Gretchen Morgenson of the NYT does a nice job today explaining how the hedged and leveraged mortgage-backed securities market impacts interest rates:
Mortgage-backed securities respond violently to moves in interest rates. When rates fall and homeowners refinance, some of the mortgages in large portfolios held by banks, hedge funds and mortgage originators are cashed in. That requires the managers of these portfolios to rebalance their hedges by buying Treasuries. Such buying helped push interest rates down to ridiculous levels earlier this year.
When rates rise, refinancings drop, and the average life of a mortgage grows. That forces traders to rebalance portfolios by selling Treasuries. Selling begets selling; interest rates spike.
–Mortgage Markets Are Out of Control, NYT 8/17/03
Within the Treasury market, mortgage-backed traders now have the biggest impact due to their response when rates rise or fall. The government bond market is overshadowed by the mortgage-backed securities market: “Treasuries and corporate bonds each account for about 22 percent of the Lehman Brothers United States Aggregate Index, a measure of the whole fixed-income market; mortgage-backed securities make up almost 35 percent.”
Morgenson quotes Jim Bianco (of Bianco Research): “the last time interest rates moved up — in the mid-1990’s — the mortgage-backed securities market was much smaller and more manageable. Back in 1996, the mortgage market was roughly half the size of the Treasury market,” he said. “Now it is 125 percent of the Treasury market.”
The size of the market and the fact that so many players are heavily leveraged make a disaster almost inevitable. “If you look at the last 15 years of bond market derivative debacles, a lot of them involved mortgages,” he said. “These things have killed more people than any other trade.”
And what of the extreme volatility in the Bond markets? Bianco argues that risk is not being properly managed. “We wouldn’t see these wild undulations in interest rates if they had already been hedged.”
The risk of systemic instability is magnified because Fannie Mae and Freddie Mac not only package and sell mortgage-backed securities in the capital markets, but also keep some of these securities in their own portfolios. Thus, they are exposed to credit risk AND interest-rate risk. It’s yet another reason why these companies should once and for all be deprived of the government’s imprimatur, so that they have less incentive to engage in reckless behaviour.