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The Institutional Risk Analyst

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Is it Springtime in Housing?

New York | Last week the Mortgage Bankers Association released their annual production report for 2018. It is not a pretty picture. The Federal Open Market Committee has supposedly been “helping” the housing finance sector for years by purchasing long-dated securities, yet mortgage lenders have turned in their worst performance in decade. The MBA estimates total residential mortgage production volume at $1.64 trillion in 2018, down almost 7% from $1.76 trillion in 2017.

“In basis points, the average production profit (net production income) was 14 basis points in 2018, compared to 31 basis points in 2017. In the first half of 2018, net production income averaged 18 basis points, then dropped to 9 basis points in the second half of 2018,” reports Marina Walsh of the MBA. “Since the inception of the Annual Performance Report in 2008, net production income by year has averaged 49 bps ($1,020 per loan).”

The good news for the mortgage industry is that, since December when the FOMC did a double pirouette and stopped hiking interest rates, long-term bond yields have fallen and lending volumes have picked up. While increased lending results did not show up in the Q1 earnings for the largest banks, there was clearly a surge of activity in the first three months of 2019.

Joel Kan, MBA's Associate Vice President of Economic and Industry Forecasting opined: "Purchase activity remained strong and increased slightly, reaching its highest level since April 2010. The spring buying season continues to be robust, with activity more than 7 percent higher than a year ago and up year-over-year for the ninth straight week."

Could it be that after years of monetary chemotherapy the housing sector is recovering of its own accord, despite the “help” from the FOMC? The answer is yes. The smart leaders in the industry are positioning for stronger volumes down the road and lower interest rates. Unlike heavily regulated commercial banks, mortgage firms tend to be quite nimble and highly sensitive to changes in the sales cycle caused by interest rate movements, prepayment rates and other factors. Of note, after peaking around Thanksgiving 2018, interest rates seemed to bottom at the end of March and have risen in the first half of April.

But the big obstacle to profitability for independent mortgage banks remains the cost to originate or acquire a loan. The MBA reports that total loan production expenses - commissions, compensation, occupancy, equipment, and other production expenses and corporate allocations - increased to $8,278 per loan in 2018, up from $8,082 in 2017. Excessive regulation at the state and federal level is a big component of higher loan production costs.

Another recurring theme is a scarcity of mortgage related assets, which like houses are being produced in too little quantity for meet market demand. The result is a price war among the major residential loan aggregators, but you won’t read about it in the financial media. Suffice to say the falling volumes put increased upward pressure on secondary loan prices. Many banks and other owners of 1-4s simply keep the assets in portfolio instead of selling them. The chart below from SIFMA shows that many asset classes and especially mortgages and CLOs have not yet recovered from Q4 2018.

Having spent the past two weeks on the road attending mortgage events on both coasts, we have a pretty good view of the state of the mortgage sector and where things are headed. As in 2018, liquidity remains the big concern in the industry, in large part due to paltry profits but also because of the absolute increase in funding costs. Credit concerns are there, but so far the numbers related to credit costs remain very muted and, indeed, extraordinary. Credit costs for bank owned 1-4s remain negative at the end of Q1 2019, for example, with serious delinquency rates at just 2% (200bp) and charge-offs of just 30bp.

We heard Mark Fleming, Chief Economist at First American, talk about whether 2019 is the year that the housing market turns and ends it’s 7-year bull run. The good news is that the number of households is finally starting to grow, but supply remains the key constraint. And many households are moving from expensive coastal markets and into more affordable markets such as NC, TX, IN, CO and OH. This is bad news for states like NY, CT and NJ, where an exodus of affluent homeowners to other states is finally forcing sellers to capitulate in the high end suburban markets.

San Khater, Chief Economist at Freddie Mac, likewise confirmed that a larger cohort of younger buyers is entering the market and that first time buyers are being forced to move further from the city center to find affordable housing. With the median age of the first time home buyer in the early 30s, Khater sees an increase in younger buyers looking for their first house. Of note today’s mortgage production is pristine in terms of delinquency compared with 2008-2014 mortgage loan vintages.

While high-end home prices may be softening, home price appreciation remains robust at the lower end of the price scale, according to Laurie Goodman, Co-Director, Housing Finance Policy Center at Urban Institute. Significantly, Laurie believes that we currently have a 330k deficit in terms of the number of new homes being constructed vs new households created. Whereas the supply of new homes exceeded demand in the 2000s, today the opposite is the case due to soaring land prices and restrictions on new home construction.

A scarcity of assets is not just visible in the market for homes and the secondary market for residential loans. Mortgage servicing rights or MSRs continue to trade at record multiples, this even after the bond market rally in Q1 2019 and the related downward marks on MSRs recorded in earnings for many large cap financials. Note that banks now own less than half of the $110 billion or so in total residential MSRs, as shown in the chart below.

As and when default rates rise, the bull market in MSRs will end. Levered investors will flee the cost of default servicing. MSRs are naturally occurring negative duration assets, the polar opposite of a loan or a fixed income security, but with a short credit put position attached. Yet in a stable housing market with falling loan volumes and rising asset prices, MSRs are trading at premium prices.

In the financial hunger winter engineered by the FOMC under Ben Bernanke and Janet Yellen, MSRs were the best performing fixed income asset class. Will this be the case in 2019 and beyond? Or will winter finally arrive for home prices in 2020? Our view is that home prices are unlikely to fall significantly. Scarcity of assets, soft volumes and low profits are and will be the watchwords in the residential housing sector for 2019.


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