I'm short one house, so I owe a monthly "dividend". I anticipate covering some time in the future. Yes, I rent.


My thesis is that as Americans increasingly don't pay their mortgages, people with money will be increasingly unwilling to loan them money to buy houses, causing mortgage rates to rise. Rising rates and tightening lending standards will cause prices to fall. I'm not hoping to catch "the bottom", but would like to wait until after a large drop has occurred, possibly another 2-3 years in my area.

I had come to terms with the fact that I should be able to buy a much cheaper house, but will have to pay a high rate for whatever portion I mortgage. But, with all the recent talk of shorting TLT, it got me thinking that I should be able to effectively "lock in" current rates while waiting for prices to drop. I do this by shorting TLT at current levels, then as interest rates rise I can use my profits from TLT to buy down points or reduce my loan amount. If rates fall further (any scenarios where that happens?), I take a loss on TLT, but my mortgage interest rate falls by a similar amount. Am I missing anything here?


A few questions:
1) Is there a mortgage bond fund that would track closer than TLT would? I'm mostly concerned about widening risk spreads. TLT wouldn't cover me as risk spreads between mortgages and treasuries widen.

2) How do I size the hedge? I'm a little fuzzy on this.

3) Any other ideas along these lines?

Thanks,
Keemo

Hah! even institutions haven't mastered this perfectly.

Two choices and neither is available to individuals:

1. If dead sure about buying within a year, Contract CMM (constant maturity mortgage) - pretty rare instrument traded off the shelve, call ur GS/LEH/MS rep. You can contract a 30-yr mortgage rate for a year out and it still will be liquid. Basis risk to libor or treasury is out.

2. For longer than a years decision, go buy interest rate option, preferrably that which correlate well to mortgage rate, which is Libor swap. The simplest crudest form is buy 2 yr option on 2yr, 5yr, and 10yr swap equal weighted and the sum of notional is the same as the amount you'd like to borrow.


Maybe u can do #2, check CBOE website if they have the options for those swaps.

Thanks Mtg, I think I'm probably 2 years out unless prices come down really fast. I'll check out CBOE and see what's out there...

Before hedging, remember - Mortgage rates will stop tracking Treasuries in a real credit crunch. Jumbo mortgages already have.

If you do short one of the bond ETFs, (a) I think you gotta pay the interest out every month, and (b) you might want to pick IEF or the one between IEF and TLT to run closer to the 10-year.

The kind of environment in which mortgage rates go sky-high is going to be unpleasant in other ways (either high inflation or a really bad economic situation in which case you might have trouble with the intermediaries holding the account where you have your hedge). I would suggest keeping things much simpler and pick plain-vanilla investments that are anticorrelated with mortgage interest rates and/or which you think (based on fundamental economics) will outperform in a high-mortgage-rate environment.

I usually don't deal with mortgage rate hedging but here is my take after 1) looking at swap option premium, 2) observing how flat the swap curve is, and 3) the possibility that if rate goes up it's the swap rate that's going up more than mortgages (i.e swap curve is the one steepening) ...

I deduced you would need $1,100 per $100,000 loan to lock your mortgage rate at the today's 6.0% rate for TWO years. You'd pay about $700 to lock it for a year. This by selecting 2y options on swaps that approximate your mortgage rate the best.

Not a bad deal considering that's like adding 0.55% to today's rate and lock it for two years. If you think in 2 years we're at 8% you make 1.5% a year.

Shops will easily charge you double because they intend to compensate for the risk in hedging your demand here.