GSEs give on COVID loans, but not on putbacks

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The Mortgage Bankers Association annual gathering in Philadelphia raised a lot of hopes and expectations for change in 2024. Sadly the gap between Washington and the housing sector has never been wider, as illustrated by the letter from the MBA, National Association of Home Builders and National Association of Realtors to Federal Reserve Chairman Jerome Powell.

First and foremost, the Federal Open Market Committee shows no inclination to lower interest rates. If anything, the FOMC is still talking about another rate hike later this year. But remember these are the same folks who told us that inflation was "transitory," and thereby caused the failure of several large banks.

We did not attend the MBA annual this year because the event began as Q3 bank earnings season commenced. The good news is that bank credit conditions remain quite positive, with most banks reporting lower credit loss builds than last quarter.  The bad news is that with the 10-year Treasury touching 4.8%, most of the banks in the U.S. are insolvent on a mark-to-market, fire sale basis.

Bank of America, for example, reported a negative valuation on its market facing exposures of $21 billion in Q3 2023, up from negative $20 billion in accumulated other comprehensive income or AOCI in the previous quarter. If we haircut the $603 billion in BAC's held-to-maturity securities by say 20% to reflect the effect of rising interest rates, the bank has a net loss position approaching $150 billion. We have not even mentioned the bank's loan portfolio. 

Think of all of the 2, 2.5 and 3% coupon loans that BAC and other large banks retained in their portfolio instead of selling those loans into the secondary market at inception for 104 and buying T-bills. The cost of the Fed's "transitory" inflation head-fake to all bank shareholders is incalculable. H/T to Komal S. Sri-Kumar.

Of course, loan defaults in the world of 1-4 family mortgages remain extremely low, even negative for prime loans typically owned by banks. Yet the average coupon on the loans held in portfolio by most banks are points underwater compared with current market funding costs. Those low-coupon loans and bonds held by banks will depress earnings for years to come.

For independent mortgage banks, funding costs are basically above the coupons on many new loans held for sale. The average loan coupon for conventional loans, for example, is nearing 7% and the industry is writing loans in the mid-7s to over 8 depending on the credit score.

The intense financial pain being felt by many IMBs raised hopes that FHFA Director Sandra L. Thompson would address the potential reform of the Federal Home Loan Banks, which currently serve less than a third of the residential mortgage market. As IMBs take greater and greater share of 1-4 family lending and servicing, the FHLBs are increasingly out of a job.

Director Thompson did not mention the FHLBs except in passing and said nothing about the prospect for reform. This is hardly surprising since the FHFA has not yet proposed any changes to the FHLBs. 

In fact, the FHFA has twice solicited comments on several aspects of the FHLBs, including changes to membership. The FHFA has privately encouraged the mortgage industry to take the lead on Capitol Hill. Nothing done. 

Since the incumbent managers of the FHLBs refuse to consider any changes to the membership rules for the system, Thompson is probably wise to avoid a political fight. The FHFA is the regulator of the FHLBs in name only. The community bankers control the FHLBs and the banking industry lobby in Washington has thwarted any effort at change. 

The IMBs and MBA together have not been able to make the case for opening FHLB membership to nonbanks, a change that requires new legislation. Perhaps once the IMBs control 75 or 80 percent of the market for 1-4 family lending and servicing, and some of the marginal FHLBs face eventual closure, Congress will act. In the meantime, nothing has been done.

The natural growth of IMB market share has its roots in the 2012 National Mortgage Settlement and bank regulatory changes made after the 2008 crisis. But this process is now about to accelerate because of the latest Basel III bank capital proposal, which significantly raises capital requirements for mortgage loans as well as servicing assets.

"The U.S. banking regulators' Basel capital proposal increases capital requirements for most mortgages relative to the current U.S. rule, and by even more compared to what is specified in the latest international Basel agreement," notes Greg Baer of Bank Policy Institute. 

"The regulators' proposal includes both higher capital charges for the credit risk of a mortgage as well as a new, additional capital charge for operational risk, and will make mortgages more expensive and homeownership less affordable," he concludes. As banks leave the market for residential mortgages, IMB market share will soar and FHLB financing volumes will decline.

On a happy note, the FHFA announced during the MBA convention that it will revise the treatment of active single-family mortgages backed by Fannie Mae and Freddie Mac for which borrowers elected a COVID-19 forbearance under the GSE representations and warranties framework.

Under the updated rep and warrant policies, loans for which borrowers elected a COVID-19 forbearance will be treated similarly to loans for which borrowers obtained forbearance due to a natural disaster. Both Fannie Mae and Freddie Mac took the position that loans that were delinquent for even a month during COVID would not be treated the same as loans that are delinquent during a natural disaster. 

We called for Director Thompson to change this unfair treatment of COVID loans back in February in this column. Rack up another win for the good guys. But that's not all. During her prepared remarks, Director Thompson noted a large reduction in repurchase requests from Fannie Mae and Freddie Mac since the peak in early 2022. She also promised additional changes to come, reports Originations Editor Brad Finklestein. 

Some lenders told NMN that they see the change as positive: "I think it is a change," one top lender told NMN. "I believe this is really only directed at one of the two GSEs, but we're already seeing some movement from them."

But another large conventional lender dismissed the gesture and predicted that the GSEs will simply charge a fee for alleged loan "defects" but avoid a buyout and leave the loans in the MBS pools.

"The impact will be that the GSEs will generate fee income without taking any risk, but the lenders will pay," notes the veteran executive. "The GSEs will only have to deal with loans that actually default, but otherwise they get to pocket the fee for doing nothing."