Russian military vehicles on parade in 2010. Source: Wikimedia Commons.

Earlier this week, I came across the following headline: "Mortgage Rates Hold Ground After Ukraine Headlines."

The point of the piece, as the title suggests, was to highlight the paradox that mortgage rates hardly moved today despite reports that Russian troops had crossed the border into Ukraine.

To mortgage professionals and bond traders, this makes sense. Of course mortgage rates would head lower if Russian tanks rolled across the border with Ukraine!

But is it really so obvious? I mean, think about it. Why are mortgage rates tied to otherwise irrelevant geopolitical positioning in Eastern Europe? More specifically, what serves as the transmission device to connect them?

The answer to this requires that we weave together three different things.

First, mortgage rates aren't set by banks; they're set in the bond market -- or, more formally, the market for fixed-income securities.

As you may recall from the financial crisis, once a mortgage is underwritten, it's typically packaged with other home loans into a "mortgage-backed security," which is then sold to institutional investors like insurance companies, pension funds, and university endowments.


Moreover, because almost all newly issued mortgage-backed securities these days are insured by Fannie Mae or Freddie Mac -- in industry lexicon, these are known as "agency" securities -- they carry the same risk as a bond issued by the federal government itself.

In other words, if you have a lot of money to invest but don't want to risk the principal, then an agency mortgage-backed security is a great vehicle to consider.

This brings us to the second thing. In the face of unrest -- be it economic, political, environmental, military, or whatever -- investors have a tendency to abandon risky assets in favor of safe ones.

And what's safer than an agency MBS? Answer: nothing. As a result, when events cause investors to get nervous, they substitute out of things like equities, causing stock prices to fall, and into Treasury bonds and agency MBSes, causing their prices to rise.

We've now arrived at the third and final piece to this puzzle -- that is, the relationship between the price of fixed-income securities like agency MBSes and their yield or interest rate.

Although it seems counterintuitive at first, the price of a fixed-income security and its yield is inversely related. Dig a little deeper, however, and this makes sense. If a $100 bond pays $2 a year in interest, its yield is 2% ($2/$100). But if investors bid the price of that bond up to $150, its yield drops to 1.33% ($2/$150).

And don't forget that the interest rate an MBS pays relates back to the actual mortgages contained therein.

So, to tie everything together: Mortgage rates are set by the price, and thus yield, of mortgage-backed securities. The price of mortgage-backed securities, and particularly those issued by Fannie Mae or Freddie Mac, is a function of market risk -- the higher the risk, the higher the price.

Consequently, because a Russian invasion of Ukraine would be perceived by market participants to increase risk, it would drive the price of mortgage-backed securities higher. And because these prices are inversely correlated to yield, it follows that the interest rate on new mortgages would move lower.

Make sense? I'll be the first to admit, this isn't obvious from the outset. Yet at the same time, while Wall Street may prefer that you think otherwise, this is far from rocket science.

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