreciation.

Snapshot: Curve Inversion Treasury Bond Rates 1/05/07

Term Yield

Two-Year 4.79%

Ten-Year 4.68%

30-Year 4.77%

Source: WSJ. Note: Midday Trading. (c) 2007 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com