Fallout from Refinancing

As homeowners chase low rates, bondholders get caught in a cycle of volatility

American home-financing is a marvelous machine. Thanks to a huge market for mortgage loans, the U.S. has the highest percentage of home ownership of any major economy--68% of households. Mortgage bankers are so efficient that almost anyone can refinance when interest rates fall and put spending money in their pockets. So many did just that over the past 18 months that they probably saved the economy from a major downturn. Some $1.3 trillion of mortgages were refinanced since January, 2001.

Yet the opportunity to pay off mortgages early carries a little-noticed cost that is growing with each additional mortgage. Refinancings are making a key part of the financial system--the bond market--a riskier place, with the widest price movements in 15 years. The danger is that the very investors who make mortgage money so available could be hit with crippling losses from swinging prices, threatening their trading partners and roiling the markets.

The reason is the size and nature of the mortgage market. Mortgage loans, which are bundled and traded as debt securities, now make up nearly 40% of the bond market, dwarfing even U.S. Treasuries. To banks, insurers, and pension funds, they offer long payment streams over the life of the mortgages--typically 30 years. Government-sponsored mortgage companies such as Fannie Mae (FNM ) and Freddie Mac (FRE ) are big investors, too. Sure, these players assume some mortgages will pay off early when homeowners refinance or sell. But if interest rates make sharp moves, their estimates go out the door.

When falling rates lead to a wave of refinancing, institutions rush to replace the income from retired mortgages by buying, say, U.S. Treasuries, which will continue to pay. If they don't act quickly, their portfolios could sink even lower. The problem: This buying drives up bond prices and pushes down yields and mortgage rates--triggering more refinancing and exaggerating the move. "As interest rates are falling, everyone holding mortgages [securities] needs to go back and square up by buying something," says Daniel J. Ivascyn, portfolio manager at Pacific Investment Management Co. (PIMCO), which holds over $100 billion in mortgages and related instruments.

Rising interest rates trigger volatile trading, too. When rates go up, institutions sell their mortgage securities so that they won't be stuck with lower payments than they need to offset their liabilities. That's the problem that clobbered the savings and loans in the '80s.

Bond-market volatility--measured by the fluctuation between daily highs and lows--is at its highest since 1987, says market analyst James A. Bianco of Bianco Research. Daily swings for 10-year Treasuries were even wider the past 12 months than in 1998, when Long-Term Capital Management collapsed, and during 1994's interest-rate surge.

Why does volatility matter? For one, it raises transaction costs for corporations and investors going to the market. Sellers have to take lower prices; buyers pay higher prices than they otherwise would. A larger concern is the increased chance that a big institution will suffer crippling losses if, in these wild markets, rates move more than their models predict. In 1994, $600 million Askin Capital, a hedge fund that was trading mortgage securities, collapsed as rates climbed.

Bianco says Fannie Mae and Freddie Mac could cause real trouble. Their portfolios total $1.2 trillion, more than half the value of Merrill Lynch & Co.'s mortgage index. They hedge the majority of their risk, which means they pass it on to others. Freddie Mac's chief investment officer, Gregory J. Parseghian, says he uses outside experts to double-check his portfolio. "We have appropriate humility [about] all of the ways that you can be wrong," he says.

Perhaps Fannie, Freddie, and other institutions will avoid a wipeout. Even so, when bond investors take a hit from a sharp price move, they know who to thank: the American homeowner.

By David Henry in New York

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