Opinion

Prepayments: Ginnie Mae vs. the big banks

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In my last comment, "The problem with Ginnie Mae's new restrictions," we took our friends at Ginnie Mae to task for changing the rules on pooling for reperforming loans or RPLs. The goal of the change: to slow prepayment rates on Ginnie Mae securities. But as any MBS repo trader will tell you, the rules are not the problem.

Servicers do early buyouts of delinquent government loans in order to capture the gain-on-sale opportunity when the loan gets back on track or is modified. If the EBO loan goes to foreclosure, that is the least attractive scenario. As one industry veteran told NMN: "No point in picking up spread [on EBOs] if your cost to run to liquidation torpedoes the platform ..."

Some folks in Washington may think that discarding decades of established industry practice with respect to loan pooling criteria will slow mortgage prepayment rates, but in fact, it does not matter at all. You see, the chief buyers of EBOs as well as profoundly distressed loans are large banks with big, liquid balance sheets. They're duration-hungry dinosaurs that are ravenous for earning assets of any description thanks to our friends on the Federal Open Market Committee.

Some 15% of Ginnie Mae servicing held by nonbank issuers is now delinquent. But the banks are going to be the predominant buyers of EBOs, both their own issuance and FHA/VA/USDA loans issued by others.

"Wells Fargo has purchased $14 billion of delinquent government-backed mortgages this month, leading the pack among servicers beginning to feel the balance-sheet pinch of the coronavirus pandemic," reports Kate Berry in NMN. "The banking giant was among companies that purchased roughly $20 billion in loans total from investors that were over 90 days past due, according to data from Ginnie Mae investment pools."

In fact, a lot of servicers buy past-due loans way before they reach 90 days delinquency because there is intense competition for these assets. For a nonbank issuer, a delinquent loan offers the opportunity to earn a significant fee when the loan is re-pooled into a new Ginnie Mae security. But for banks, there is no particular need to resell the loans.

Any intention that Ginnie Mae may have had to slow prepayment rates by changing the rules on RPLs seems to be thwarted by the grim economic reality facing the big banks. By adding several trillion in new liquidity (i.e., deposits) to the U.S. banking system via Treasury bond and MBS purchases, the FOMC has dramatically pushed down asset and equity returns for the industry. Buying Ginnie Mae EBOs is actually a good trade in risk-adjusted terms for banks.

As we noted previously, there is a glaring and frankly growing conflict between the policy goals of the Department of Housing and Urban Development and those of the Federal Open Market Committee, which has pushed down market rates through massive open market purchases to the tune of $4 trillion in just 60 days. This conflict is essentially responsible for the degree to which HUD and Ginnie Mae find prepayment rates on current coupons to be excessive.

The Mortgage Bankers Association's weekly forbearance and call volume survey over the past few weeks has shown that roughly 40% of loans in forbearance under the CARES Act stayed current and exited the program without event. Some call these loans "dirty current." Some 17% of loans were reinstated and 10% were dealt with as a partial claim, MBA reports.

With a superior cost of funds, it makes sense for the bank to buy the delinquent loans out of the pool and work with the borrower, if delinquent. If the customer is paying, then the bank simply collects the mortgage payment every month and banks the excess spread, the amount above what it actually costs to fund and service the loan.

"These were all performing loans before the pandemic and the borrowers opted into forbearance because of the CARES Act," Rick Sharga, president and CEO of CJ Patrick Co., told Kate Berry last week. "These were not nonperforming loans beforehand. A large number will go back to making payments or will get reinstated and a small number will get loan mods or an extended forbearance."

This is precisely the point that has troubled many people inside HUD and Ginnie Mae, as well as in the investment community, namely why should a "dirty current" loan that happens to be in CARES Act forbearance but is still paying, be bought out of the MBS pool? Shouldn't that loan simply remain in the MBS pool, saving the investor from a prepayment? Somebody ought to ask Fed Chairman Jerome Powell this question next time he is on Capitol Hill.

The constant prepayment rate for the $1.1 trillion in Ginnie Mae 3.5% coupons were running around 40% in June, a blistering rate that is likely to increase in coming months. With coupon spreads at 2% and the current production Ginnie Mae MBS coupons headed for 2%, this means consumers can get a 3% mortgage or better, which is great news for the FOMC and the economy.

But it is bad news for Ginnie Mae and MBS investors, who have been paying five- and six-point premiums on newly minted government MBS only to receive prepayments at par. At the present rate of prepayments, on-the-run MBS (which are, in theory, comprised of 30-year mortgages) will basically disappear within a year or so.

Over the next several years, much of the existing MBS will prepay due to refinance transactions, a fact that makes the competition for assets — from big banks, REITS, mortgage banks and funds — even more intense. Banks face rising servicing expenses and large amortization charges for servicing assets, even as retail production dwindles. Thus they must become buyers of assets again.

Meanwhile, the nonbanks are enjoying one of the most profitable periods in a decade, profits driven largely by the FOMC's policy actions and the related high rate of mortgage prepayments. With banks offering their swollen balance sheet for EBOs of delinquent government loans, any effort by Ginnie Mae and others to control prepayments through rule changes may be for naught.

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