In a more normal financial environment we expect that when stocks trade lower mortgage rates benefit. This is because when money flows out of stocks it typically finds its way into the bond market which helps drive yields lower.
However, on many occasions over the past two weeks we’ve seen both stocks and bonds sell-off together causing mortgage rates to rise. Why has this dynamic changed?
The reason is that many investors, hedge funds, and institutions are having to sell assets because of “margin calls“.
To understand what a margin call it is first important to understand that many investors borrow money in order to purchase financial securities. By employing leverage they are able to increase their return on equity (when the value of these securities rise).
The lenders who lend money on margin require that investors keep a certain proportion of equity relative to leverage (much like loan-to-value ratio on a home). For example, if a bank is to lend an investor $1.0 million on margin they may require that the value of the account maintain a level of at least $2.0 million.
When the value of the securities decrease below this level, the lender issues a “margin call”. This call forces the investor to sell assets and raise cash to pay back the loan.
If enough investors are forced to do this concurrently, as they are in today’s environment, then the financial markets are flooded with securities and values of all asset classes decrease together.
This is why in today’s market, we are seeing the stock market decline AND mortgage rates increasing.