New hope for the '07 economy

By Jim Jubak

Could the housing market be about to get lucky? Unexpectedly low mortgage rates are arriving just in time to help overextended recent home-buyers by opening the refinancing window one more time -- and in the knick of time.

Yes, housing prices are falling -- prices of existing homes fell 1.7% in August, the first year-to-year decline since May 1995. And yes, new home sales were down 23% in August from the July 2005 record high.

But without rising interest rates to put the squeeze on buyers who used adjustable-rate and interest-only mortgages to buy more house than they could really afford, the correction in the housing market isn't going to turn into the bust that so many are predicting (with a certain ghoulish relish, I might add).

And right now it looks like these buyers, and the economy as a whole, are going to dodge a bullet -- a big .357 Magnum-sized bullet.

It's still too soon to say anything definitive about 2007, but I'm starting to see a glimmer of hope that the year will turn out better than most economists and many Wall Street analysts expect. Lower mortgage rates and lower energy prices could be enough to keep the economy chugging along at a faster speed than the 2.5% that economists are now projecting for the first half of 2007. (For an earlier take on this topic see my column, "A sweeter scenario for 2007.")

Back to bonds

It all starts with the bond market, as so many trends do in the financial markets.

After the Federal Reserve chose to stand pat on short-term interest rates at its Aug. 8 meeting and then again at its Sept. 20 meeting, bond investors concluded:

• Ben Bernanke and company were done raising interest rates

• inflation was under control

• economic growth was weak enough that the Fed's next move would be to reverse course and cut interest rates in 2007 to head off the danger of an economic slowdown.

I think bond investors have misread the Federal Reserve: An interest-rate cut in 2007 is by no means guaranteed and inflation isn't anywhere near dead. But in the short run, what matters is that bond investors have been bidding up the price of long-term Treasury bonds on a belief that interest rates will be lower in 2007 (which would boost the price of bonds and give bondholders a tasty capital gain). That has lowered the yield on 10-year Treasury notes to 4.6% on Sept. 27 from a 2006 high of 5.22% on June 30, 2006. The 10-year Treasury note now yields less than it did in June 2004, when the Federal Reserve finally began raising short-term interest rates from the 1% level they had hit in June 2003.

We haven't seen the bottom on rates

That decline in the yield on the 10-year note is itself good news for anyone looking to buy a house or wanting to refinance. The interest rates on many mortgages -- both fixed and adjustable -- are pegged to the yield on 10-year Treasury notes. So, for example, the drop in the Treasury yield has taken the interest rate on a 30-year fixed mortgage down to 6.25%. That's not as low as the sub-6% rates available in the middle of 2005, but it sure beats the 6.8% rate on a 30-year mortgage prevailing on July 21, 2006.

But I don't think we've seen the bottom on yields or on mortgage rates. That's because low mortgage rates lead to increased numbers of refinancings, which then lead to more buying of 10-year Treasury notes and a further decline in yields on those notes.

It works like this. Most mortgages these days aren't held by the lenders that issue them. Instead they are bundled together and sold as mortgage-backed securities to big institutional investors, such as pension funds and insurance companies. These institutions like the relative safety of these bundles of mortgages, their higher yields and their predictable income streams.

Well, relatively predictable income streams, that is.

A flood of refinancings

Refinancings reduce the duration of those income streams -- when a mortgage-holder prepays, he or she puts a premature end to a stream of future payments. And that's a problem for these institutional investors who try to match the date of their future obligations -- such as pension payments to retirees -- with the date of income flows. For an insurance company that was counting on having a specific cash flow nine years from now, a drop in the maturity of a mortgage-backed security to eight years is a big deal.

The way to fix this maturity gap is to buy long-term securities that put the portfolio back on schedule. For many big institutional investors, the best way to add length to a shortening duration is to buy long-term, 10-year Treasury notes. So as bond yields have declined and prepayment worries have climbed, more institutional investors have stepped into the bond market and bought 10-year notes. This, of course, causes the yield on the 10-year note to fall even further, raising more worries about prepayments and sending yields still lower.

The worries seem to be justified, according to recent data from the Mortgage Bankers Association. Mortgage refinancing applications jumped by 9.5% in the week that ended Sept. 15 from the week before. That continues a trend that began about two months ago, when mortgage rates began to decline from June 2006 highs.

Waving their ARMs

Many of those refinancings involve adjustable-rate mortgages. In every month from May 2004 to June 2006, adjustable-rate mortgages made up 30% to 35% of all mortgage applications, according to the Mortgage Bankers Association. You can easily understand why so many holders of adjustable-rate mortgages would try to refinance too. Three years ago, the monthly payment on a $200,000, three-year adjustable-rate mortgage at 4.25% would have been just $984; this year, the rate on that mortgage could well be 6.25% with a monthly payment of $1,212. In 2007, the rate could well be 7.4% and the monthly payment $1,354.

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