What Really Drives Mortgage Rates? | Michael Bright with Ron Sion

Michael Bright: Hello everyone, this is Michael Bright, CEO of the Structured Finance Association, and we’re beginning a podcast series of short quick hits on topics of the day with experts in the topic of discussion. And we’re lucky to be joined today by Ron Sion, not only an old friend of SFA and of mine personally, but a long-term seasoned MBS investor in various capacities and enthusiastic watcher of policy and the mortgage markets, and someone who is going to spend some time today talking us through the current dynamics in the mortgage space, as well as a little bit of background for those who aren’t experts in the topic on what drives mortgage rates and mortgage spreads. With that, Ron, thank you very much for joining us today.

Ron Sion: Thank you, it’s great to be here.

Michael Bright: Awesome, thank you. Before the price of crude oil and other forms of WTI and all the other types of oil—maybe we need to have a podcast at some point on the different things going on in the oil market—before that dominated headlines, we spent several months with a huge focus on mortgage rates, the level of mortgage rates, what was happening to mortgage rates, what was driving mortgage rates. And so we thought it might make sense for our audience to have a little bit of a discussion with an expert about the things that go into the mortgage rate, things that go into the mortgage spread, and what the drivers are right now, and maybe what the drivers are expected to be in the coming years. So that’s the topic for the day. Does that work for you, Ron? How do you think about the topic of talking about a little mortgage rates here?

Ron Sion: I am always excited to do that.

Michael Bright: Okay, so we’re going to start basic, but don’t worry, we’re going to get into more detail. But a lot of times in the public policy realm in particular, but also in the media, there’s this idea that the Fed sets mortgage rates, or what the Fed does will influence what you get on your mortgage. And certainly to some extent that is true, but not exactly to the extent that I think the media effect sometimes has. So Ron, let’s start with something basic. Mortgage interest rates, they’re not just correlated to the Fed funds rate—meaning the rate that the Fed sets. What does drive the level of mortgage rates, before we get to mortgage spreads, but just the aggregate level, what should consumers or watchers be looking at as opposed to just what the Fed does?

Ron Sion: So from the perspective of the risk-free rate, the Treasury rate that actually matters for mortgages, remember that most mortgages in the United States are 30-year mortgages. They’re long mortgages. The Federal Reserve sets overnight rates, so there’s a big difference between the two. There is a Treasury market that trades very actively: 2-year Treasuries, 5-year Treasuries, and 10-year Treasuries. And it’s the longer Treasuries that actually have the greatest influence on mortgage rates.

Michael Bright: Got it. And not 30-year Treasuries though. You mentioned that mortgages are 30 years, but they’re not driven by the 30-year bond?

Ron Sion: They’re also driven in part by the 30-year bond because mortgage payments happen monthly for 30 years. They’re driven by rates all across the Treasury curve. So it’s a little bit of all the different Treasury rates are the ones that people generally consider to be the risk-free rate that goes into the mortgage rate, that affects the mortgage rate.

Michael Bright: All right, so while the media gives attention to the Fed funds rate or what the Fed has done and J. Powell in his speeches, really the driver of mortgage rates is the entire yield curve?

Ron Sion: It’s the entire yield curve that’s driven by the expectations of what the Fed will do over time, but also other things.

Michael Bright: Like inflation?

Ron Sion: Exactly. It is like inflation and expectations of inflation over time, growth expectations of growth over time, and then what people call a term premium, which is how much in excess of the expectations of inflation and growth the Treasury rates trade. But another thing to recognize is that those are all backed out of the Treasury yield. So the Treasury yield is wherever buyers and sellers are willing to trade the Treasury on any given day, and then from that we can back out what the market expectations are for all those other things.

Michael Bright: Got it. So a lot of drivers in there. Now, that’s looking at the Treasury rates, but the Treasury yield curve and all those expectations. So turning to mortgages specifically, they don’t trade flat to Treasuries. And we’re going to talk a little bit about some of those drivers and what the drivers of that difference have been in the last couple of years. But there’s this term called convexity that gets used in MBS. I think it could use some explaining. So mortgages have negative convexity and it makes it more difficult for MBS investors to purchase these bonds and manage them. But what is that and how does that work?

