On Sunday, the Mortgage Banker’s Association held its annual conference in Nashville. Lenders and managers clash rising interest rates and increased capital requirements regulators – this in response to the market risk triggered by the Federal Open Market Committee. Washington’s solution to growing risk? Industry consolidation to separate the weak from the strong among small depositories and independent mortgage banks.
A decade and more since the Great Financial Crisis, the mortgage industry continues to adjust capital, risk profiles and business models. Creating and selling 30-year residential mortgages (with free and in-the-money prepayment option) is in many ways an act of madness. But even worse is the idea that IMBs are sort of the problem in residential loans.
Fed Chairman Paul Volcker wiped out thinly capitalized savings and loans in the 1980s by pushing interest rates above funding costs. Many thrift companies lacked federal deposit insurance and failed en masse. And yet, it was non-bank lenders who came to Ginnie Mae’s rescue when S&Ls were wiped out by double-digit interest rates four decades ago.
“During the S&L crisis of the late 1980s, IMBs bailed out Ginnie Mae by buying the mortgage servicing rights from bankrupt S&Ls and the RTC,” recalls David C. Stephens, COO of United Capital Markets. “Other IMBs, as master repairers, salvaged Ginnie Mae MSRs from failing S&Ls, prior to RTC liquidation.”
“IMBs built Ginnie Mae,” Stephens continues. “Lomas Mortgage issued the very first Ginnie Mae security. Kisslack and other non-banks were major issuers of Ginnie Mae securities for many years. More recently, banks have been spooked by the misuse of “False Claims Act” and other abuses from DOJ prosecutions under President Barack Obama. They are still afraid to re-enter the market because the abuses have not been corrected.
The wrongs of the past still linger in the minds of many mortgage lenders, but today such thoughts are a happy distraction from the prospect of a market that seems headed for double-digit mortgage coupons. well subscribed by the first quarter of 2023. Double-digit loan vouchers? Let’s do the math.
The yield of MBS Fannie Mae for delivery in November is around 6.4%. Adding 1.75% for the spread of the MBS over the 5-10 year Treasury mixed yield gives us more than 8% for the balance on the sale of the loan in the secondary market. It’s today. MBS created a trade a year ago against the 10-15 year mixed yield BTW, if and when they trade.
If the FOMC makes two more 75 basis point rate hikes this year and then pauses, imagine the new issuing agency’s MBS yield goes into the 8% range and that means lending coupons in the 9 or 10 for average conventional loans – assets with 720 FICO and 80 loan-to-value ratios. Weaker borrowers will benefit from double-digit loan coupons in conventional and bank loans.
As this author noted in a missive on market value losses caused by rising interest rates (“Will the FOMC smash the financials?“), the relentless rise in benchmark yields has put many older loans and securities under water, so much so that these government-insured MBS are now listed as distressed assets on a discounted price instead of an efficiency.
There are literally hundreds of billions of dollars of government-insured loans and securities created in 2020-2021 that are fifteen, twenty or more points below the original issue price. Because of this, dozens of custodians are now technically insolvent and will lose access to bank financing and federal mortgage lending banks without waivers from federal regulators.
Granting waivers to insolvent banks assumes that the “accumulated other comprehensive income” or negative AOCI deficit is ultimately reversed. But maybe not. What if those Fannie, Freddie and Ginnie Mae 1.5 and 2 never come back in the money?
COVID-era loans and securities are a low-coupon ghetto that TBA traders avoid due to high price volatility. JPMorgan, Bank of America and Wells Fargo together had nearly $50 billion in negative AOCI ratings on their available-for-sale portfolios in Q3 2022. The sector’s negative rating on the $3.2 trillion of MBS held by banks could amount to hundreds of billions of dollars. dollars.
Banks and IMBs are sitting on management portfolios made up of loans that may not be in the money for refinancing for many years to come. This creates a deep dilemma because the related MSRs held by these companies now carry higher valuations that depend, in part, on the future potential for refinancing the loan. Without new lending and recovering portfolio assets, the current fair values of MSRs are in question.
Additionally, more aggressive issuers took advantage of the MSR as its value rose in order to raise funds. The magnitude of the interest rate hike since the start of 2022 is far greater than the rate cut in 2020-21, leading to the obvious question: where will the money for future margin calls come from? on MSR financing as interest rates eventually come down? And the loans behind these MSRs may not be in the money for refinancing for years to come, if ever.
Even if the FOMC suspends rate hikes at the end of 2022, putting the fed funds rate around 5%, it leaves the financial community with a stack of market risks embedded in portfolios due to market volatility. Now you know why all the regulators, from the Fed to the OCC for banks, to the Federal Housing Finance Agency and Ginnie Mae, are all urging JPM’s Jamie Dimon and other banks and IMBs to raise more capital.
The movement of interest rates determines the balance in market risk and therefore the credit risk the bank takes on by lending against a pool of fixed coupon mortgages. And IMBs don’t take on as much market or credit risk as custodians who actually fund mortgage business.
When it comes to mortgage market risk, being a bank is actually worse than being an IMB. Banks operate with a leverage of 15:1. IMBs have 2 to 3 times greater leverage. Every dollar of loss in a bank absorbs more capital, whether due to credit loss or market risk. This is why banks require 10% or more capital for assets and federal deposit insurance. However, the mere fact of having capital is insufficient without good control of market and interest rate risks.
“IMBs are nowhere near as powerful as banks,” Stephens of United Capital Markets told NMN. To say that Basel III is a good match for the risk of IMBs owning MSRs is totally at odds with the public record. You cannot justify a 250% risk weighting with previous loss experience with an IMB. Without a strong market for released and curated MSRs, there would be no GNMA origins.”
As the MBA meets in Nashville, many IMBs will be looking for buyers or wondering if they should turn off the lights completely and go home. Many yield-hungry custodians, on the other hand, will be salivating at these rising loan coupons and wondering how to get a taste of the door to offset unrealized losses in the portfolio. And everyone in the financial world is wondering how to survive the tsunami of market risk caused by the highest mortgage interest rates in twenty years.