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Does Mortgage Hedging Raise Long-Term Interest Rate Volatility?

Volatility is an ever-present feature of financial markets. Recent history has evidenced several episodes of heightened volatility. Events such as the Russian debt crisis, the collapse of LTCM, and the disruption of the Asian markets in the late 1990s have all been responsible for periods of heightened volatility.

While such volatility can be viewed from a macroeconomic perspective as the source of economic instability, from a complete markets perspective, this volatility represents the efficient functioning of markets in the face of uncertainty. Over the past two decades, markets, institutions, and practices have been examined as possible sources of 'excessive' volatility. This paper examines the possible role of mortgage hedging in creating volatility in interest rate markets.

Starting in 1990, 30-year fixed mortgage rates declined from a high of 10.5% to a low of 5.2% in June of 2003. This decline in rates led households to refinance their mortgages in record numbers. The refinancing activity peaked during the years of 1992-1993, 1998 and most recently, in 2003. By the end of 2003, up to 40-45% of the $7.0 trillion single-family debt outstanding was financed in 2003 alone.

The volume of refinancing activity in 2003, for example, led to close to $3 trillion of mortgage debt outstanding to be re-struck at lower rates. Despite the huge volume, the US mortgage market managed to respond flexibly, providing homeowners the benefit of lower rates.

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Does Mortgage Hedging Raise Long-Term Interest Rate Volatility?