It’s no longer news that the housing boom was the direct result of the easy money that flowed into home lending through the blossoming mortgage backed security market. Faced with extremely low yields, investors stretched out for higher returns, purchasing exotic products that financed sub-prime borrowing and turned a part of the population from great renters, into horrible home owners. Huge losses followed for many investors and the colossal misallocation of capital drove the economy into a deep debt laden recession. The market is very easy to forget the danger of certain risks.

Very low inflation expectations, foreclosure moratoriums, first time homebuyer tax credits, $1.25 trillion in MBS purchases by the Fed and government acronyms like HAMP, TALF and TARP have all done their part to keep mortgage rates at historic lows for over a year now, and all they keep doing is fall. Homeowners who are able to refinance see a 4.67% 30-year mortgage and immediately begin to ask what their monthly savings will be. But to investors the question should be, “Who the heck is lending money as these rates, and why”?

The main difference between Agency MBS and Treasuries is the prepayment risk. Borrowers are given the option to prepay any part of loan at any time, almost always without penalty. From the perspective of the bond holder, that option to the borrower is a negative. In theory, if rates drop, the borrower will refinance at a lower rate, and the bond holder will receive principal back early and will be forced to reinvest at a lower interest rate. If rates rise, the borrower is more incentivized to pay the mortgage as slow as possible, leaving the bond holder with less principal to reinvest at higher rates. To compensate the bond holder for this inconvenience, the borrower receives a higher interest rate from the beginning. The market determines that “spread” and it has never been as low as it is right now.

But is the spread justified? The vast majority of people who have a good enough equity position in their home have already refinanced. The Fed could certainly drive rates down more with additional quantitative easing if we get another major leg down in home prices, but that might do so much damage to homeowners’ equity to make the lower rate matter a bit. Result… slow prepays going forward, mortgages begin to look much more like bullets, and that spread that investors are so used to goes away.

So where is the danger? First of all not every mortgage backed security is identical. The market prices various risks differently, so relative value within agency MBS does come around from time to time. Capturing that value while staying within risk guidelines is a challenge but worthwhile in this rate environment. The danger lies in abandoning rational thinking and stretching out into higher risk areas to capture the spread you were used to getting in your comfort zone.

Spread comes and goes and market movements tend to overshoot equilibrium over time. Higher risk comes in the form of moving out the curve to earn a higher yield, moving into credit sensitive product to capture extra spread or even moving to a lower position in the capital structure (buying stocks), and all risk isn’t punished or rewarded at the same time. The past week is a perfect example of that. But in an environment where uncertainty and government intervention dominate, excessive risk should be avoided and patience should be exercised.

Have a great 4^th of July weekend.

Cliff J. Reynolds Jr., Investment Analyst