How the Fed and Treasury are hurting housing

In mid-March of this year, the explosion of COVID-19 caused the market for just about everything in fixed income to seize up, scaring the stuffing out of the members of the Federal Open Market Committee and their counterparts at the Treasury. Simply stated, the market for Treasury and agency debt evaporated for several weeks even as stocks swooned.

In response, the FOMC began to purchase trillions of dollars in Treasurys and agency mortgage-backed securities, forcing down interest rates across the yield curve and sharply boosting mortgage lending for both purchase and refinance loans to record levels. Issuance of agency MBS is now running well above $300 billion per month as issuers of all stripes drive volumes.

In addition to buying existing securities, the Fed also began direct lending programs to support various sectors of the economy, including buying private company debt. But two areas that have not been a recipient of the Fed's largess, sadly, are the government loan market and the market for private, non-agency mortgages.

The FHA/VA/USDA market is the foundation of the mortgage market, but has no lender of last resort. Unlike the conventional market, where Fannie Mae and Freddie Mac ultimately provide a liquidity backstop, Ginnie Mae has no balance sheet.

In both the case of private mortgages and government loans, the Fed and Treasury display a remarkable nonchalance regarding vital parts of the housing finance sector. So serious is the situation facing government mortgage lenders, for example, that former Ginnie Mae President Ted Tozer called for the creation of a liquidity facility for them.

"The independent mortgage bankers are going to be left to their bank lines and other less-stable financing sources to meet their advance requirements as delinquencies, I expect, will creep up and refinances will come down," Tozer said in a report published by Urban Institute co-authored with Karan Kaul. They wrote:

"The fundamental differences between the Ginnie Mae and GSE models are central to understanding the need for a federal liquidity facility for government loans. The flexibility the GSEs have has enabled them to take effective action to limit downside risk for servicers of their loans, primarily by capping principal, interest, taxes, and insurance advances at four months. In comparison, Ginnie Mae's limited role and various constraints leave it unable to go beyond PTAP. Furthermore, Ginnie Mae has no authority to advance taxes and insurance."

So far, the Fed and Treasury have turned down requests for assistance for government lenders, causing some in the industry to wonder aloud whether Treasury Secretary Steven Mnuchin wants to see nonbank lenders fail so he can have a trophy for his political wall. But the government loan market is not unique. The market for private loans has also suffered dramatically in recent months.

Liquidity basically disappeared in the world of non-qualified mortgage lending at the end of the first quarter. March and April were about fire sales as collateral that had been trading at a premium to book fell to a 20-point discount. Several large REITs came to the brink of failure. The situation could not have been more dire, yet the Fed and Treasury did nothing. Prime whole loan, private-label collateral now trades, when it does trade, at distressed levels.

"A lot of the think tank guys spooked the Fed on private RMBS," notes one industry CEO. "The Fed has now figured out that the private-label bonds are much safer. My sense is that if the market takes another header, RMBS will be added to TALF," the federal Term Asset-Backed Securities Loan Facility program. Hopefully so.

Some observers might think that private mortgages are a tiny market of less than $100 billion in unpaid principal balance — the province of specialized jumbo lenders like Redwood Trust and First Republic Bank. But, in fact, the private-label loan market is far more important and represents a quarter of the U.S. mortgage industry.

The private-label loan market is part of the $2.8 trillion complex of bank-owned mortgages. These are loans that tend to be prime credit, which are larger than allowed in the agency market, sometimes much larger. This market finances a growing segment of the U.S. housing market as home price inflation caused valuations to soar at double digit rates — at least until March.

Until March, banks used the private-label market to value and purchase third-party production. The collapse of liquidity in the non-QM market caused a significant compression in home prices above $1 million in many markets, although the surge of urban flight to the suburbs may moderate this impact.

The lack of liquidity in non-QM loans has caused larger banks to step back from third-party production channels and terminate warehouse lines for non-QM lenders. Today, if you are looking for a jumbo mortgage, your only practical call is 1) your bank or 2) a hard-money lender that will charge you double digit rates in many states.

Ponder the fact that the Fed won’t purchase "AAA"-rated private-label mortgage bonds, but it will buy the debt securities of private companies, many of which are actually junk credits. What’s wrong with this picture? Supporting the private market will help investors, but more important, it will enable banks to resume purchases of third-party production of prime jumbo mortgages.

It is tempting to think that low interest rates will cure all ills in the housing sector, but this view is seriously in error, as we learned in 2008. Liquidity is also vital. By not supporting government lenders, on the one hand, and also withholding reasonable liquidity to the private-label mortgage market, on the other hand, the Fed and Treasury are risking the economic recovery. We need a change in policy now, before it is forced upon us by circumstances later this year.