Wider spreads can help originators offset negative MSR marks

Mortgage lenders could benefit from the surge in refinancing due to widening market spreads, and that could help offset damage to servicing rights portfolio valuations, according to Keefe, Bruyette & Woods.

Rates for mortgage loans have fallen in recent days, but not as fast as the 10-year Treasury has fallen. In the overnight hours of March 9, driven by the coronavirus and its effects on the global economy, the 10-year yield fell as low as 0.38%; by 11:53 a.m., it was at 0.59%, still down 17 basis points from its previous close.

"We believe the spike in mortgage refi applications has meaningfully increased pricing power for originators, especially those with more meaningful scale and efficient technology," wrote KBW Analyst Bose George. "That's manifested in wider primary-secondary mortgage spreads, which should lead to exceptionally strong gain-on-sale margins over the coming months."

He pointed out that the spread of primary mortgage rates over the Fannie Mae current coupon have widened to 140 basis points, up 30 bps in two weeks, and are wider by 45 bps versus the 10-year average.

But the trade-off from increased refi volume is the hit to mortgage servicing rights portfolio valuations because of mark-to-market accounting rules.

"However, many lenders typically hedge this risk, and the economic benefits are positive over time for lenders with meaningful mortgage origination capacity," George said.

Penny Mac Financial Services is best positioned to benefit among the publicly traded mortgage companies it follows, KBW said. Flagstar Bancorp also should benefit.

Meanwhile, Mr. Cooper and New Residential "now also have meaningful mortgage origination capacity that can help offset negative MSR marks. New Residential also hedges, but Mr. Cooper does not," George said.

Last week's Freddie Mac mortgage rate survey put the 30-year fixed at 3.29%, which at the time was 250 bps above the 10-year Treasury yield. That is much wider than the average spread of 170 bps over the prior decade.

"We estimate at current mortgage rates, roughly 58% of the GSE 30-year fixed-rate universe carries a rate incentive of at least 50 bps," George said. "At mortgage rates of 2.75%, almost 75% will carry an incentive. While we don't expect all of those loans to turn over, we think lower mortgage rates will likely pull in cohorts of borrowers whose incentive has never been this strong."

Meanwhile, REITs having concentration in specified pools of mortgage-backed securities has generated stronger results than likely given the rapid decline in rates.

"However, prospectively, we think this reinforces some caution around the amount of purchase price premium that's being absorbed into new investments given such high MBS prices. Specified pool premiums over (to-be-announced MBS pools) hit their highest level in years last summer when rates declined, but have now step-changed another leg higher, as investors search for protection against faster prepays. Faster prepays will likely pressure the economic returns of the agency REITs, since their bond premium continues to absorb a high share of their equity," George said.

Fannie Mae prepayment speeds on 30-year FRMs in February were up 12% compared with January, while Freddie Mac's were up 15%. However, Ginnie Mae prepayment speeds were unchanged month-to-month, according to KBW.

A separate report from KBRA said there are likely "indirect coronavirus effects" on RMBS.

"Negative effects on consumer confidence could lead to dampened consumer spending and, in turn, a decrease in home prices," the report said. "In addition, certain geographic areas which are highly dependent on tourism may see prolonged declines in demand, due to restricted travel which may depress local economies. Foreign investment into the U.S. may be affected — potentially resulting in volatility in home values in more affluent areas of the country, where such investors drive value in upper-end housing."

But another hit from COVID-19 could be to borrowers' income from an extended illness and related medical bills, KBRA said.

"Medical bills can be a financial burden for many Americans, resulting in pressure on homeowners' ability to cover mortgage payments if personally affected by the virus or covering costs for family members," KBRA explained. "The risks are highest in transactions that have heightened exposure to borrowers with low-to-moderate income where such increased medical costs would be most impactful."

As a result, mortgage servicers are likely to get an increase in hardship applications, leading to elevated levels of loan modifications, payment extensions or grants of longer grace periods. Those will negatively affect RMBS performance, KBRA said.