why are the rates not coming down and what is really going on
Didier Malagies • March 31, 2020
why are the interest rates not coming down, read below and learn why
This is what really is going on in the market! read and learn
Mortgage Crisis and Fed Unintended
Consequences
The Coronavirus Meltdown
The current Coronavirus crisis is having a critical impact on the Mortgage Industry,
which could potentially make the 2008 financial crisis pale in comparison. The
pressing issue centers around capital that’s required by Mortgage Lenders to be
able to function and meet covenants that are required for them to continue to lend.
Here’s How The Mortgage Market Works
Let’s begin with the mortgage process. A borrower goes to a Mortgage Originator
to obtain a mortgage. Once closed, the loan is handled by a Servicer, which may or
may not be the same company that originated the loan. The borrower submits
payments to the Servicer, however, the Servicer does not own the loan, they are
simply maintaining the loan. This means collecting payments and forwarding them
to the investor, paying taxes and insurance, answering questions, etc. While they
maintain or “service” the loan, the asset itself is sold to an aggregator or directly to a
government agency like Fannie Mae (FNMA), Freddie Mac (FHLMC), or Ginnie Mae
(GNMA). The loan then gets placed inside a large bundle, which is put in the hands of
an Investment Banker. That Investment Banker converts those loans into a
Mortgage Backed Security (MBS) that can be sold to the public. This shows up in
different investments like Mutual Funds, Insurance Plans, and Retirement
Accounts.
The Servicer’s role is very critical. In order to obtain the right to service loans, the
Servicer will typically pay 1% of the loan amount up front. The Servicer then
receives a monthly payment or “strip” equal to about 30 basis points (bp) per year.
Because they paid about 1% to obtain the servicing rights and receive roughly 30bp
in annual income, the breakeven period is approximately 3 years. The longer that
loan remains on the books, the more money that Servicer makes. In many cases,
the Servicer might want to use leverage to increase their level of income.
Therefore, they may often finance half of the cost of acquiring the loan and pay the
rest in cash.
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Servicer Dilemma
As you can imagine, when interest rates drop dramatically, there is an increased
incentive for many people to refinance their loans more rapidly. This causes the
loans that a Servicer had on their books to pay off sooner…often before that 3-year
breakeven period. This servicing runoff creates losses for that Mortgage Lender
who is servicing the loan. The more loans in a Mortgage Lender’s portfolio, the
greater the loss. Servicing runoff, or even the anticipation of it, can adversely
impact the market valuation of a servicing portfolio. But at the same time, Lenders
typically experience an increase in new loan activity because of the decline in
interest rates. This gives them additional income to help overcome the losses in
their servicing portfolio.
But the Coronavirus has caused a virtual shutdown of the US economy, which has
created an unprecedented amount of job losses. This adds a new risk to the
servicer because borrowers may have difficulty paying their mortgage in a timely
manner. And although the Servicer does not own the asset, they have the
responsibility to make the payment to the investor, even if they have not yet
received it from the borrower. Under normal circumstances, the Servicer has plenty
of cushion to account for this. But an extreme level of delinquency puts the Servicer
in an unmanageable position.
“I’m From The Government And I’m Here To Help”
In the Government’s effort to help those who have lost their jobs because of the
Coronavirus shutdown, they have granted forbearance of mortgage payments for
affected individuals. This presents an enormous obstacle for Servicers who are
obligated to forward the mortgage payment to the investor, even though they have
not yet received it. Fortunately, there is a new facility set up to help Mortgage
Servicers bridge the gap to the investor. However, it is unclear as to how long it will
take for Servicers to access this facility.
Servicing runoff, or even the
anticipation of it, can adversely
impact the market valuation of a
servicing portfolio.
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But what has not been yet contemplated is the fact that a borrower who does not
make their very first mortgage payment causes that loan to be ineligible to be sold
to an investor. This means that the Servicer must hold onto the asset itself, which
ties up their available credit. And with so many new loans being originated of late,
the amount of transactions that will not qualify for sale is significant. This restricts
the Lender’s ability to clear their pipeline and get reimbursed with cash so they can
now fund new transactions.
Mark To Market
This week - Due to accelerated prepayments and the uncertainty of repayment, the
value of servicing was slashed in half from 1% to 0.5%. This drastic decrease in
value prompted margin calls for the many Servicers who financed their acquisition
of servicing. Additionally, the decreased value of a Lender’s servicing portfolio
reduces the Lender’s overall net worth. Since the amount a lender can lend is based
on a multiple of their net worth, the decrease in value of their servicing portfolio
asset, along with the cash paid for margin calls, reduces their capacity to lend.
