Last date in this report is 2025-03-11




Mortgage back securities (MBS) issued by a government sponsored enterprise (GSE) is interest and principal risk free. The risk free rate implicit in MBS is provided by the GSEs (FNMA, GNMA, FHLMC).

MBS Conduit

The all in rate for GSE MBS costs out, in addition, the cost of the orginal mortgage borrowers prepayment option, the 45 days delay in paying out the interest on the original loan into into MBS, costs to service the loan, the cost of the trusts to hold and payout interest and principal of the orginal mortgage loans which are placed into pools of whole loans and then in the trust.


Consistently overtime, those all in costs have 30 year conventional mortgages 1.6% over the US Treasury 10 year rate when it was equivalent to the risk free rate. Therefore 30 year conventional mortgage rates are 1.6% over the risk free rate.

Risk free rate sourced from 30 year mortage rates are directly from the 30 year mortgage rate and is not based upon the US Treasury 10 year rate. This is due to the stand alone risk free nature of MBS.

The anlaysis below uses a long term depiction of daily 30 year conforming mortgage prices. Conforming being mortgages that meet the criteria set by the Federal Housing Finance Agency (FHFA). They’re eligible to be purchased by government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.

These loans have set limits and guidelines for borrower credit profiles, loan amounts, down payments and property types. The FHFA adjusts the conforming loan limits every November to account for changes in the housing market. Current conforming loans have :

The above variables assure the GSE that once placed in a MBS it is the equivalent of at least AAA. Then with the GSE support, the MBS becomes “risk free”.

Note the variables are engaged with the macro economic dynamics and therefore must price to the current and expected evolution of NGDP. Rates, in terms of level, are not a factor in this “grid”. Therefore conforming mortgages are always pricing to NGDP and are “risk free” given the end use on GSE MBS. They are not priced as per the recent US Treasury 10 year market rate unless the US Treasury 10 year is engaged with the economy as are mortgage lenders and borrowers.

However, as shown below, the US Treasury 10 year market rate was equivalent to the risk free rate such it was easier to use the US Treasury 10 year rate as the proxy for the risk free rate. Conforming 30 year mortgage rates less cost of the conduit to transform the mortgages into GSE MBS is the risk free rate concsitently, though brief periods of shock do cause sector segmentation but returns to the risk free rate.





There are several yield curve models.

The models contain a Werner process which uses the expected volatility in rates using realized volatility - a binomial model with the first such model being Merton. Then the affine models use the binomial model and calibrate to the current long duration level usually oberved in the market as well as an expected or observed curvature in the model, the term premium.

Ho Lee is the next generation model after Merton.

Ho-Lee
Ho-Lee



The problem with Ho-Lee is that while giving a good idea as to the term premium, the long rate is near conceptual and not reality. But the Ho-Lee model is not a ‘no-arbitrage’ which requires the final maturity rate to be inputted.


The Nelsen-Siegel model has the the volatility input of Ho-Lee but then uses a curvature factor, a ‘drift’ factor, and then a factor which draw the ever increasing rate back to the terminal rate inputed.

Nelson-Siegel

Nelson-Siegel is a ‘no arbitrage’ which while eliminating the the ever rising levels of Ho-Lee does require the terminal rate to be inputted so as to derive the curvature. It is akin to a regression of the existing yield curve and is not predictive. Therefore once the terminal rate - we derive a risk free terminal rate - the affine curve is produced but does not have as far as rates go predictive capability.