Ron Sion: So before we get to convexity, let’s start with duration. Duration is defined as, for every change in the yield of a particular bond, how much does the price change? So think about it for a 10-year Treasury bond, every 100 basis points, every 1% that changes on the yield moves the price a little less than 10 points. So it’s just the sensitivity of the price for a change in interest rates. Convexity is how much that duration changes, that sensitivity changes. For a Treasury bond, it doesn’t change very much because it’s always, for a 10-year Treasury, a 10-year maturity. For a mortgage, however, it can change a significant amount because the borrower has the option to refinance the mortgage whenever they want. And when will they refinance their mortgage? When they move, but mostly they’ll refinance when mortgage rates are low and they can refinance into a lower rate. So when rates fall, the duration of the mortgage—so think about it how much time until you get your money back if you’re an investor—shortens, because everyone’s refinancing, all the borrowers are refinancing. And when those rates are rallying, the yield falls in the market, that’s exactly when you want that coupon because you have a higher coupon as market rates are falling and that’s really good for you, but in the meantime, all the borrowers are giving back your money. The opposite happens when rates go up. Everyone stays in their home, which is what we’ve seen since 2021. At the same time, the market rates are higher and you want those higher market rates as an investor, but no one’s giving you your money back and you’re stuck with this low coupon. That is the reason why investors suffer from the negative convexity.

Michael Bright: Exactly. Okay, so in market parlance, the borrowers have purchased an option. They’ve purchased the option to refinance their loan when rates go down, or the option to stay in their house all the way out to 30 years if rates go up and that’s something that they want to do because the rate that they have is lower than prevailing market rates. Is that the right way to think about it? There’s an option that’s embedded in there?

Ron Sion: Yes, they have an option. They don’t have to pay for that option like a penalty. They can refinance whenever they want.

Michael Bright: Okay, so the borrowers purchase an option, which means the MBS investor has sold the borrower an option. That has to be priced into the spread. Is that fair?

Ron Sion: Yes.

Michael Bright: Okay, so that option is not a static value. It changes over time and that drives spreads. Is that correct?

Ron Sion: Correct. So it’s created by a variety of—there’s a few inputs into it and it changes over time, the value of that option.

Michael Bright: Okay, how do market participants value that option? There is a swaptions market that I think we should talk a little bit about, that is a broad liquid market that’s a barometer for that. Speak to us about how other market dynamics lead into the pricing of the value of that option and therefore the spread at any moment in time.

Ron Sion: Okay, so we’re going to split the value of the option into two very general buckets. One is how likely a borrower is to pay off the mortgage and especially refinance when rates fall. So let’s say the prevailing market rate is 1% lower than their mortgage rate, how likely is it that they’ll refinance? And the second bucket is how likely is it that we’ll get to 1% below their mortgage rate? In the first bucket, what the value of that option is going to be based on is everything from the borrower’s characteristics, like their credit score, how big the loan is, geographically where they are, as well as policy. The more policy makes it easier to refinance, the more likely that borrowers will refinance in lower rates. The second bucket is based on, you were talking about the swaption market, that’s based on the options market that liquidly trades, which is basically what the expectation is of volatility of Treasury rates in the market. The higher the expectation of volatility, the more we think that rates can move around and therefore the bigger the chance that we will see very low mortgage rates that will cause the borrowers to refinance.

Michael Bright: All right, so vol. Volatility. So that’s not just a theoretical concept, right? This is a quantifiable, tradeable metric?

Ron Sion: Yes, the volatility, that implied volatility in the Treasury market trades very liquidly and it trades for different periods of time, for different maturities of Treasuries. It is a very liquid market.

Michael Bright: Yeah, so that’s the swaptions market. That drives what we call implied vol, that filters into the spread. So we’re not just winging it when we say volatility. We’re talking about an actual mathematical formula and maybe we’ll do a podcast on Black-Scholes’ model and the subsequent iterations of that in the future. But basically the point is there is a vibrant derivatives market for swaptions of different expirations and different tenors and all these things, a huge grid, and all of that gets filtered into the value of the embedded option that the borrowers purchase and therefore the value of the spread that MBS trades at relative to Treasuries.

Ron Sion: Yeah, that spread, by the way, is called an option value for mortgages, or an option cost is probably more what people use. And that option cost is, as you said, something that mortgage investors model. It is based on, yes, the volatility that you see in the market, but also that likelihood of a borrower to refinance in different mortgage rates, which has been modeled based on the experience that investors have seen from borrowers over decades. There is a tremendous amount of effort put into mortgage modeling so that investors can value that option very accurately.

