Why Mortgage Rates Exceed Treasury Yields

As noted, the 10-year Treasury yield is an imperfect reference for the mortgage rate: An MBS and a Treasury note differ in their cash flows, their credit risk, and whether a borrower pays an intermediation margin on top of the underlying rate. To build a better reference, I construct a hypothetical benchmark bond-a 10-year Treasury note adjusted to mimic a mortgage-and define the coupon spread as the difference between the mortgage rate and the coupon on this bond.

I construct the benchmark bond in three steps, each addressing one of the differences.¹

Cash flows: A Treasury returns principal in a lump sum at maturity; a mortgage returns it gradually through amortization and home sales. The benchmark bond returns principal at the same pace as a mortgage, but with no refinancing.

Credit insurance: Mortgage investors (that is, MBS buyers) are protected against borrower default by Fannie Mae and Freddie Mac, which charge a guarantee fee (about 42 basis points) for this insurance. I add the guarantee fee to the benchmark's coupon so that the benchmark matches the credit quality of a Treasury note.

Intermediation: Lenders earn their compensation by selling the mortgage (packaged with other mortgages as an MBS) to investors at a price above par (that is, above the face value of the loan), and the premium compensates them for originating, packaging, and selling the loan. I capture this markup by pricing the benchmark bond above par by that same premium, using a measure known as OPUC (originator profits and unmeasured costs), following Fuster et al. (2013).

Even after all three adjustments, the coupon spread-the difference between the mortgage rate and the coupon on this adjusted benchmark bond-is still large and volatile (Figure 2).