Fed moves cause major headaches for the mortgage ecosystem

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A happy note as the New Year begins. Industry leader PennyMac is celebrating its 15th anniversary. PennyMac went public in 2009, one of several firms that started from the ashes of Countrywide Financial after the 2008 financial crisis. The creation of PennyMac Financial and its companion REIT, PennyMac Mortgage Trust, also marked the expansion of non-banks into mortgage lending and servicing. 

Today virtually the entire market for selling agency and government-insured loans is controlled by nonbanks. Commercial lenders have stepped-back from facing low-income consumers, fearing reputation risk at the hands of ambitious regulators and sub-zero real returns. Of note, Wells Fargo just confirmed its intention to exit correspondent lending and accelerate the reduction of its servicing book, including bulk sales of MSRs. 

The rise of independent mortgage banks is a blessing for America and for agencies such as Ginnie Mae. Nonbanks have performed brilliantly over the past 15 years, clearing up the wreckage of private label loans after the 2008 collapse and then moving on to restore growth to conventional and government mortgage finance after years of doldrums. Nonbanks took distressed servicing from Citigroup and Bank of America, among others, and greatly enhanced consumer protection and service in the process. 

Most recently, nonbank financial firms dealt with COVID loan forbearance and the increasingly irrational demands of progressives in Congress. Together the larger nonbank servicers processed hundreds of thousands of loan modifications and loan forbearance periods for consumers, often incurring costs that nobody in Congress or the Treasury ever thought to recognize much less offset.  

Does helping consumers during COVID at least warrant a thank you to the mortgage industry from President Joe Biden? Don't hold your breath. 

Loan default is the newest entitlement of the 21st century. Sadly, in the era of progressive beneficence, consumers do not have minimum net worth requirements for an FHA loan. Banks could never deal with servicing the low FICO, high LTV loans (aka subprime) seen in the FHA market. Hyper-efficient nonbanks saw an opportunity and seized it with both hands. 

The growth of nonbanks in residential mortgages is more a tale of return than a new chapter. Nonbanks called savings & loans dominated mortgage finance from the Great Depression through the 1990s, when commercial banks took over to their everlasting regret. 

During the period of the rise of the nonbanks to dominance in housing finance, by no coincidence, the Federal Open Market Committee steadily pushed down interest rates. The most extreme example of FOMC interest rate market manipulation in 2020 and 2021 has now created a huge potential risk for lenders and investors.

The Fed fueled record gain-on-sale profits for adept lenders in 2020 and 2021, but also embedded a short-put option on the balance sheets of owners of loans and MSRs: lenders, REITs and even the GSEs and the Fed itself. With the period of sharply lower rates in 2020 and 2021, the industry soared but now faces a fearsome hangover as prices for loans and securities created during the period of Fed ease plummet in price.

Most large banks, Fannie Mae and Freddie Mac, and the Fed start 2023 arguably insolvent on a mark-to-market basis, as this writer noted in a blog post. In Q3, all U.S. banks had $350 billion in unrealized losses on available-for-sale assets. Add in a 15% to 20% haircut on portfolio loans and securities and the industry is insolvent to the tune of about $2 trillion on some $20 trillion in total bank assets. 

The good news for nonbanks is that they are generally in the business of selling loans. Banks, the GSEs and REITs, and the Fed buy loans or MBS for portfolio. Now holders of loans and MBS that were originated in 2020 and 2021 face a liquidity issue very similar to the savings and loan crisis of the 1980s. That Ginnie Mae 2% MBS originated in 2020 is now trading at about 85 cents on the dollar vs. 103 when originally issued. And these securities are already underwater in terms of funding costs.

The same problem that banks face with unrealized losses thanks to the rapid rise of interest rates is also felt by Ginnie Mae issuers and the GSEs. When issuers of MBS repurchase a delinquent loan, say a 3.5% mortgage made in 2021, they pay the MBS investor par. But what happens to the loan?  In the case of Fannie and Freddie, it adds to credit expenses but also creates a future market loss. 

In the first nine months of 2022, Fannie Mae saw a significant increase in credit expenses, from a GAAP benefit to income of $4.2 billion in 2021 to $2.9 billion in new loan-loss provisions. But perhaps more significant was the billion-plus swing into loss for loans sold from the portfolio. As the GSEs compensate servicers for buyouts of delinquent conventional loans, they face substantial losses when these low-coupon loans are eventually modified and sold. 

Many people were rightly concerned when Ginnie Mae was forced to seize the portfolio of Reverse Mortgage Funding (RMF) before the new year.  Yet the fact is that Ginnie Mae and HUD have direct access to the Treasury, which reportedly wrote a check for over $600 million to cover the arrears for RMF.  

The GSEs, on the other hand, must finance themselves as nonbank issuers and meet a variety of cash needs, including supporting conventional lenders. As the GSEs are forced to purchase more delinquent loans, the cash cost in terms of credit and market risk will grow. Unlike Wells Fargo, the GSEs cannot walk away from correspondent lending.