Michael Bright: So I want to talk about the drivers of that option in a minute. But before we do that, there’s also something called an option-adjusted spread. So you talk about the option value, but then there’s this thing called OAS. So quickly, as quick as someone can explain OAS, define OAS and tell us how that adds on to the spread or can be subtracted from the spread.

Ron Sion: So the yield at which a mortgage trades in the secondary market—and by secondary market I just mean the market as people are trading mortgage securities—that mortgage rate can be broken up into three pieces. One is what we call the risk-free rate, which is basically the mix of Treasuries across the yield curve that match the cash flows of the mortgage. So there’s the risk-free rate. The second component is the option cost, which we just spoke about, the value of that option. And the remainder is the option-adjusted spread, which is basically the spread above Treasuries after adjusting for that option that we just spoke about.

Michael Bright: Okay, so all these factors, technical terms, they all go into the mortgage rate. You’ve got the risk-free rate which is based on inflation and growth expectations. You’ve got the volatility and the optionality that’s embedded in there, which is driven by things like swaption vol and expectations for volatility. And then the OAS, which is a metric for, beyond all of that, how do investors feel about mortgages right now? Is that kind of how I think about it?

Ron Sion: Yes, I’ll also say it a different way that I think could be intuitive: what makes mortgage rates move? Number one, if Treasury rates move. So Treasury rates go up or down, that’ll move mortgage rates. Number two, if the market thinks that the likelihood of a borrower to refinance is going to be higher, that convexity is more negative. What drives those? Either policy changes that make borrowers more likely to refinance, or an increase in the market’s perception of volatility in the market. And finally, how much investors, after that option, are willing to receive for mortgages over, say, Treasuries after taking into account the option. So the more comfortable investors are with mortgages, the tighter that spread, therefore the lower the mortgage rate. And the less comfortable investors are with mortgages, the higher the spread and therefore the higher the mortgage rate.

Michael Bright: All right, excellent. So let’s take a second and dive into that vol piece again, since that’s really a big piece here. Mortgage spreads have moved around a lot over the last 12 to 18 months. Quickly, take us on the journey of what’s happened in mortgage spreads and therefore vol, or vice versa I guess I would say, over 2025, what were the dynamics? What were the dynamics early 2026, and then where are we last, say, month, in terms of the market pricing of this volatility option?

Ron Sion: Yeah, so last year mortgage rates fell about three-quarters of a point. And the drop in the mortgage rate came predominantly in the second half of the year. And in that second half of the year, three things contributed to that fall in the mortgage rate. Number one, the fact that Treasury rates fell. That was about a third of it. Number two, the drop in the market’s expectation of volatility. We just spoke about that. The market believed that there was less volatility in Treasury rates going forward and that dropped that option cost that we spoke about by another quarter of a percent. And finally, a tightening in the mortgage spread that investors were willing to purchase mortgages at after accounting for the option. So that’s the option-adjusted spread, that OAS that you spoke about. Interestingly and coincidentally, each one tightened by about a quarter point and that meant that mortgage rates fell by three-quarters of a point. This year, however, mortgage rates have gone up. So they continued going down at the starting, but then, especially because of geopolitical events, Treasury rates went up, the volatility that the market expected went up, and as a result mortgage rates went up from their low in February about half of a percent, and subsequently fell about a quarter.

Michael Bright: And again, they’re going with Treasury rates but also changes in volatility. So 2025 was a year where volatility was going down, down. We had certainty or a sense of certainty over what the Fed’s direction was going to be, we had a sense of certainty over where inflation and growth were going to be. 2026 starts and a lot of that certainty dissipates, which leads to higher volatility, higher implied volatility in the swaption market, therefore wider spreads. In the last, what, three weeks, that’s started to come down a little bit, but that’s been the journey of mortgages over 2025 and 2026.

Ron Sion: Correct.

Michael Bright: Okay. All right, now, how much is like external buying impact this? So if you have a non-Fed—the Fed bought mortgages intentionally to lower rates for a while—the GSEs have announced that they’re going to be buying more mortgages, there’s speculation over banks buying more mortgages. How does an investor look at these external purchasers of mortgages and the impact that they have on mortgage rates and spreads?

