The Rise In Long Interest Rates - Another Take

I was saying yesterday that the rapid increase in home mortgages outstanding may be responsible for the sharp rise in long interest rates, caused by a rush to hedge all the CMO/CDO bonds created by their securitization. Such loans more than doubled from $4.8 trillion at the end of 2000 to $9.7 trillion at the end of 2006, a compound annual growth rate of 12.5%.

We know that many of those loans were of the "innovative finance" type, i.e. variable rate, balloon, negative amortization, etc. Their basic feature was that monthly payments were not fixed but were ultimately benchmarked against short-term interest rates, which were at historic lows in the 2001-04 period. As such loans start to reset (see chart below from Credit Suisse, click to enlarge), borrowers have a choice: pay the higher variable rate or re-finance to a fixed mortgage. Given the flat shape of the yield curve (Fed Funds = 5.25%, 30-year Treasury = 5.22%) many borrowers may decide to go for the certainty offered by a fixed rate mortgage, since staying with the variable loan will result in similar monthly payments, anyway.

I have added the "We are here" arrow to the CS chart above, pointing to 5 months after the data was published, i.e. now. Notice the sharp jump in mortgages being reset from May to June: from $25 billion/mo. to $40 billion/mo. There must be significant added demand for long-term money from all those mortgages switched to fixed rate, causing long rates to rise. The pressure from resets is going to increase further to $50 billion/mo. and stay high for another 13 months.

Again, this has nothing to do with the "strengthening" economy or inflation: the Debt Bubble is creating its own technical interest rate dynamics, shaping the yield curve in unexpected ways.