[PEN-L:30687] Re: Re: banks

[michael perelman <michael@xxxxxxxxxxxxxxxxx>]

Wessel, David. 2002. "U.S. Appetite for Refinancing Contributes to Bond
Volatility." (26 September).
 Fannie, Freddie, banks, Wall Street houses and others who borrow money
from one place and use it to buy big pools of mortgages.  Their profits
come from borrowing money at, say, 6.5% and lending it to homeowners at
7.5%.  When a homeowner pays off a 7.5% loan and takes out a 6% mortgage
instead, that profit can turn to a loss.  Big players are still stuck
with paying out 6.5%, but can't find a safe way to earn that much on
their cash.
 The big players may not buy Treasury debt directly, but they make side
bets on financial markets, called "derivatives," from dealers who buy
Treasuries to cover the risk.
 When rates fall a lot, the big financial institutions may need extra
insurance, even if only temporarily. That means more demand for
Treasuries, which pushes market interest rates lower.  And the lower
rates go, the more refinancing, and the more need for the big
institutions to buy insurance, and so on.
 Bond traders say that is a factor in causing the bond market gyrate.
10-year U.S. Treasury notes are paying 3.749%, lower than they've been
since 1958.
 Similar dynamics could give interest rates an extra upward shove when
the bond market turns around; unwinding the insurance policies will mean
someone is selling Treasuries. In short, homeowners, Fannie, Freddie and
big investors all doing the logical thing may accentuate the swings in
the bond market. And that could accentuate swings in an economy that
relies so much on borrowing at rates tethered to the rates the bond
market sets on U.S. Treasuries.
 Peter Fisher, the U.S. Treasury under secretary for domestic finance,
points out in speeches that we have invented a system that passes a lot
of volatility to financial markets because we like stabilizing things
like employment and household income.  Better wild swings in bond prices
than wild swings in your monthly mortgage payment or your wages.  Not
all investors like volatility, though.  So now, just as there are
markets for stocks, bonds and mortgages, there are new markets for
volatility.  "It seems to me," he lectured bond dealers in June, "that
we all have been a little slow to question some of the assumptions on
which our current understanding of the 'volatility market' are based."
In other words, even the big players don't fully understand what's going
on.
 According to Fannie Mae, 75% of all mortgages are held by investors who
have borrowed money to buy them, which means little moves in markets can
cause big reactions.  The Bond Market Association says there are $4.5
trillion in mortgage-related securities today.  That's 15% bigger than
the market for corporate bonds and 50% bigger than the market for U.S.
Treasuries.
 In 1994, the Federal Reserve raised short-term interest rates a little,
and the bond market raised long-term interest rates a lot, partly
because of the gyrations in the market for mortgage securities. Since
then, the size of that market has more than doubled.



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Michael Perelman
Economics Department
California State University
Chico, CA 95929

Tel. 530-898-5321
E-Mail michael@xxxxxxxxxxxxxxxxx