Worried About A Mortgage Rate Spike? You Have Options By Brett Arends Wall Street Journal 09-30-2009

Worried About A Mortgage Rate Spike? You Have Options
By Brett Arends
The Wall Street Journal
September 30, 2009

Good news for prospective home buyers: You can find 30-year mortgages for less than 5% again. But those rates may not last . And these days it's almost impossible to lock in a rate while you hunt for a home. Banks—for understandable reasons—now want to evaluate a property before pre-approving borrowers.

Mortgage rates have been falling in concert with sinking interest rates on long-term Treasury bonds. The two are closely related, through a complex mechanism involving mortgage-based securities. And if mortgage rates start rocketing again in the next few months, a rebound in long-term Treasury yields will likely be the cause.

People who worry that rates will spike again before they find a home can protect themselves by investing in a mutual fund that tracks long-term interest rates. Or they can buy call options on one of those funds instead. If Treasury rates suddenly skyrocket, you may make back what you would lose on the mortgage rates.

This may sound like some incredibly complex footwork, and most people will shy away from trying these moves. But considering the cost of even a slight rate change over the life of a mortgage, they're worth considering.

After all, if you're looking to buy a typical $200,000 home, a rise in mortgage rates from 5% to 6% will cost you an extra $1,300 a year for the next 30 years.

Several funds track long-term interest rates. Among them are two exchange-traded funds that you buy like shares on the stock market, the ProShares Short 20+ Year Treasury fund (TBF) and the ProShares UltraShort 20+ Year Treasury fund (TBT). There is also the Rydex Inverse Government Long Bond Strategy mutual fund (RYJUX). (Technically, these funds track the inverse of the price of long-term government bonds, which in turn is inversely related to the yield.)

These funds come with risks. The two exchange-traded funds, TBF and TBT, are specifically designed to track daily moves in the long-term bond market rather than long-term moves. The TBT is particularly volatile because it is what is known as an "Ultra" fund—it will give you double the market move, up or down. The drawback: If rates fall further while you are house hunting, you will save extra money on your mortgage —but you'd lose money on these funds.

That's why the options market looks especially interesting.

You can purchase call options on the TBT fund. These calls wager that the $4 billion fund will see a sharp rise in share price in the next few months, and could operate like a form of insurance if mortgage rates suddenly spike during your real-estate search.

Here's how it works: Today, with 30-year Treasury rates at just 4%, the TBT is about $44 a share. But for $1.20 a share you could buy a $50 call option on the fund, good for any time between now and January. That would simply give you the right to buy the TBT at $50 between then and now. So if long-term interest rates were to skyrocket over the next few months, and the TBT soared to, say, $60, you'd pocket a profit of $10 a share (less the $1.20 in costs for the option).

Because the TBT tracks daily performance, there is no absolute way of knowing what long-term Treasury rate would correspond to any given price on the TBT. But the fund was about $59 in June.

Issues like compliance and complexity probably deter most financial intermediaries from offering any such product. That's a shame, because an options hedge could be very useful to a lot of middle-class Americans.

No strategy can offer perfect protection against mortgage rates: it's a work-around, based upon derivatives of derivatives of the Treasury market. But anyone who thinks or fears that long-term interest rates will rise dramatically in the next few months might look at buying call options on the TBT.