Preparing for what's next as the COVID mortgage boom wanes

A year now since the peak of secondary spreads for residential mortgages near 4% in summer 2020, there is evidence that the residential mortgage market is cooling, particularly for more expensive homes. From Westchester County, New York, to the Rockies, the COVID-induced run on trophy vacation properties located far from major cities seems to have run its course.

One well-placed mortgage finance executive reports that in once-sleepy White Fish, Montana, there are many of out-of-state license plates, the town is packed with new arrivals and bids for seven-figure-plus homes swooned in the last 90 days. A similar phenomenon in the suburban New York region has also run its course, suggesting that the first part of the COVID trade in pricey escape homes is ended.

Even as the bond market has seen the benchmark 10-year Treasury note fall below 1.3% in yield, consumers do not seem to be responding, suggesting that there may be more than a little housing burnout operating in the world of mortgage finance as well as in related areas such as construction and home improvement.

“The tepid response of American homeowners to lending rates near 3% has mortgage bond investors asking if the refinance wave is over,” writes Chris Maloney in a Bloomberg News article. “Lower Treasury yields are not a signal that the economy is getting set to experience robust growth.”

Maloney notes that the surge in headcount in the mortgage industry in 2020 was far less than the build seen in 2008, doubtless because of vast improvements in productivity seen in the industry. But this increase in productivity will only mean more intense competition for falling loan volumes as the year goes on.

Some lenders, of course, continue to increase headcount for LOs and operations professionals in preparation for what one industry veteran calls “the final battle.” United Wholesale Mortgage, for example, has pursued a scorched earth strategy of matching the secondary market price of any loan in the wholesale channel.

Such beggar-thy-neighbor behavior is causing mortgage bankers to be very bearish on future profitability. Fannie Mae's Mortgage Lender Sentiment Survey for Q1 2021, for example, showed more than half of respondents expecting down revenue and profits for the remainder of the year.

“Over two-thirds of the respondents, 69% said their profits will decrease over the next three months, while just 11% expected them to increase, for a negative net differential of 58%,” reports Brad Finkelstein of NMN.

“Net share measures the difference between the percentage that believes profits will be higher and those that said they will be lower. That makes three consecutive quarters in which lenders were pessimistic about their profitability.”

Even as the volumes tighten, some large lenders continue to add capacity. Citigroup, for example, continues to add operations positions nationwide, including senior underwriter and sales roles. The money center bank largely exited residential mortgage half a decade ago, but now appears to be coming back into the home loan market.

The more challenging operating environment for lenders means that expense management is coming back into vogue – including not leaving money on the table. Looking at mortgage servicing rights, for example, issuers are increasingly focused on monetizing MSRs instead of giving them away.

“Last year, spreads were so wide that we were effectively paying people to take MSRs,” one veteran issuer says. “Now that behavior seems absurd with servicing assets trading north of five times cash flow.” The issuer says the hot trade now is buying government MSRs with the aim of refinancing from FHA loans into conventionals.

Purchase mortgage volume continues to be strong, notes Ed Pinto at the American Enterprise Institute, with week 26 running 36% above the same week in 2019 and at about the same level as in 2020. While refinance volumes are softening, the mortgage market remains strong and on track for another good year – albeit with sharply lower margins.

As the housing complex shows signs of slowing and managing costs is again the priority for rational market participants, the Federal Open Market Committee is repositioning for an earlier reduction in purchases of mortgage-backed securities and even TBAs. The Fed distorted the mortgage market via “quantitative easing,” pulling years worth of mortgage loans and home sales, and related consumer spending, into only a few months in 2020.

One senior industry regulator expressed concern that independent mortgage banks (IMBs) could take 3 to 4 points out of a mortgage sale last year. The fact is, the Federal Open Market Committee made this surge in profits inevitable, but now follows a period of weaker volumes and narrowing spreads. And a reduction in purchases of MBS by the Fed could see mortgage rates rise meaningfully.

IMBs that were wise enough to constrain profits and retain MSRs when the cash flowed abundantly over the past year, now have the luxury of selling these increasingly valuable assets or enjoying the cash flow. Firms that did not retain servicing now must survive on cash and investment as secondary market execution slips into the red.

Also concerning is the migration of risk from the FHA market to the conventional market of Fannie Mae and Freddie Mac, the result of the FOMC goosing home price appreciation via low interest rates. The flow of refinance volumes from government loans to conventional assets, for example, could push Ginnie Mae MBS volumes into net runoff for 2021.

Changes made by former Federal Housing Finance Agency Director Mark Calabria to the cash windows of the GSEs, for example, crimped these GSE volumes, but plain vanilla production made up the difference. Smaller IMBs have been forced to rediscover the joys of issuing their own MBS.

The changes to the cash window contained in the latest Preferred Stock Purchase Agreement between the GSEs and Treasury significantly impacted the profits of certain mortgage issuers. Don’t look for these changes, which allowed some aggressive issuers to access effectively lower guarantee fees and avoid appraisals, to change anytime soon.

Ironically enough, acting FHFA Director Sandra Thompson, who authored the draconian capital rules for the GSEs, may soon be under pressure to make changes in order to counter a slowdown in the housing sector. Many of the Calabria-era reforms resulted from public rule making, so do not look for rapid changes in the PSPA or capital rule.

One possible area for change by Thompson are the more than decade-old loan-level pricing adjustments, pricing rules that were put in place to prevent consumers from refinancing and thereby protect the GSEs after 2008. Any such changes will also hurt the profitability and risk profiles of the GSEs, showing that tight spreads and falling volumes are a challenge for all of the inhabitants of the housing finance complex.