September 25, 2023 | This week, The Institutional Risk Analyst is headed for the Digital Mortgage 2023 in LAS. But first a quick comment on higher interest rates for longer after the latest FOMC meeting.
The cries of “surprise” from the Wall Street analyst herd about the prospect for no significant interest rate cuts in the near-term are so predictable. We think the obvious statement is that maybe the ultra low interest rates of the post 2008 period were excessive, at least judging by the mounting losses at the Fed.
The fact that the Yellen Treasury is preparing to repurchase “illiquid” bonds to augment “market liquidity” is another big hint. Do you think banks want to sell Treasury notes and bonds with the 10-year note at 4.4%? And yes, bank stock prices may even go down in the near term. We'll be updating readers on Charles Schwab (SCHW) later this week.
We think that equity managers need to start thinking about whether the past five years of downward skewed interest rate markets is really a good indicator for the future. Perhaps the new lower bound for short-term interest rates is not zero but more like 3-4%? The 10-year was 4.49% on Friday and the yield on the conventional loan index was 7.2%. Fed funds, meanwhile, seems stuck below 5.5%. Imagine if the Fed cuts short-term rates a whole quarter a point 12 months from now and that's it.
At the Digital Mortgage event, we will be participating in several panels, including a discussion in the PM 9/26 at the Wynn with former FHFA Director Mark Calabria about the future of Fannie Mae and Freddie Mac. Needless to say, the outlook for either GSE being released from government control seems more distant now than ever before.
Our short take on the future of the GSEs looks a lot like the character played by Bruce Willis in the 1995 film by Terry Gilliam, “Twelve Monkeys,” but we’re looking forward to a great discussion. In this regard, read our latest comment in National Mortgage News ("Washington's fretting over nonbank risk is misguided"). Imagine if the GSEs were released from conservatorship, but then were immediately designated as a "systemically important financial institution" (SIFI) by the FSOC How do you think that would work for private investors?
In a perfect world, the private sector would lift most of the prime and middle thirds of the mortgage world, while the GSEs and Federal Housing Authority and other agencies would support housing policy for the lower income portions of the markets. The key role for government, IOHO, is promoting first-time home ownership with subsidized products focused on the bottom third of consumers (< 670 FICO) in terms of credit. Notice that the market for non-agency private mortgages has largely disappeared since the start of 2023.
Fact is, virtually the entire residential housing sector currently operates with government credit support, so that investors need only ponder market risk and funding. Sadly, Silicon Valley Bank forgot that option-adjusted duration thing. But the key point is that virtually the entire market for 1-4 family mortgages reflects a government subsidy worth several points in terms of loan price. Keeping the GSEs in conservatorship simply makes this middle class subsidy a permanent fixture of the mortgage markets.
Because of the federal credit wrap on agency and government-insured 1-4s, credit risk is mostly taken off the table with US mortgages, but with a lot of operational risk borne by banks and nonbank servicers of government assets. The pricing of mortgage-backed securities reflects this credit subsidy, thus if we raise the fees charged by Fannie Mae and Freddie Mac for guaranteeing MBS and the underlying loans, the conventional loan rate would rise accordingly. Private mortgages, even prime jumbos, are relegated to the world of "fringe" products that ebb and flow with interest rates and funding costs.
The irony is, of course, that the current enterprise capital rules now in place for the GSEs essentially require Director Sandra Thompson to raise gfees. At the end of 2022, the FHFA reported on the fees charged by the GSEs. Total average guarantee fees increased 2 basis points (to 56 basis points), average upfront guarantee fees increased 2 basis points (to 13 basis points) and average ongoing guarantee fees remained unchanged at 43 basis points.
So, let’s set the table. Imagine that FHFA Director Thompson follows the current capital plan and proposes a 20-25bp increase in the total average gfees charged by Fannie Mae and Freddie Mac so that they can “accumulate capital.” As and when home prices start to weaken, the urgency for accumulating capital and putting back "defective" loans to issuers will intensify.
Let’s also imagine that new residential loan volumes will be lucky to touch $1.6 trillion in 2023 and 2024 and that loan rates are going to slowly rise toward 8% as the industry struggles to eliminate capacity and thereby restore profitability. The Darwinian struggle for loans in the primary loan market will start to resemble WWI trench warfare.
Finally, let’s imagine that loan delinquency slowly rises to above 2019 levels over the next 12-18 months and loss given default (aka “net loss”) for 1-4s likewise normalizes back into positive territory. Keep in mind that delinquency for the bottom quartile of mortgages in the FHA market are already in the low teens and climbing.
Source: FDIC, MBA
In the event of a gfee increase by Fannie Mae and Freddie Mac, we might imagine that the GSEs would lose significant market share, both to private issuers and the Federal Home Loans Banks. Lower FICO borrowers would no doubt migrate back to the FHA. But any real decline in GSE market share assumes that private investors are willing to take first loss on credit risk for conventional loans for an extra 75bp in yield. Probably not.
As the FHFA under Director Thompson has injected more and more politics into the operations of the GSEs, the execution at the cash windows of both GSEs has suffered. With a 75bp average total gfee, would the market for private label MBS return? Or, more likely, would conventional lending volumes simply crater as consumers balked at 8.5% mortgage rates? That's our bet.
"Raising to 75 would be counter intuitive to their mission," one top-ten correspondent lender tells The IRA. "That level of gfees makes FHA a much better option for customers, so the customers on the border of doing an FHA or a Conventional loan will now go FHA – typically they are the lower income borrowers FHFA is trying to serve. Further, a gfee hike makes the housing affordability worse as less borrowers will qualify in the highest rate environment we’ve seen since the 90’s. In addition, the good middle class borrowers getting the $350k house may also go FHA as the rate differential will be so much greater."
But of course mortgage rates already are headed over 8% because of the inversion of the Treasury yield curve. The on-the-run Fannie Mae MBS for delivery in October (TBA) is a 6.5% coupon trading at 100-26 bid at the close Friday. If you are writing 7.5-8% mortgage loans, you really want to sell that loan into a 7% MBS in TBAs for October, if you can find a bid. Notice that there are no 7% contracts on the screen. Remember, lenders sell short in TBAs so that they can lock the cost of a pool delivered a month hence.
To add to the misery, the mortgage market is still in contango, meaning the near MBS contract is trading at or below the price for TBAs for October and November. Lenders are slowly going to ratchet up loan rates until the secondary market execution returns to profitability. Keep in mind that warehouse funding for prime clients is SOFR +1-2%, so you are lucky to break even on carry until you sell new loans into the MBS pool. And just for giggles, the average coupon in the Bloomberg MBS index is still below 3%.
TBA Prices & Spreads
Source: Bloomberg (09/22/2023)
So, again, if Fannie Mae and Freddie Mac take their gfees up to 75bp, will that convince private investors and banks to own 1-4 family loans? Probably not. Will the volumes in the conventional loan market likely fall further? Yep. If you want to hear the rest of the story, come join us at Digital Mortgage 2023.
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