Fixed rate mortgages have disconnected from 10-year treasuries.

I spoke about the disconnect yesterday in Financial System Broken – Markets ‘Utterly Unhinged’. Please take a look if you have not yet done so. It’s not just mortgages that are “unhinged”. Our entire financial system is on the verge of locking up.

Curve Watchers Anonymous has asked to see a few pictures of exactly what’s happening. That’s a reasonable request, so let’s take a look.

15 Year Fixed Mortgages vs. 10 Year Treasuries

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15 year mortgages tend to track 10 year treasuries within a reasonable band. There was a major disconnect starting in January as treasury yields dropped but fixed rate mortgage rates soared. Neither Bernanke nor homeowners are pleased with this development.

A revolt on the long end of the curve (10 year and greater) is making matters even worse.

Bond Market Revolt On Long End

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Note: The above chart is from yesterday. It is possible the revolt is over already. Blomberg is showing the 30-year long bond at 4.46 and the 10-year note at 3.50 this morning. Also this morning the Fed announced an emergency TAF increase to $100 billion and jobs were a disaster. That may have quieted the long end of the curve, at least for now. Except for this note, the text of this article remains as I wrote it yesterday.

The above chart clearly shows the start of a bond revolt at the long end of the curve. 10 year treasury yields (and even more so 30 year treasury yields) are refusing to follow the Fed Funds Rate lower. This is just a tiny revolt so far. Bernanke better be praying it does not get out of hand. I don’t think it will but it could.

Both the widening spreads and the revolt are hampering moves of those hoping to refinance into fixed rate mortgages. Ironically, those in ARMs specifically tied to LIBOR are getting some relief, even though new loans do not appear to be picking up all of the yield drop in LIBOR.

What Is LIBOR?

LIBOR stands for London Interbank Offered Rate and it is the rate that banks charge each other for short term lending, overnight to as long as a year. 1 month LIBOR tends to closely track the Fed Funds Rate.

How are ARMs Rates Computed?

Answers.Com has a nice section on ARMs and how to compute the loan interest rate.

To compute the loan interest rate, the lender adds a margin to an index rate selected as the benchmark, or base rate. The most common indexes are the Constant Maturity Treasury (CMT) Index of Treasury issues with the same final maturity; the Treasury Bill index, based on the current auction yield of 3-month, 6-month or 1-year Treasury bills; the 12-month Moving Treasury Average, computed from the Treasury CMT index for the previous 12 months; the 11th District Cost of Funds Index, the weighted average cost of savings accounts, Federal Home Loan Bank advances, and other sources of funds paid by savings institutions in the 11th Federal Home Loan Bank district; the London Interbank Offered Rate (LIBOR), the rate major London banks charge each other for borrowings; the certificate of deposit (CD) index, the average rate earned by nationally traded certificates of deposit; and the bank Prime Rate, the rate banks charge their prime business borrowers. The most popular are the Treasury indexes, the 11th District Cost of Funds Index, and the LIBOR index. A popular variation of the adjustable-rate mortgage is the HYBRID ARM, in which the loan has a fixed interest rate for 3 to 10 years and thereafter adjusts according to market conditions.

Six Month LIBOR

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5-1 ARMs National Average Yield

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The above chart shows a national averages of 5-1 ARMs that may include points. Those loans may be tied to LIBOR, treasuries, or some other index so it is impossible to get a perfect bead on how big this disconnect is. However, on the assumption that most of those loans are tied to LIBOR, the spreads have widened when they should not be.

Interest Only Loans

We happen to be in an interest only loan tied to 1 month LIBOR. However, we make payments as if we were in a 15 year fixed loan (extra principle payments every month). Our spread is extremely low (125 basis points). One advantage of this type of loan is the flexibility to only pay interest should an emergency arise. A second advantage when the Fed is cutting, is a mortgage rate that drops right with those rate cuts. Obviously this latter point works both ways.

1 month LIBOR is currently sitting at 3.06. It was 3.10 or so at the beginning of the month when the interest rate for the month was set. That made our mortgage interest rate 4.35% (3.10+1.25).

If the Fed cuts 75 basis points in March as is priced in (assuming LIBOR drops 75 basis points along with it), our mortgage rate will drop to 3.6%.

If you can get an interest only LIBOR based loan with a good spread (and you have the discipline to make extra principal payments every month), ARMs are not a bad idea here. I am basing this statement on the belief that the Fed Funds Rate and LIBOR are going to go lower and stay lower longer than most think.

The problem is getting a good spread. On new loans it will take a sterling FICO score and probably a huge down payment to get a great spread.

It is also important to remember the “trap”. One better be prepared to make higher interest payments if LIBOR acts wildly as it did last August (or if the Fed starts raising interest rates again). Our rate shot up to something like 7.5% for a couple months in the August credit crunch when LIBOR disconnected temporarily from the Fed Funds Rate.

With that in mind, if you are thinking of getting into an interest rate only loan because it is all you can afford, please don’t do it. Things can happen.

Teaser Rates

If you look at Bankrate.Com or rates on Bloomberg provided by Bankrate.Com, you will see what appears to be some pretty good deals. For example, consider the following snapshot.

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The odds are quite long that you cannot get those rates without paying an excessive number of points, are willing to make a huge down payment, have a tremendous FICO score, or possibly all of the preceding.

My friend Dave Donhoff at No Bull Mortgage had this to say about teaser rates: “Any company that pays to advertise on Bankrate.Com (or other such listing services) and gives an honest quote, is likely throwing money away. Furthermore, if rates look too good to be true, they are.

A Call To ARMs

Could the Fed specifically be targeting ARMs with their rate cuts? Yes, that is possible. Many ARMs (especially interest only loans and Pay Option ARMs) are tied to 1 month LIBOR. With $trillions in ARM mortgages about to reset, and with those underwater unable to refinance, Bernanke could very well be doing a slash and burn of both the Fed Funds Rate (and the US dollar) to help those stuck in ARMs, even if it is not helping those in fixed rate mortgages one iota.

Mike “Mish” Shedlock
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