Opinion

The banks are back in residential mortgages

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The collapse of interest rates last week opened the door for an historic surge in new mortgage originations, perhaps approximating the manic increase in loan production seen in the early 2000s. While the prices of homes have recovered since 2008, production volumes have only started to truly get back to prior levels in the past year due to lower interest rates.

New-home construction continues to lag as well. There still remains vast amounts of pent up demand for housing, demand that has now been unleashed with the drop in the 10-year Treasury bond yield below 1%.

The chart above from the Mortgage Bankers Association shows actual production through the end of 2019. Notice that huge surge in production in the third and fourth quarters in 2019, driven largely by an increase in refinance volumes above purchase mortgage production for the first time since 2016. For the full year, MBA estimates that almost $2 trillion in new mortgages were originated, again, the best year since 2016. But the outlook for 2020 and beyond is even brighter in terms of new loan production.

Just about every loan in the $11 trillion market for home mortgages is in the money for refinancing due to the precipitous decline in interest rates. For mortgage originators, this means a frantic scramble to add capacity in order to meet the expected demand for new purchase and particularly loan refinance transactions. As the yield on the 10-year Treasury falls, the primary and secondary market spreads have expanded to over 220 bp as of the end of last week, meaning bigger profits for loan originators.

With the return of volume and profitability to mortgage lending, it is no surprise that commercial banks are coming back to the market. JPMorgan Chase, Bank of America and Citigroup, to name just a few, have all announced increases in personnel focused on residential mortgages after a long hiatus. Production is being expanded and new emphasis placed on wholesale and correspondent channels for the first time in over a decade.

Why are the banks returning to residential mortgages? For starters, the rest of their respective balance sheets is not exactly brimming with opportunities. Earnings for U.S. banks have been falling for several quarters under the weight of falling yields for loans, leases and securities and rising funding costs. From commercial and industrial loans to multifamily credits, banks are choking on assets with poor returns and increasingly suspect credit profiles after years of falling yields and benevolent credit experience.

It might surprise some readers of NMN to learn, for example, that residential mortgage lending and issuance of agency residential mortgage backed securities is again an important area of volume growth for U.S. banks going into 2020 and beyond. In particular, the fourth quarter actually saw bank sales of mortgage notes into RMBS with servicing retained rise for the first time in almost a decade, signaling a renewed interest in correspondent lending on the part of several large banks.

Sales of residential loans into the secondary market for securitization was once the leading source of non-interest income for banks, but today is less than a tenth of previous peak levels seen in the mid-2000s. Look for U.S. banks to expand their footprint in RMBS over the next several years in a desperate effort to offset weakness in other areas of the bank income statement.

Along with the new commitment by banks to residential mortgage lending, the share of mortgage servicing these depositories hold is again starting to rise after nearly a decade of declines. In the fourth quarter, assets serviced for others by U.S. banks rose back above $6 trillion for the first time since 2016. This is a clear indication that commercial banks are leaning back into the residential mortgage business, albeit still focused on larger loans in the conventional market served by Fannie Mae and Freddie Mac rather than the government loan market served by Ginnie Mae.

Notice that the total amount of loans servicer by nonbanks has now risen above the level of bank portfolio holdings of one-to-four family mortgages, which have been trending flat to down for more than a decade. It's no accident, non-interest fees paid to banks related to mortgage servicing doubled in the fourth quarter for an implied yield of over 9% for the mortgage servicing rights.

As the total pool of outstanding mortgages grows strongly for the first time in a decade, banks are seeking to grow their share of the pie, again because of the dearth of remunerative opportunities in other asset classes. But as both banks and nonbanks seek to maximize loan production and purchases, they are running fast to stay ahead of the big negative in any falling interest rate environment, namely mortgage loan prepayments.

Just as bond prices rise when interest rates fall, the value of negative duration assets such as MSRs fall when rates decline. The expectation that existing loans will repay early decreases the estimated value of future cash flows from the MSR. Thus while lenders and investors in MSRs look forward to a new crop of residential loans and juicy gains on RMBS sales, the flip side of the coin is that falling interest rates could result in some enormous write-downs in the value of MSRs for banks, nonbanks and REITs such as Annaly Capital and New Residential.

The good news is that mortgage originations in 2020 could rise by 30% or more from 2019 levels, perhaps reaching more than $2.5 trillion or better in overall production. So long as primary/secondary spreads continue to widen, profitability in the industry could be the best seen in many years. The bad news, however, is that loan prepayments also are likely to reach historic levels, causing pain and some significant losses for investors in whole loans, RMBS and MSRs. But the big news in 2020 is that the commercial banks are back in residential mortgages.

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