Unintended Consequences
The Fed’s desire to bring mortgage rates down isn’t just damaging servicing
portfolios because of prepayments, it’s also wreaking chaos in Lenders’ ability to
hedge their risk. Let’s look at what happens when a borrower locks in their
mortgage rate with a Mortgage Lender. Mortgage rates are based on the trading of
Mortgage Backed Securities (MBS). As Mortgage Backed Securities rise in price,
The Fed’s desire to bring mortgage
rates down isn’t just damaging
servicing portfolios because of
prepayments, it’s also wreaking
chaos in Lenders’ ability to hedge
their risk.
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interest rates improve and move lower. A locked rate on a mortgage is nothing
more than a Lender promising to hold an interest rate, for a period of time, or until
the transaction closes. The Lender is at risk for any MBS price changes in the
marketplace between the time they agreed to grant the lock and the time that the
loan closes.
If rates were to rise because MBS prices declined, the Lender would be obligated to
buy down the borrower’s mortgage rate to the level they were promised. And since
the Lender doesn’t want to be in a position of gambling, they hedge their locked
loans by shorting Mortgage Backed Securities. Therefore, should MBS drop in price,
causing rates to rise, the Lender’s cost to buy down the borrower’s rate is offset by
the Lender’s gains of their short positions in MBS.
Now think about what happens when MBS prices rise or improve, causing mortgage
rates to decline. On paper the Lender should be able to close the mortgage loan at a
better price than promised to the borrower, giving the Lender additional profits.
However, the Lender’s losses on their short position negate any additional profits
from the improvement in MBS pricing. This hedging system works well to deliver
the borrower what was promised, while removing market risk from the Lender.
But in an effort to reduce mortgage rates, the Fed has been purchasing an
incredible amount of Mortgage Backed Securities, causing their price to rise
dramatically and swiftly. This, in turn, causes the Lenders’ hedged short positions of
MBS to show huge losses. These losses appear to be offset on paper by the
potential market gains on the loans that the lender hopes to close in the future. But
the Broker Dealer will not wait on the possibility of future loans closing and demands
an immediate margin call. The recent amount that these Lenders are paying in
margin calls are staggering. They run in the tens of millions of Dollars. All this on top
of the aforementioned stresses that Lenders are having to endure. So, while the
Fed believes they are stimulating lending, their actions are resulting in the exact
opposite. The market for Government Loans, Jumbo Loans, and loans that don’t fit
ideal parameters, have all but dried up. And many Lenders have no choice but to
slow their intake of transactions by throttling mortgage rates higher and by reducing
the term that they are willing to guarantee a rate lock.
Furthering the Fed’s unintended consequences was the announcement to cut
interest rates on the Fed Funds Rate by 1% to virtually zero. Because the Fed’s
communication failed to educate the general public that the Fed Funds Rate is very
different than mortgage rates, it prompted borrowers in process to break their locks
and try to jump ship to a lower rate. This dramatically increased hedging losses from
loans that didn’t end up closing.
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Even Stephen King Could Not Have Scripted This
It’s been said that the Stock market will do the most damage, to the most people, at
the worst time. And the current mortgage market is experiencing the most perfect
storm. Just when volume levels were at the highest in history, servicing runoff at its
peak, and pipelines hedged more than ever, the Coronavirus arrived.
Lenders need to clear their pipelines, but social distancing is making it more difficult
for transactions to be processed. And those loans that are about to close require
that employment be verified. As you can imagine, with millions of individuals losing
their jobs, those mortgages are unable to fund, leaving lenders with more hedging
losses and no income to offset it.
What Needs To Be Done Now
Fortunately, there are many smart people in the Mortgage Industry who are doing
everything they can to navigate through these perilous times. But the Fed and our
Government needs to stop making it more difficult. The Fed must temporarily slow
MBS purchases to allow pipelines to clear. Lawmakers need to allow for first
payment defaults, due to forbearance, to be saleable. And finally, the Fed must
more clearly communicate that Mortgage Rates and the Fed Funds Rate are not the
same.
We have faith that the effects of the Coronavirus will subside and that things will
become more normalized in the upcoming months.
It’s been said that the Stock market
will do the most damage, to the most
people, at the worst time.
Check out our other helpful videos to learn more about credit and residential mortgages.
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