Getting ahead of the COVID-19 crisis

Over the past several weeks, the mortgage industry has been shocked by the COVID-19 virus from China and a severe financial meltdown on Wall Street. Spreading impact on the real economy, however, is what really has our leaders worried. I described some of these challenges in a comment for The American Conservative.

A number of proposals have been floated for debt payment holidays and other types of moratoria, but such approaches offer solutions that are worse than the problems. Specifically, a proposal from House Financial Services Committee Chairman Maxine Waters, D-Calif., would allow homeowners to skip payments on mortgages (and everything else), then try to finance the float required to keep payments on $10 trillion in mortgage-backed securities current. HUD and the FHFA have already declared a moratorium on home foreclosures that servicers and note holders must finance.

Obviously, it is far easier to send people a check and keep the money flowing through the system than it is to allow people not to pay their mortgage and then fix the resulting damage. Along with fully funded and extended unemployment insurance, a scheme to say pay Americans each month one-twelfth of the taxable income last year makes a lot more sense and is infinitely easier to implement and manage. In many cases, Treasury could simply send payments electronically.

The basic message is that it is much, much easier to put money into the front of the U.S. payments and financial system via subsidies than trying to manage/implement moratoria in the middle, with banks, nonbanks and everyone else in the mix. The Waters plan of moratoria and subsidies is unworkable. MMT has become inevitable by fact of arithmetic. Whether unemployment insurance or direct payments, if we want to protect the financial system and the mortgage industry, this is how we do it.

Another related challenge is the question of financing. Over the past several weeks, financing for many mortgage banks and REITs has tightened. Many players that were reasonably hedged before the crisis found themselves net-short duration as the 10-year Treasury note came close to a zero percent yield. The bond market then backed up, with the 10-year last seen well-above 1% as investors look to raise cash in a largely dysfunctional funding market. Meanwhile, mortgage rates and yields on mortgage-backed securities have risen due to a lack of liquidity.

The Federal Reserve has provided massive cash to the markets, but has confined these operations to the primary dealers. Much like the Vatican in Rome, the Federal Reserve Board is reluctant to make changes to its long-established channels for monetary policy. First among these rules is the idea that the Fed can effectively execute monetary policy through the few large banks — aka primary dealers — that directly face the Fed as counterparties.

Second, the Fed assumes that changes in policy, once transmitted via the primary dealers, will influence the U.S. economy and particularly housing finance and related sectors such as home building. But the dealer-centric world of the FOMC not only creates liquidity problems for markets but now seems less and less effective in terms of influencing housing. Since housing broadly defined is one of the biggest parts of the U.S. economy, whether the FOMC can use interest rate targets to influence credit availability in housing is kind of a big deal. The fact that yields on MBS have been rising suggests that the Fed needs to change its approach.

In terms of liquidity and financing, the Fed needs to relent and create a standing facility that is open to all banks and dealers operating in the U.S. money markets. Such a proposal has been championed by the St Louis Federal Reserve, which long ago recognized that the Fed's exclusive use of primary dealers to execute policy, added to changes in bank regulation and liquidity rules, was limiting the flow of liquidity to the broader market, including nonbank mortgage firms and provides of other types of consumer finance.

The authors of the St Louis Fed's proposal note that the Fed could make liquidity available to the markets continuously "by operating a standing overnight repurchase (repo) facility that would permit banks to convert Treasurys to reserves on demand at an administered rate." Same goes for MBS. Looking at the gyrations in the markets over the past week, such a facility seems to be long overdue. Indeed, as banks become more taxed by demands for liquidity across the economy, the Fed will need to make additional changes to help support and protect mortgage finance.

"The securitization market is stuck square in the middle," notes Ralph Delguidice of Pavilion Global Markets. "Americans can't make debt payments. Congress says they don't have too. The 'trust' must have cash flows or they are unwound. Servicers (and GSEs) are required to advance dollars. They can't get the liquidity."

On Thursday, the Federal Reserve Bank of New York published guidelines for purchases of mortgage securities, including a range of coupons from 3.5s to 2.5s, with the greatest emphasis on the lower coupons. One way that the Federal Reserve can very directly add liquidity to the domestic scene is to initiate a massive program to purchase low-coupon agency and government MBS directly from issuers, bypassing the to-be-announced market and the large bank dealers, and focusing exclusively on rate refinance transactions at lower rates.

"If the Fed comes in and simply pumps up the price of GNMA 2s to 103, it will put the vast majority of independent mortgage lenders out of business due to margin calls they cannot meet, not to mention massive pipeline fallout," notes retired Countrywide banker Alan Boyce.

"If instead the Fed bids directly for 2% MBS and guarantees a risk-free takeout of 103, then the mortgage bankers can originate loans with 3% or lower coupons without worrying about market volatility," he argues. "And the Fed can state ahead of prepayments on its own mortgage portfolio. Mortgage bankers will have a chance to help the economy and make money at the same time. The Fed will add big liquidity to households and banks. Win-win."