In 30 seconds or less …

With the Federal Reserve announcing a target of 0.0% to 0.25% Fed Funds Rate (the interest rate charged to banks for borrowing money overnight), consumers have been confused as to why new mortgage rates initially dropped to 3.29%, quickly rose again to 3.65%  and only now are settling at 3.5% for 30 year fixed rate conforming mortgages. Why not 0%?

Duration of the Loan – Fed Funds are overnight liquidity loans and not long term financing like a mortgage

Credit Quality of the Borrower – Highly regulated banks default a lot less than the average consumer or borrower

Collateral Quality – Fed Funds require AAA type collateral that can be liquidated immediately for the full value of the loan. Our houses and cars don’t hold the same values nor can they be sold quickly at full market value in times of stress

Market Disruption – Bottom line, there is an absence of demand for anything but the lowest risk.  Why?

• Liquidity and Volatility in Mortgage Backed Securities (MBS) The Fed’s aggressive purchases of MBSs over the past couple weeks has had unintended consequences and destabilized traditional mortgage hedging. The Fed pulled out of the market today sharply dropping MBS prices. This extreme volatility is making it hard to work through margin calls and hedge origination pipelines. Why does it matter? The US Mortgage Market is the second-largest fixed income market in the world after US Treasuries.  It matters!
• Confusion over the CAREs act which calls for 180 day forbearance (typically, forbearance means they just extend the loan for 6 months without negatively impacting your credit). The call for forbearance of mortgage payments is only for borrowers whose mortgage are government backed – FHA, Federal Home Loan Banks, Fannie Mae & Freddie Mac. The act does not cover privately owned or bank held mortgages.  If you or someone you know can’t make their mortgage payment, have them call their servicer immediately to work out something regardless of who owns it.
• More confusion & liquidity concerns over the CAREs act for non-bank lenders/servicers. The Act clearly provides support for traditional banks but not non-bank mortgage lenders/servicers. Ginnie Mae, another government corporation that guarantees timely mortgage bond payments like the GSEs, was left out of the Act. (Drafting Error?) It primarily supports first-time home buyers, Veterans Administration, and low-income borrowers. So Ginnie Mae came out with announcement today saying they’d support liquidity needs for the non-bank lender/servicers through the crisis. The Mortgage Bankers Association estimates $75B to $100B needed if a quarter of the borrowers take advantage of forbearance for 6 months or longer. (The Mortgage Note 4/1)  
• Liquidity & Valuation challenges continue for traditional Mortgage Servicing Rights (MSR) investors like Real Estate Investment Trusts (REITs) & Hedge Funds as they work through margin calls with pricing volatility on their MBS assets and higher prepayments than expected flowing through the MBSs. (Remember, last year mortgage rates were around 4.25% or higher.)

IN THE WEEDS –

Let’s step back and look at some of the basics so we can understand the bigger market issues now.

What is the bench market mortgage everyone talks about?

It’s a 30 year fixed rate conforming mortgage loan. Translation please ~ it is a mortgage with the same interest rate for the life of the loan.  The mortgage is originated under the guidelines as set out by one of the Government-Sponsored Entities (our old friends Fannie Mae or Freddie Mac) and sold to them for packaging into the capital markets as Agency Bonds which provides liquidity to the housing market. The maximum size of their loans is regulated and set at  $510,400 or less for 2020.  The most common length of a loan is 30 years, followed by 15 years. Investors like the uniformity of the bench mark collateral that’s bundled into the Agency Bonds and the implied government guarantee to repay the bonds.  

So explain to me why I can’t get a 0% interest rate on my loans?

• Duration – The Fed Funds Rate provides overnight liquidity to banks via loans that are re-set each day. As we said, most mortgage loans are typically 15 or 30 years. You as the borrower are paying a higher coupon (or interest rate) to cover the investors risk of missing out on a better (higher) rate in the future and for taking the risk of uncertainty as to what could happen over the next 30 years. Remember, as the borrower, you control how long the mortgage stays in place.  If you make all the payments timely, the mortgage can stay in place for the full 30 years if you want! And now with forbearance, many of these loans could go to 30 years and 6 months.  Historically, the average loan is only in place for 7 years because so many Americans move up, get transferred, move for retirement or refinance.

• Quality of the Collateral – The loans issued to banks at the “Fed Window” or the Federal Reserve Discount Window are fully collateralized with high quality assets like Treasury Notes, Municipal Bonds, or other AAA securities. If a bank defaults overnight, the Fed keeps the collateral and sells it into the market to recover ALL of their money. While your house tends to be an appreciating asset or increases in value as time goes on, the Financial Crisis of ‘08 proved that housing values can drop, too. Therefore, the quality of the collateral on a mortgage is not the same as the AAA collateral at the Fed Window so you have to pay a higher interest rate.  Taking it a step further, car loans charge even higher interest rates despite the shorter term of 3 or 5 years car loans because the value of the car depreciates the longer you use it.  Finally, unsecured loans like student loans, personal loans and credit cards which have no collateral at all demand even higher interest rates than collateralized loans.

