Why margin calls are currently causing mortgage rates to rise

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.

Dow drops more than after September 11th

How important do the markets think the financial bailout is?

On news that the $700 billion financial rescue plan got voted down in the House of Representatives th Dow Jones Industrial Average fell by almost 800 points.

To put that in perspective, when the markets opened following September 11th the Dow Jones dropped 644 points.

Rate Update for September 2, 2008


Mortgage rates are up across the board today.  We shifted our outlook to a locking position on Friday and our shift proved timely.

We alluded to technical trading patterns on Friday as a reason to lock and mortgage-backed bonds have now broken below the 100-day moving average which is partially why rates have moved higher.

Watch today’s you tube video to understand why we think lower oil prices will initially cause rates to rise but then move back lower. 

Current Outlook: locking in near term but recommending a long-term floating stance

Rate Update for August 25, 2008

Mortgage rates are modestly lower today as mortgage-backed bonds trade inversely with the stock market.

Mortgage rates are benefiting from a “flight-to-quality” which I explain in today’s you tube video which can be viewed here-

Later this week the Personal Consumption Expenditure (PCE) report is scheduled to be released which is an extremely important piece for inflation expectations.  For now, we will remain in a floating position.

Current Outlook: floating bias

How The Stock Market Impacts Mortgage Rates

Although inflation expectations are the primary factor that influence the direction of mortgage rates on a day-to-day basis the stock market can also have an impact.

To understand how this relationship works it’s first important to understand how mortgage rates are determined.

Mortgage rates are entirely determined by the price of mortgage-backed bonds (MBS’s). MBS’s are bonds that are issued by Fannie Mae and Freddie Mac that are backed by the interest paid by mortgage holders. Like the stock market, there is an exchange where MBS’s are traded.

There is an inverse relationship between the price of MBS’s and mortgage rates. When the price of MBS’s increase mortgage rates drop and vice versa.

So, to understand how the stock market can influence mortgage rates we have to understand how they impact the price of bonds. Stocks and bonds compete for the same investment dollar.

In other words, an investor with money to invest has to make a decision to invest their money in either the stock market or in the bond market (it should be noted that there are other investment options, but these two classes are the primary vehicles for investment capital).

For an investor, stocks are generally thought to provide higher returns over time but also come with greater volatility.

Conversely, bonds tend to have lower returns over time but have less volatility. Because bonds tend to provide low volatility with modest returns, the bond market can often act as a “safe-haven” for investors who sell their stock positions.

Therefore, in general, when the stock market goes down it is a sign that investors are selling stocks and shifting their capital into bonds. This boosts bond prices and drives mortgage rates down.

Conversely, when the stock market rallies it is a sign that investors are selling bond positions in order to shift capital into the stock market. The greater supply of bonds on the market drives prices lower and pushes mortgage rates higher.

It’s important to understand that there are a myriad of factors that impact mortgage rates on a day-to-day basis.

Inflation expectations and technical trading patterns are two of the primary factors that we monitor. However, in the absence of new information on these two topics it’s not uncommon for mortgage rates to be impacted by the stock market in the aforementioned manner.