File this under things I don’t understand.
During the Covid-19 pandemic, the Federal Reserve lowered short term interest rates and rates across longer maturities followed suit. The rates on mortgages, such as the 30 year mortgage which is common in the U.S., hit all time lows of 2.65% in January 2021.1
Home buyers and existing home owners financed new purchases or refinanced existing mortgages at these historically low rates. This appears to be a very rational financial decision.
Banks and financial institutions; however, lent substantial sums of money at these historically low rates. In hindsight, this appears to be a less good decision. Using TLT as a proxy for the value of longer dated bonds, the value has fallen close to 50% in three years.
Now, rates have increased sharply to unexpectedly high levels. Mind you, these are not historically high rates. The highest rate on a 30 year mortgage in the U.S. is 18.63% set in October 1981.1 But the rates are certainly local maximums in terms of the memories of most people. You would have to go back to 2000 to find rates this high.2
So now what?
Existing homeowners are understandably reluctant to give up these rates – in other words – sell any property financed with low rate mortgages or paydown low rate mortgages quickly.
Banks, financial institutions, and investors who hold these low rate mortgages appear to have locked themselves into an under-performing asset for a long time. The thesis appears to be that these entities are going to hold these assets to maturity, which means they will eventually get the principal back, so the unrealized loss sitting on their books is not a concern. In this case, they will be earning roughly half as much interest as a similar mortgage made today. In a poorer scenario, these institutions sell these assets – for whatever reason – and take a substantial realized loss.
It seems to me that I am missing something somewhere, and do not see how this plays out (efficiently).
Mortgage owners that locked in low rates appear to have received a huge financially engineered (one-time?) benefit. But now have little incentive to sell their properties or pay down their debts. So the gains are literally trapped in their house.
Lending institutions lent money at historically low rates and picked up transaction fees along the way. But are now holding under-performing assets for a couple of decades.
Is that it? Are we stuck in the world where:
- Most existing homeowners are unlikely to sell for discretionary reasons.
- Refinancings appear to be highly unattractive.
- Repaying mortgage debt would also be less attractive since Tbills are earning well above the low rate mortgages.
- Banks and financial institutions are holding relatively unattractive mortgage assets regardless of how accounting rules make these appear.
- Real estate transaction volumes are going to be substantially lower for the foreseeable future.
It is almost like the average U.S. mortgage holder outfoxed the supposedly sophisticated financial institutions. But somehow the financial institutions appear to be unimpaired in any way. And participants are going to wait in their respective corners until…until…until what?