I’m taking another look at the yield curve: How it affects pay-option ARMs, interest-only mortgages, and standard 3-1 and 5-1 ARMs.

There is much good news to report. Let’s start off with a peek at the yield curve itself.

Click On Any Chart In This Post To See Sharper Image

Treasuries Yield Curve

Chart Courtesy of Bloomberg

The yield is now 2.60% and those long treasuries or the treasury ETFs such as TLT (the Lehman 20+year treasury fund) or IEF (the Lehman 7-10 year treasury fund) have benefited handsomely.

Bullish Flattening Still In Progress

Notice the difference between the 2003 reflation effort by the Fed and the current reflation effort by the Fed. Top to bottom the difference between the 3 month yield and the 30 year yield is much smaller. This was an enormous treasury rally and most missed it.

There is one more piece of information needed to discuss how this is all affecting mortgages and that is LIBOR.

Key Benchmark Rates

Note how existing mortgage rates have barely dropped in spite of a massive decline in yield on the 10-year treasury on which fixed mortgage rates are tied. I called for this disconnect 3 years ago on the basis of rising default risk. We certainly have seen that in spades.

Of far more interest to Bernanke than new mortgages, however, are the masses of people in Pay Option ARMs, interest only mortgages, and regular ARMS about to reset.

Most adjustable rate products including Pay Option ARMs are tied to either 1 year treasury rates or LIBOR. In the following chart I penciled in the current rate for LIBOR and treasuries in the January 2009 column.

1 Year Treasury Rate

1 Month LIBOR

Anyone in a 3-1 ARM or 5-1 ARM about to reset is about to get a huge break. The red squares show the difference. Mortgage relief is coming to everyone about to reset and enormous mortgage relief is coming for those in 3-1 ARMs about to reset. Those in 3-1 ARMs may see a drop of as much as 4% depending on whether or not they had an initial teaser. Regardless, everyone appears poised to benefit.

Those in interest only loans tied to 1 month LIBOR that resets every month have been benefiting for quite some time. We are in that category. Our spread is 1.25% over LIBOR rounded to the nearest 1/8 which means our interest rate in January will decline to 1.75%. It is currently 3.25% (LIBOR was close to 2.0% this month).

Free Money

Let’s add one final piece to the puzzle. I talked about it in Quantitative Easing American Style: Free Money.

The Fed is looking at the “benefits” of purchasing longer-term Treasury securities. The benefit is to banks who are front running the trade. Banks can now borrow from the Fed at the discount rate of .5% and invest somewhere out on the yield curve at a higher rate.

And as long as the Fed is not going to contract credit, banks can hold to maturity and pocket “free money”. The odds of Bernanke contracting credit any time soon are essentially zero.

Banks have two reasons to buy as many treasuries as they can.

  1. Free Money (as long as Bernanke does not contract money supply).
  2. Drive yields down to stop foreclosures.

Bond Investors Turn Bullish At Long Last

Treasury bears have been fighting this enormous pent up demand for treasuries for years. Now the irony is at long last Bond Investors Turn Bullish on Treasuries.

Treasuries were a screaming buy at yields above 4%. Now investors like them at yields of 0-2%. Go figure.

Repeating what I said in the above link:

In addition to a continuing increase in banks’ cash assets (to increase their cash ratios against liabilities and loans), we should now see banks’ holdings of treasuries rise significantly. By the mid to late ‘2010s, expect to find that the Fed and US member banks will be the largest holders of US Treasury debt by far.

Just as happened in Japan, those expecting instant and lasting fireworks when the bond bubble explodes are likely to be very disappointed. Low yields can easily be the norm for a long time to come.

Bernanke has every intention of keeping rates as low as he can for as long as he can. With that backdrop, banks will continue to borrow from the Fed at the discount rate and buy as many treasuries as they can given that lending makes virtually no sense in an environment of overcapacity, weak demand, and rising unemployment.

However, this finally puts some light at the end of the housing tunnel, even though it is extremely premature to be looking for any kind of fast recovery. Unemployment is poised to soar in 2009 and that will offset a great deal of the benefit of falling yields.

The ARMs reset problem may go away (as long as rates stay low). However, one problem is an exit strategy from this madness, the second is those underwater still have an incentive to walk away, and a third problem is other severe problems (commercial real estate, credit card defaults, etc) are poised to get much worse. In other words this is a short term cure that delays the eventual recovery, just as happened in Japan.

Also bear in mind that given the backdrop of rising unemployment, boomer retirement concerns, and a stock market that has obliterated nearly every IRA and pension plan in the country, this economy rates to be very weak for quite some time, most likely years.

For those reasons, I still favor an L Shaped Recession, a thesis I laid out on April 8, 2008.

Addendum:

“Rancho Cal” writes …

In California, I don’t think the reduction in the rate will make much of a difference for those in option ARMs. Something like 70% those holding these mortgages are paying the minimum (negative amortization) payment every month because they cannot even afford the interest only payment. Most of the loans taken out from 2005 through 2007 in California were option ARMS. Once the loans reset and payments on the principal need to be made, these loans will go bad, regardless of the interest rate.

My reply: That is correct.

Notice I only said the reset problem “vanishes”, a word I wish I did not use. “Postpone” is a far better word. All other problems remain and postponing the problem is one of the reasons for the “L” Shaped recession coming down the pike.

Mike “Mish” Shedlock
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