Don't Be Lulled by 14 Basis Point Average Monthly Change in Rates

Between April 1971 and June 2003, what was the size of the typical monthly change, in basis points, of the average 30-year, U.S. fixed-rate mortgage?

Our colleagues at Yahoo Finance recently asked that question of Internet surfers.

The options given were 7 basis points, 14 basis points, 28 basis points, 42 basis points or 56 basis points.

The correct answer, according to data provided by Freddie Mac, is 14 basis points, on the conservative end of the spectrum of choices offered. Interestingly, 28% of Yahoo's responders guessed right - suggesting that many consumers have followed mortgage rates closely enough to make an educated guess. The most popular answer, however, was 7 basis points, which was the choice of 43% of Yahoo's responders.

Be that as it may, what can portfolio managers learn from this broad historical data?

Obviously, the long-term average can be misleading to anyone trying to hedge a portfolio. As Yahoo noted, there were some months during the past three decades when rate swings were much more dramatic. In the 1980s, when average mortgage rates reached a peak of 18.45%, there were times when rates moved by more than 150 basis points in a single month. Of course, mortgage companies didn't have to worry as much back then about how those swings would affect the value of their mortgage servicing rights, since MSRs from loans they originated themselves were usually not on the books.

But these days, accounting for MSRs is a big issue, and so protecting the value of those portfolios is more important than ever.

Amy Crews Cutts, a Freddie Mac economist, has been studying the most recent sustained refinancing boom to look at the relationship between mortgage rates and lending activity.

Ms. Crews Cutts found that the recent "refi tsunamis" of 2002 and 2003 reflected, not surprisingly, a sharp decline in rates. Rates have fallen by 40% since 2000, when the 30-year average was above 8%.

Over a 63-week period, the average 30-year mortgage rate fell an average of 3.1 basis points per week. She said that during much of that period, small rate changes didn't pump up refinancing volume until rates fell to a certain threshold and hit a plateau there. She believes the refinancing boom may still have some steam left in it, in part because of changes in the yield curve between adjustable- and fixed-rate products.

In late 2001, when the yield curve briefly was inverted, one-year adjustable-rate mortgages and 30-year, fixed-rate mortgages were basically at about the same rate. Since then, the yield curve has widened considerably.

While many borrowers have refinanced out of adjustable, balloon or hybrid products to take advantage of low fixed-rate mortgages, with the spread between fixed- and adjustable-rate lending products increasing, the opposite could start to occur. In recent years, lenders have been more aggressively selling "hybrid" loans that remain fixed for a period of time, typically three, five, seven or 10 years, before adjusting to one-year, adjustable-rate loans. With a steep yield curve driving up the price of 30-year loans relative to shorter terms, many homeowners are taking the bait.

"I don't think the refinancing market is done because there are still a lot of options for people to consider, particularly for people who are willing to consider another mortgage product other than a fixed-rate loan," Ms. Crews Cutts said.

Few homeowners plan in 30-year time increments, she points out. And many don't plan to remain in their current home for more than three or five years, so they might ask themselves, "Why pay for a longer term?"

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