Consumers and lenders are taking it on the chin because of the abrupt disappearance of demand for certain exotic mortgage securities.
Because of the retreat by investors, home loan rates have risen faster than rates for comparable Treasury securities, costing the average borrower about $500 a year in extra interest.
And from the lenders' standpoint, that makes mortgages even harder to originate at a time when volume is already slumping.
Dozens of Components
Wall Street has been very successful recently at wringing as much value as possible out of mortgage collateral.
This has been done by cutting the securities into dozens of components, each tailored to meet different investment objectives. Since the components sell at premium prices, this approach tends to keep rates to a relatively small spread above Treasuries.
However, some of the components -- such as principal-only securities -- have turned extremely volatile.
"We are going through a period of wider spreads because we cannot find purchasers of exotic securities," said Joseph Hu, director of mortgage research at Oppenheimer & Co.
A principal-only, or PO, is a bond class that gets repaid as mortgage holders pay back the principal on their loans.
If rates fall, POs do quite well because investors get paid back faster. But if rates rise, making borrowers less likely to take out new mortgages and return the principal early, the securities do poorly.
Needless to say, March, when rates skyrocketed, was a very, very bad month for holders of POs.
According to Karl Mendenhall, head of secondary marketing at First Union Mortgage Corp., this has led to a great deal of uncertainty about how to price existing exotics as well as how to make new ones. "When ever you have uncertainty, you have to pay for it," he said.
As a result, the components now being offered are less complicated and less efficient. "It's more difficult to structure a deal," said Dale Westhoff, a mortgage analyst at Bear, Stearns & Co. "And some tranches, like inverse floaters, are difficult to sell, even illiquid."
Some See Temporary Problem
The question that many are asking themselves is how long this situation will remain. Luke Hayden, head of secondary marketing at Chemical Bank, thinks that some of the illiquidity in exotic derivatives is temporary, caused by leveraged investors backing away from an uncertain market.
Mr. Hu, though, wonders if some of the value that Wall Street was able to extract from the collateral was at the expense of investors who did not quite understand what they were buying.
If that is true, and if investors now know better, then yields may remain wide.