For every intervention, there are unintended consequences. The agency mortgage market looks, well, weird. The coupon stack, as it’s called, represents all the mortgage coupons investors can buy and the associated cost of each incremental 0.5% of coupon.

When markets are worried about refinancing, the cost to buy higher coupons becomes very low because The higher the coupon, the faster it will prepay, which decreases the carry or yield of coupons priced above par (prepaid principle balances are returned to investors at par or 100% of face value, so any amount paid above par is an amortized loss as homeowners refinance).

Below you can see that it’s only been cheaper to buy higher coupon mortgages one other time - and that was during the largest refinance event ever in 2002/2003.


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Above is the Mortgage Refinance Index. See the large spikes in 2001 and 2002? That’s the disease and the cure. The market is pricing in a return to the refinancing environment of the early 2000s, and that's no doubt what the Fed is trying to accomplish with its “quantitative easing” purchase of MBS. But, thankfully, those days are gone forever.

The refinance landscape has changed dramatically. A large portion of the refinancing activity during that period was driven by the aforementioned fixed to floating refinancing. Because the securitization market for floating rate mortgages has been hurt, most ARM rates are higher than fixed rates.

The option ARMs with the teaser rates - well, let’s just say that the companies offering that product aren’t around anymore. I’m also guessing that income and employment will actually be verified this time around; with unemployment skyrocketing, many people will not qualify.

Yes, Ben might be trying to throw a refinance party, but there are very few people able to attend.

So why is the market pricing higher coupons to such a Draconian refinancing environment? It’s because it is not the market doing the pricing. The Treasury has hired a couple of money managers to purchase lower coupons. Sure, refinancing activity will pick up - but most likely not enough to make the higher coupons expensive versus the lower coupons that the government is artificially inflating.

In fact, my firm has stressed our high-coupon mortgages to much higher prepayment speed assumptions than models would suggest, and the yields are still attractive.