Rising Mortgage Rates: A Bailout Side Effect?

The average 30-year mortgage rate jumped to 6.46%, up from 5.94% a week ago. The last time we saw a spike like this was 1987. Higher mortgage rates means even fewer people will be buying houses, vacant home prices will fall, and owned-home values will decline. This also means the value of all those bank-owned, mortgage-exposed securities (the cause of the credit freeze) just ticked down. That makes me nervous. Let’s talk about how this happened. But first…

Intro to Bonds
There is a wide variety of bonds out there. For our purposes, we’ll talk about the three hugest bond categories, listed in order of riskiness:
1)Government bonds: These include T-bills (Treasury bills), T-notes, and T-bonds. When you buy these, you’re lending money to the government. These things are guaranteed by the government. If the government is short of cash, the Treasury will print you up brand new cash. No risk means low rate of return for investors.
2)Fannie/Freddie bonds: Fannie Mae and Freddie Mac were set up by the government (i.e. they’re government sponsored entities, or GSEs) to help move mortgages and make them cheaper, because homeownership was thought to be good for America. Because the government has a hand in these organizations, GSE bonds are considered less risky than corporate bonds. But, they’re not explicitly guaranteed by the government. As such, GSE bonds have moderate risk and offer a moderate rate of return for investors.
3)Corporate bonds: Companies, including banks, issue these to raise money. But companies are allowed to go bankrupt. This higher level of risk means a higher rate of return.

Lehman Brothers was a company that went bankrupt. That sucked. A lot of people, including other banks, were holding Lehman bonds. A ton of people had CDS exposure to those bonds. A bunch of institutions still have accounts at Lehman that are currently frozen. And ultimately, it destroyed confidence between banks. It is not good for a bank to go bankrupt.

Uncle Sam’s $250 Billion Bet on Banks
On Tuesday, behind closed doors, the Treasury, the Federal Reserve, and the FDIC basically forced a couple big banks (including Citigroup, JPM Chase, and Bank of America) to accept a government investment. In return, America would get ownership stakes in the banks and a 5% annual return. There were other terms to the deal, but that’s not important to this discussion. Ultimately the banks were borrowing money cheaply and, assuming those banks don’t go belly up, the taxpayers would earn a decent rate of return.

Bank Bonds Suddenly Look Sweet
Now that the government has a hand in these banks…maybe they won’t be allowed to go bankrupt. Very quickly, the risk level of these banks’ bonds fell. In fact, bond market action suggested the bank bond risk was similar to GSE bond risk. In other words, banks bonds' risk now reflected that of the second category of bonds we spoke of. But bank bonds offer a higher rate of return than GSE bonds. So why buy GSE bonds?

The Effect on and of Fannie/Freddie Bonds
In order to compete with bank bonds, GSE bonds have to offer a higher rate of return. In order for GSE bonds to offer a higher return rate, mortgage rates have to go up. The dynamics of this relationship are complicated, and I’ll explain in a future post. I suspect we’ll hear more about Fannie Mae and Freddie Mac in the near future. That might be a more appropriate time to explain how the GSEs operate.

The Big Picture
So, did the Treasury consider the bank bailout’s effect on mortgage rates? Gosh I hope so. Regardless, no plan was going to be perfect. Especially a plan that had to be rushed. I think this mortgage rate spike might just be a side effect, sort of like a mild fever after a vaccine. Remember, the primary goal of the bailout plan was to unfreeze credit in an effort to prevent Great Depression 2. I believe that Great Depression 2 would be much, much worse than any effects of the mortgage rate spike we’re seeing now.