Back in October, the Obama Administration extended the HARP (Home affordable refinance program) to allow homeowners to refinance if even if their mortgages were underwater. This change had a direct effect on the mortgage market. Specifically, mortgage securities with high coupons (where the homeowners were paying high interest rates) fell in value. This was because the market anticipated that a greater number of these homeowners would be able to refinance their loans at lower rates. Previously they had been unable to do so because their loans exceeded the value of their homes. I blogged about this back then and it appeared to be a classic case of negative convexity in the MBS market.
Now comes the news that the market has largely recovered. The amount of expected refinancings will fall far below those initially predicted, apparently in large part due to the decreased credit scores of many homeowners.
(note link to FT website will require you create a free account to view the article).
Showing posts with label convexity. Show all posts
Showing posts with label convexity. Show all posts
Tuesday, December 6, 2011
Tuesday, October 25, 2011
Negative convexity in mortgage bonds
I love it when the real world behaves in just the way that I wrote on the class room white board!
Case in point: Mortgage bonds have negative convexity over certain ranges of interest rates. This means that when rates fall the value of the bond falls instead of increases as would be the case for a typical bond. The reason for this effect is refinancing by the homeowners whose mortgages make up the cash flows of the bond. As these homeowners refinance, the amount of promised cash flows declines, and so does the value of the bond. Interest rates matter here because lower interest rates result in more refinancing.
OK, so what is happening today? Well, there are a lot of homeowners who can't refinance because they have negative equity. So even though they see interest rates fall, they cannot take advantage of these lower rates, that is, until now. President Obama's latest initiative to enable these under water homeowners to refinance will result in many mortgage bonds getting paid off early and, as a result, fall in value.
The FT has a great article on this which notes that only the mortgage bonds which had coupon rates that are above the prevailing mortgage interest rates suffered a price decline around the announcement of the plan - exactly as we would expect.
As noted in the article, part of this plan is basically paid for by a wealth transfer from the mortgage bond holders to households.
Case in point: Mortgage bonds have negative convexity over certain ranges of interest rates. This means that when rates fall the value of the bond falls instead of increases as would be the case for a typical bond. The reason for this effect is refinancing by the homeowners whose mortgages make up the cash flows of the bond. As these homeowners refinance, the amount of promised cash flows declines, and so does the value of the bond. Interest rates matter here because lower interest rates result in more refinancing.
OK, so what is happening today? Well, there are a lot of homeowners who can't refinance because they have negative equity. So even though they see interest rates fall, they cannot take advantage of these lower rates, that is, until now. President Obama's latest initiative to enable these under water homeowners to refinance will result in many mortgage bonds getting paid off early and, as a result, fall in value.
The FT has a great article on this which notes that only the mortgage bonds which had coupon rates that are above the prevailing mortgage interest rates suffered a price decline around the announcement of the plan - exactly as we would expect.
As noted in the article, part of this plan is basically paid for by a wealth transfer from the mortgage bond holders to households.
Subscribe to:
Posts (Atom)