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).
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
:
Loan limit 766,550 for a single-family home in most markets to 1,149,825 in higher-cost areas.Borrower credit score, FICO 620 or higher.
Borrower debt ratios debt-to-income (DTI) ratio of 36 percent or less, can go up to 50 percent with specific compensating factors
Down payment/home equity, 3 percent down for a purchase or 5 percent equity for a refinance. If less than 20 percent equity requires private mortgage insurance (PMI).
Loan-to-value (LTV) ratio max 97 percent, depending on the
mortgage and the borrower.
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.
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 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.