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The Institutional Risk Analyst

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Is it Springtime in the US Mortgage Industry?

Richard Cordray and Mick Mulvaney

New York | It’s a strange time in the housing market. Home price increases have been running above the posted inflation rate for more than five years, yet lending volumes are expected to fall again in 2018 for the third year in a row.

The end of the Progressive Inquisition at the Consumer Finance Protection Bureau is in sight, yet the housing industry continues to reel from the massive increase in the cost of regulation, which has seen productivity in the world of mortgage finance cut by two thirds since 2012.

News reports suggest that thousands of jobs could be lost in mortgage finance this year due to rising interest rates and falling lending volumes. This is primarily due to slack demand for mortgage refinancing as a result of rising long-term interest rates. Chart 1 below shows the 12-month average price change from CoreLogic for all US homes going back to the 1970s.

Source: CoreLogic

Note the upward surge in average home prices during 2012-2014, which was due to the work-out of distressed mortgages. Closing the gap between the deeply discounted value of foreclosed homes and normal sales accounted for a lot of the price gains reported during this period. The more subdued average home price action in many coastal markets since 2014, however, is still a multiple of the official inflation statistics coming from Washington.

Despite policies from the Federal Housing Administration and Federal Open Market Committee meant to boost house finance, regulation and extremely tight secondary market terms are hurting profitability and employment in the mortgage industry. Most of the credit flowing from Washington is going to consumers buying larger homes rather than first time home buyers. Meanwhile, prices for mortgage servicing rights (MSRs) are still trading at a discount to the underlying collateral, as the FT’s John Dizard reports.

Mortgage industry maven Rob Chrisman wrote recently of colleagues working “in a business where many are experiencing contracting volumes and contracting margins. Bank of the Ozarks of Little Rock will stop originating home loans for resale on the secondary market, a line of business that had ‘operated at essentially break-even’… Every company is taking a hard look at the continued high cost of originating loans, regardless of channel, and evaluating profitability. Watch for plenty of changes in 2018.”

With Mel Watt, head of the Federal Housing Finance Administration, leaving office in less than a year, speculation about the chances for reform of the housing enterprises, particularly Fannie Mae and Freddie Mac, has grown. So much so, in fact, that somebody decided to leak a letter from Watt to members of the Senate Banking Committee regarding his views of GSE reform.

“Watt said that once they are returned to the private sector, Fannie and Freddie would be the first two ‘secondary market entities’ able to issue government-guaranteed mortgaged backed securities as a common security that has a mandated rate of return set by a regulator,” American Banker reports.

If, as Watt suggests, the idea is to have two “private” utilities with a government backstop for catastrophic risks, then that is what we have today. The two enterprises have government ownership with private capital standing in front in the form of risk sharing transactions. The key flaw in both Watt’s plan and the Senate proposal for GSE reform is the role assigned for private equity capital in the “privatized” Fannie Mae and Freddie Mac.

If Congress wants to privatize the GSEs, then they should go right ahead. But please note that private mortgage companies are trading well below book value at present. You see, there is no utility in providing two more independent mortgage banks to an industry with profitability issues. If true privatization is the object of GSE reform, then the last thing the mortgage sector needs right now is Fannie Mae and Freddie Mac in drag, pretending to be private finance companies. All ties between the federal government and the GSEs must be severed to make “privatization” a reality.

Instead of continuing the strange pretense of the “private” GSEs, better to simply liquidate the two enterprises and focus the distribution of all government housing subsidies on the FHA and Ginnie Mae, as suggested in several alternative plans floating around the House of Representatives. The US government through FHA would offer insurance on eligible loans held by any issuer without providing a backstop for the corporation. The private bank or non-bank would then sell the mortgage backed securities to investors, with either GNMA cover, private insurance or no insurance at all.

As today, higher quality mortgages such as prime jumbos would not require any government insurance cover whatsoever, but the real opportunity is to privatize the 60% of the market now served by the GSEs. If you think of the mortgage market today, 25% of all mortgage loans are held by banks in portfolio with no cover, about 50% (mostly prime loans) are guaranteed by Fannie Mae and Freddie Mac, and the rest of the market (including below prime loans) are covered by the FHA and GNMA.

Private investors could easily accept uninsured prime mortgage securities now covered by the GSEs and do so at a lower cost to consumers. Some three quarters of all loans today have FICO scores above 720, quality loans that private investors would readily accept. The pricing for Fannie Mae’s risk transfer deals calculated by Well Fargo suggests that virtually all of the default risk from GSE mortgage exposures could be underwritten by the private sector and at a cost that is a fraction of the guarantee fees charged today by the GSEs.

Meanwhile, across town, acting Consumer Finance Protection Bureau director Mick Mulvaney also leaked a memo outlining how the agency will operate in future. The head of the Office of Management and Budget made clear that the bad old days of the CFPB extracting settlements from mortgage companies and banks is over. He wrote:

"We are government employees. We don’t just work for the government, we work for the people. And that means everyone: those who use credit cards, and those who provide those cards; those who take loans, and those who make them; those who buy cars, and those who sell them. All of those people are part of what makes this country great. And all of them deserve to be treated fairly by their government. There is a reason that Lady Justice wears a blindfold and carries a balance, along with her sword."

More significantly, Mulvaney confirmed that the CFPB will no longer regulate through enforcement actions and that fines and penalties will only by imposed when there is actual harm to consumers. This changes the inquisitorial approach of former director Richard Cordray, who extracted billions in wrongful settlements from private banks and mortgage companies during his reign of terror. Cordray is now seeking the OH governorship with a war chest filled to overflowing with contributions from the trial bar. Mulvaney stated in his memo:

“So, what does all of this mean, in terms of how we will operate at the Bureau? Simply put, we will be reviewing everything that we do, from investigations to lawsuits and everything in between. When it comes to enforcement, we will be focusing on quantifiable and unavoidable harm to the consumer. If we find that it exists, you can count on us to vigorously pursue the appropriate remedies. If it doesn’t, we won’t go looking for excuses to bring lawsuits…. On regulation, it seems that the people we regulate should have the right to know what the rules are before being charged with breaking them. This means more formal rulemaking on which financial institutions can rely, and less regulation by enforcement.”

Under the tyranny of Richard Cordray at the CFPB, the cost of servicing a performing mortgage rose three fold in the US, one reason why many smaller independent mortgage banks have shut their doors. Larger firms are under pressure as well, which is why half of the top ten independent mortgage banks are in bankruptcy or for sale. It is fair to say that there will be a significant number of business closures and acquisitions in the mortgage sector during 2018.

Even with the welcome regulatory changes in Washington, it will take years for the mortgage finance industry to recover to something like a reasonable cost structure. In the meantime, millions of Americans could lose their businesses and their jobs in 2018 – not primarily due to rising interest rates, but because of the abuse of power in Washington by ambitious progressives seeking higher office.

While the changes at the CFPB are welcome in the mortgage finance sector, the fact remains that 2018 is going to be a very tough year. The entire mortgage banking and REIT sector has been selling off since the end of December, reflecting investor concerns about rising interest rates and a flat yield curve. Regulatory changes in Washington are welcome and long overdue, but for the mortgage finance industry, it is still the depths of winter.

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