Ron Sion: That’s a great question. We said that ultimately the spreads of the mortgage—we try to decompose them, but it’s ultimately where in the market people are willing to buy them and sell them. That’s ultimately the case. It is clearly true that the more persistent buyers that there are, the tighter the spreads are going to be. When it comes to a large and well-known buyer such as the Federal Reserve, the market can adjust much more easily to purchasing programs because the market knows how much they’re buying on any given month and roughly how long that might take. And the Federal Reserve can tighten spreads if they’re buying a lot by half a point, half a percent rather, in mortgage rates, they can move it half a percent in spreads or even three-quarters of a percent. They can have a very substantial effect. Other buyers and sellers, you just see it in the mortgage spreads, you can kind of like back out of it, but they could definitely move it by an eighth, even up to a quarter.

Michael Bright: Okay, so marginal buyer helpful, especially structural buyer, changes in implied vol and all that kind of stuff. So that makes sense. So we’re talking about quarter points here and there. So there’s been a good bit of publicity about this additional or this $200 billion GSE purchase of MBS in an attempt to drive down mortgage rates and mortgage spreads. What’s going on with that? How does that play out? How is the market looking at that and what effect does it have?

Ron Sion: The announcement earlier this year that the GSEs—the government-sponsored entities, which is Fannie Mae and Freddie Mac—would buy $200 billion of mortgages tightened that option-adjusted spread, the spread after accounting for the option of mortgages, by about 15 basis points, which is 0.15% or just an eighth on the mortgage rate. Since then, interestingly, those spreads have widened back out and it’s partly because of some of the unrelated developments we spoke about, like geopolitical events, but also because the market believes there’s a lower likelihood of more purchases by Fannie Mae and Freddie Mac after that 200 billion. And one thing that we’ve seen is that those purchases are a little less targeted to the mortgage rate specifically, and by that I mean they’re not just buying the types of mortgages that an originator, a mortgage originator, would sell into the market. But it’s also important to note that before the announcement of the GSEs buying, mortgages were already on the tighter side, which basically means lower spreads, and part of that is actually because Fannie Mae and Freddie Mac started buying mortgages before the announcement and the market saw that.

Michael Bright: So the market was pricing some of that in, it pulled forward some of that buying when the announcement came out, and then other factors overtook the spreads?

Ron Sion: That’s exactly it. That’s exactly it. Now, mortgage spreads now—we’re speaking in middle to late April—and option-adjusted spreads are on the tighter side, and this has happened a lot of it this month after some of the geopolitical events seem to be hopefully getting resolved. So those spreads have been tightening and right now option-adjusted spreads are on the tighter side.

Michael Bright: Historically has tighter OAS impacted the GSEs’ desire to purchase MBS?

Ron Sion: Yes, definitely. When they were private entities before the global financial crisis, they would respond very much to wider spreads—they’ll buy a lot more—tighter spreads, they won’t. Since the global financial crisis, when they were in conservatorship, their balance sheet has gone down a lot, so they buy and sell a lot less in the market. But in the past, as we’ve seen in the past several months, their balance sheets are starting to increase again, they are buying a lot more in the market and yes, they do react often times to wider spreads. They buy more when it’s wider, they buy less when it’s tighter.

Michael Bright: Got it. So we’ll end on this question: looking forward in 2026, what do you think the drivers of mortgage rates and mortgage spreads, Treasury rates, etc., what is the market really looking at now to say this is what’s probably going to drive mortgage rates over the next six months or so?

Ron Sion: I think that the largest driver of mortgage rates are likely to be the Treasury rates—that risk-free rate that we talked about—and the option cost, that value of the option, rather than the option-adjusted spread. What’ll move those first two things, I think it’s going to be things outside the mortgage market. For example, geopolitical events, whether inflation does come down or if it stays sticky and therefore how the Federal Reserve will react to it. And again, it’s not the Federal Reserve exactly that matters, their overnight rate, but rather given that the expectation of their future rates, how the Treasury market would react to that. And it’ll have to do a lot with growth, and growth will be determined by how the labor market is doing and how AI is affecting productivity and these larger economic factors.

Michael Bright: All right, so we’ve got big global factors impacting the mortgage rate, not just the square building down the street, but a whole bunch of other stuff that we’ll keep an eye on. And look, I hope this has been a helpful primer but also a discussion about dynamics that we have at play right now. At all times for any of our listeners, we’re happy to answer additional questions or dive deeper into any of this. Ron Sion, thank you so much for joining us today. I think this has been a helpful conversation.

Ron Sion: Thank you very much.