The Secret Law Of Refinancing

Isn't refinancing your mortgage fun? No wonder it became one of America's favorite indoor activities. When rates were falling, which they did for years, people kept calling their mortgage brokers to get a lower rate. The combination of lower payments and all the extra cash it freed up helped keep the economy afloat, and gave serial refinancers--you know who you are--bragging rights at parties.

Now, let's have a show of hands. Who can explain what happens when millions of people refinance trillions of dollars of mortgages? (Sorry, mortgage professionals, you have to keep your hands down and not give away the answer.) Don't know? Don't feel bad. Almost no one outside the mortgage biz understands this stuff. It's not only confusing, it doesn't even operate according to something as basic as the law of supply and demand. In fact, it's the opposite. The more demand there is for refinancing, the lower rates tend to get. The less demand, the higher rates tend to get.

"People don't understand how the relationships in the market work," says mortgage expert Keith Gumbinger, a vice president of financial publisher HSH. "There are behind-the-scene dynamics that have a major impact on rates." Bear with me, and I'll take you on a tour of Refi World.

Before our exploration begins, it's time for a brief primer on interest rates and mortgages. Most mortgages are of the long-term, fixed-rate variety. The interest rate on them is keyed to the rates on long-term securities such as the 10-year U.S. Treasury note. Alan Greenspan and his merry crew at the Federal Reserve Board control short-term rates--but their influence on long rates is tenuous, at best. That's why the long-term market had one of its worst months ever in July, with long rates rising sharply at the same time short rates fell through the floor.

OK. Back to the main event. Refinancing is great for us borrowers. If interest rates go down, we refinance. If rates go up, we keep our mortgages. But refis are wretched for investors who own mortgages: Fannie Mae and Freddie Mac, pension funds and such. Fannie and Freddie have borrowed huge amounts of money and have to pay it back; pension funds have to send checks to present and future retirees. They want the payments they get from the mortgages they own to be in sync with the obligations they have to pay. Timing is everything for these guys.

When refis ramp up and exceed expectations, mortgage owners get back money they had expected to be profitably invested for years. Things get out of whack. So the mortgage owners need to "add duration," as they say in the bond biz. So they run out and buy long-term securities. Lots and lots of them. In this case, the law of supply and demand works. Bond prices rise, which translates into lower rates. Example: pay $1,000 for a 4 percent $1,000 bond, and the $40 of annual interest you get gives you a yield of 4 percent. If you pay more than $1,000, your $40 of interest yields less than 4 percent. And lower long-term rates mean lower mortgage rates.

Earlier this year, with refis surging, mortgage holders were "adding duration" like crazy and thus forcing down interest rates. The more refis there were, the more "duration" these guys bought, the more interest rates fell, the more attractive refis became. Think of a dog chasing its own tail. Then came the reversal in June, for reasons we'll get to in a minute. Now refi levels are falling. With rates rising, people are holding onto mortgages rather than flipping them. So big investors have to "shed duration" to get back in balance. They've been selling long-term securities like mad. This lowers their prices, raises their effective interest rate and thus raises mortgage rates.

Underlying economics--how much businesses, people and governments borrow, how much money flows in or out from foreign investors and so on--determines long-term rates in the long run. But in the short run, says Scott Simon, head of the mortgage team at Pacific Investment Management Co., mortgage owners adding or shedding duration is like throwing gasoline on a fire. "It's an accelerant," says Simon. "It makes rates go lower than they otherwise would, or higher than they otherwise would."

Why did the long-term market suddenly turn around and head higher in mid-June? Blame the Fed, which had been messing with the long-term market by publicly musing about buying long-term securities to raise their prices and force down long rates. The Fed's gum-flapping drove rates down. But in June, Greenspan said the Fed wouldn't buy long-term securities. Oops. The psychology changed. Investors who hadn't wanted to fight the Fed started dumping, long rates started rising, and the market's been chasing its own tail.

Hope you've enjoyed your tour of Refi World. The bottom line here: markets are sensible in the long run, but not necessarily in the short run. And they play by their own rules, not by yours.