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While nothing is incorrect in the explanation, it's an overtly complicated way to understand the intuition. Mortgages are fixed income instruments. There are 2

While nothing is incorrect in the explanation, it's an overtly complicated way to understand the intuition. Mortgages are fixed income instruments. There are 2 types of mortgages, fixed rate and adjustable rate. The article focuses on fixed rates, as adjustable rate mortgages are different for a variety of reasons. Fixed income instruments are roughly priced like this: Yield ~= risk free rate (corresponding duration treasury rate) + interest rate risk premium + default risk premium 1. Risk free rate (=corresponding treasury rate) is going up. Fed is pushing the entire yield curve up through Fed Funds and QT, not just the short end. 2. Interest rate risk premium is going up, because it is much more uncertain (compared to 2008-2018, or 2020-2022) where risk free rate will be in 1 years from now, much less about 5 years from now. We don't know what the Fed will end up doing. To understand this risk, you have to understand the duration of an instrument[1] and incorporate the uncertainty about the risk-free rate. 3. Default risk premium is uncertain, because the question depends on whether are we going to have a recession? Recession may depend on whether the Fed can engineer a soft landing. So yes, 30yr mortgage rates will go up, because #1 is going up, #2 is going up, and #3 is maybe going up. [1]https://www.blackrock.com/fp/documents/understanding_duration.pdf https://www.blackrock.com/fp/documents/understanding_duratio...

blake1 4y ago
I’m just going to talk about fixed-rate US agencies. Treasuries are option-free, while fixed rate mortgages include a prepayment option. Also, these mortgages have a strong implicit backing of the US Government, so there is no default risk. The article is about a spread, so the risk-free and interest-rate-volatility terms will be shared with a treasury. The dynamics of that prepayment risk are complex, and there is a vast literature on the subject. This article simplifies it enormously, based on my experience in this field.
- snake_doc 4y ago
  Yes, absolutely right no argument there. Intuitively, prepayment risk can be broken down into interest rate risk and default risk in its most basic terms when compared to a coupon bond. The risk relates to duration and cash flows. Early prepayments decrease duration, and decrease expected cash flows, which can be thought of in relation to interest rate risk and default risk. I guess I prefer when complex topics are broken down back to their principal parts.
yold__ 4y ago
So here is my super simple understanding take on the long-winded article. If the duration of treasuries, or whatever you are basing the spread on, is equal to MBSs, the spread would be constant. This is not the case because of prepayments (i.e. the option). When interest rates rise, refinancing-related prepayments slow. Duration increases. But, it's a hot housing market, so there is an offsetting effect. Duration is decreasing due to the housing market (buyer-driven prepayment). The option-adjusted spread would capture both these effects, but good luck with that.

blake1 4y ago

I’m just going to talk about fixed-rate US agencies. Treasuries are option-free, while fixed rate mortgages include a prepayment option. Also, these mortgages have a strong implicit backing of the US Government, so there is no default risk. The article is about a spread, so the risk-free and interest-rate-volatility terms will be shared with a treasury. The dynamics of that prepayment risk are complex, and there is a vast literature on the subject. This article simplifies it enormously, based on my experience in this field.

snake_doc 4y ago
Yes, absolutely right no argument there. Intuitively, prepayment risk can be broken down into interest rate risk and default risk in its most basic terms when compared to a coupon bond. The risk relates to duration and cash flows. Early prepayments decrease duration, and decrease expected cash flows, which can be thought of in relation to interest rate risk and default risk. I guess I prefer when complex topics are broken down back to their principal parts.

yold__ 4y ago

So here is my super simple understanding take on the long-winded article. If the duration of treasuries, or whatever you are basing the spread on, is equal to MBSs, the spread would be constant. This is not the case because of prepayments (i.e. the option). When interest rates rise, refinancing-related prepayments slow. Duration increases. But, it's a hot housing market, so there is an offsetting effect. Duration is decreasing due to the housing market (buyer-driven prepayment). The option-adjusted spread would capture both these effects, but good luck with that.