Why do Asset Backed Securities prices inversely correlate with interest rates?
My family owns some asset backed securities ("MBS") and can't figure this out. We Googled and found Mortgage Crisis and Fed Unintended Consequences, but I generalize it to Asset Backed Securities ("ABS").
The Fed’s desire to bring mortgage rates down isn’t just damaging servicing portfolios because of prepayments, it’s also wreaking chaos in Lenders’ ability to hedge their risk. Let’s look at what happens when a borrower locks in their mortgage rate with a Mortgage Lender. Mortgage rates are based on the trading of Mortgage Backed Securities (MBS). As Mortgage Backed Securities rise in price, interest rates improve and move lower. A locked rate on a mortgage is nothing more than a Lender promising to hold an interest rate, for a period of time, or until the transaction closes. The Lender is at risk for any MBS price changes in the marketplace between the time they agreed to grant the lock and the time that the loan closes.
If rates were to rise because MBS prices declined, the Lender would be obligated to buy down the borrower’s mortgage rate to the level they were promised. And since the Lender doesn’t want to be in a position of gambling, they hedge their locked loans by shorting Mortgage Backed Securities. Therefore, should MBS drop in price, causing rates to rise, the Lender’s cost to buy down the borrower’s rate is offset by the Lender’s gains of their short positions in MBS.
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