• Credit Quality – Banks are some of the most highly regulated entities in our world. Whether a big bank or a small bank, there is lots of oversight to ensure they are financially sound. That’s not to say they do not fail as we’ve seen them fail. However, they fail a lot less than the average consumer does.  Even if you have a great FICO score and good cash reserves, you could get sick or lose your great job through no fault of your own and not be able to find a new job paying as much money so you could choose to walk away from your house or your car as we saw in the aftermath of the Financial Crisis. (Interesting side note, during the Financial Crisis lenders saw borrowers make their car payments before their mortgage payments because they needed the car to get to work. Also, there are more consumer protection laws in place when borrowers default on mortgages than on cars.)   

• Processing Loans – Many lenders are having a hard time processing loans with Shelter-In-Place Orders.  Lenders also have to talk to the employers to confirm employment when employers are struggling right now as well. With many title companies, state, county, and local governments closing their offices, mortgage settlements are in limbo. (The Mortgage Report 4/1)  Further, don’t be surprised if your lender has to re-confirm employment at settlement as so many waves of layoffs are going around. Remember, be kind to those on the front line. They are trying to do the best they can in unusual circumstances!

• Market Disruption – Typically, mortgage rates rise when there is a lot of uncertainty & disruption in the market and we’ve got lots of it!  Mainly, we have no demand for anything but super low risk mortgages and the bonds they support, Agency Bonds. Market participants (mortgage originators to investors) are stepping out of the market or being forced out by liquidity problems and even bankruptcy. Just to name a few issues ….

• Cost of Servicing Going up – With record unemployment being forecasted at least in the short term, Mortgage Servicers (the company that collects, processes and tracks your mortgage payments) will see a spike in mortgage defaults (failures to make payment). It will cost the Servicers more money to collect those payments and/or work out forbearance programs. Fortunately, the Mortgage Servicers who service for the GSEs and Ginnie Mae will not have to pay the bond investors the expected mortgage payments. The guarantors (Freddie Mac, Fannie Mae, and Ginnie Mae, ultimately the federal government) will do that. But servicers that service mortgages for Jumbo Securities (bonds with mortgages above the GSE $510K maximum loan size) and other private investors may still be required to pay the bond investors causing liquidity issues for them. This part of the market is substantially smaller after the Financial Crisis.

• Unintended consequence of Fed Intervention in the Market – With the Fed actively buying Mortgage-Backed Securities (MBS) the last two weeks to provide liquidity to Hedge Funds, Banks & REITs, it destabilized traditional mortgage bank hedges that are used to help insure the originators expenses & profit are covered between the time they commit to originate a new loan and when they deliver that new loan to the ultimate buyer. With those hedges falling apart some lenders have stopped originating loans all together. In this market, it’s mostly Freddie & Fannie loans being originated.  A handful of big banks like Chase and Wells are still buying high quality jumbo mortgages for their portfolios. But the demands from the REITs are gone as many are filing for bankruptcy or are facing significant liquidity problems. (HousingWire 3/30)  And earlier today, the Fed stopped buying MBSs all together causing even more volatility.

• Demand for Mortgage Servicing Rights or MSRs is mostly gone. To help maintain appropriate balance sheet asset limits and to continue to service large loans portfolios, banks would sell the expected future cash flows of the Servicing Rights to investors and act as the investors’ agent working against a fee schedule. This is called monetization. REITs, the typical investor of MSRs, are highly leveraged by design to generate the maximum return for their investors so they would buy the MSRs on margin. They have been under siege for the past month with margin calls (aka when the collateral value no longer equals the outstanding balance of the loan, they have to put up more assets). Consequently, fewer buys of MSRs are in the market. Those who are buying MSRs are demanding more money as they are worried about their own liquidity and the cost of servicing with all the forbearance discussions.  Both Bank and Non-Bank Servicers are now looking at putting the MSRs into their own portfolios. 

To sum it all up, contraction in overall demand is leading to rising costs which comes out as higher interest rates to borrowers.

If you are in the process of buying a home or refinancing, please talk to your loan officer or real estate agent to understand your timeline and avoid any surprises.  Remember, they are as anxious to go to settlement as you are so please be kind! #BeTheCalm!!!

This article was a specific request. If you have any other topics of interest or questions, please send them to me! And forward the blog to friends that might be interested.

Susie