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The Institutional Risk Analyst

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Squeeze Play: Rising Funding Costs, Flat to Down Yields

New York | This week The Institutional Risk Analyst is participating at The Mortgage Bankers Association Secondary Conference, one of the most important events of the year for the housing finance industry. One topic we heard a lot about from various attendees is that the volatility seen in Q1 2019 has thankfully subsided this quarter, but the continued deterioration of the effective spread on loans and securities, and rising prepayments, are big concerns.

On Sunday afternoon we heard a panel at the MBA Secondary on recent attempts to attract greater levels of private capital to the market. Eric Kaplan of Milken Institute led a discussion with Liam Sargent of J.P. Morgan (JPM), James Bennison of Arch Mortgage Insurance Company and Matthew Tomiak of Redwood Trust (RWT). Bennison noted that there is considerable pent up demand for private label mortgage exposures, but issuers must bring the right types of products to market – as in the case of the GSE risk sharing transactions.

When Matt Tomiak talked about the nuances of building the RWT non-agency mortgage business since 2010, we could not help but notice again the reference to a dearth of available assets – at least at yields that made sense to these veteran loan issuers. “Our biggest competition in the jumbo mortgage space is banks at the end of the day and also insurance companies,” he observed. “Water always looks for its lowest point. Mortgage loans are always going to find their lowest cost of funding.”

“My feelings are almost hurt when people say when will private capital come back to mortgages,” Tomiak added. “We’re back, we’re here and have been for a while.” His comments made us recall that credit terms for mortgage issuers are more liberal than at any time since the financial crisis, but even this considerable concession has not been enough to offset the relentless erosion of profitability thanks to the Fed’s QE.

To that point, Peter Fisher wrote last year in a chapter of a timely new book edited by John Taylor, “Should the Fed ‘Stay Big’ or ‘Slim Down’,”:

“My view is that QE1 (2008 to 2010) had a positive impact in liquefying the banking system during and immediately after the financial crisis and that it prevented more, and more rapid, deleveraging of the US financial system. But I am deeply skeptical about the efficacy of QE2 and QE3 (2010 to 2016) in stimulating aggregate demand.”

Indeed, not only did QE and Operation Twist not help the economy, but these speculative policies by the FOMC actually did serious harm to the world of mortgage finance, the second largest market in the world after US Treasury debt. That damage is starting to emerge as one of the chief risks to the financial markets in 2019. Ralph Delguidice at Pavillion Capital wrote last week in a note entitled “Curve inversion dead ahead” that further compression of profits for leveraged players may be the next shoe to drop:

“The Fed has hit the effective lower bound as the BASEL rules that de-risk the dealer banks, and the (still) contracting system balance sheet converge to constrain the supply of private short-term credit flowing into the all-important money markets. With the Fed on pause and stalling global growth, the strong USD and wide DM return differentials will pressure US term premia lower and invert the effective real-money curve. Financials—banks and especially non-banks with no deposit capacity—are ground zero, as valuations reflect the ongoing collapse of loan carry.”

Even as loan spreads and comparable fixed income returns remain under downward pressure, visible default rates continue to fall. “Strong April mortgage performance pushed the national delinquency rate to a record low,” notes Black Knight. “At 3.47%, it’s now at its lowest point on record. Plus, the 5.51% M/M decline in delinquencies was the strongest single-month April improvement we’ve ever seen…. Meanwhile, low interest rates and the spring home buying season continue to push prepayment activity upward. In fact, April’s 17% increase in prepays brings the three-month aggregate increase to 67%.”

So while the credit environment is benign for now, the dynamics of low profits for new loan originations and rising prepayment speeds on MBS are combining to create the perfect storm for holders of mortgage servicing assets (MSAs). The Street, after all, marks its mortgage securities and MSAs to model. Rising prepayment speeds means a commensurate decline in the modeled NPV of loans, mortgage securities and servicing assets.

The table below from the Mortgage Bankers Association shows the components of gain on sale when mortgage bankers sell loans into the secondary market. Notice that the numbers are not nearly as bad as one might think looking at the aggregate profitability data. “What's interesting is that while margins were down last year, they weren't down as much as some people thought they were,” notes industry veteran Joe Garrett of Garrett, McAuley & Co. Also observe that the portion of the total gain attributable to MSAs has been rising since 2014 and jumped 10% in 2018 alone. This provides yet another data point to suggest that Fed Chairman Jay Powell is wrong when he says that asset values are not inflated.

The crucial issue for the mortgage industry and especially for the specialty investment funds and REITs in this sector is whether the rise in prepayments is a temporary phenomenon associated with the rally of the 10 year Treasury and the resulting good Q1 production environment or will be confirmed by future quarters. If prepayments continue to rise, then the Street is likely to see a good bit more pain in Q2 when it comes to mark-to-model on MBS and MSAs. The good news is that the MBA refinance index has fallen significantly since the end of April, thus the mortgage bankers, REITs and other investors in RMBS may be spared drinking from the bitter cup of rising prepayments through 2019.

As we’ve noted for over a year, the structural increase in funding costs described by Delguidice in the short-term money markets is also working on the US banking industry, where interest costs are galloping along at a 70% annual rate of increase. We’ll be updating our projections for 2019 when the FDIC releases the Q1 2019 aggregate data for the US banking industry. For a number of reasons, we think that for banks, REITs and other leveraged investors, the minimum floor of funding costs is rising much faster than asset returns. That is, a classical funding squeeze a la the 1980s.

More Reading

National Mortgage News (May 20)

Peter Fisher, Hoover Institution

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