The chaos wrought by the FOMC keeps unfolding

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As we look forward to the start of Q2 2023 earnings, financials of all descriptions  are facing rising levels of liquidity risk. Banks are fighting to keep deposits on the books, while independent mortgage banks (IMBs) worry about low volumes and access to wholesale warehouse credit. But these short-term considerations may be missing the big picture staring us all in the face.

Over the past several decades, increasing volatility in interest rates caused by the manic policy swings of the Federal Open Market Committee, caused a structural change in the mortgage market. Refinance opportunities became more frequent and larger in terms of volumes, allowing the industry to carry more overhead per dollar of volume. Veteran mortgage executive Bill Dallas provided some insight into that question in an interview by Maria Volkova in National Mortgage News: 

"What's interesting is almost none [of my clients] have a lot of perspective about the mortgage business. A lot of them have never been in an environment that is predominantly purchase. I was raised in that environment. I spent my first 20 years in an environment where we didn't have refinances really. Everything was a purchase. I think they're struggling with that. And then the second shoe that hit them all is margin compression, and product compression, which they weren't expecting. Almost everybody's business model that I saw underestimated the amount of compression on the gross revenue side of their business."

Remember the glib characters who were talking about an end to Fed rate hikes and 5% mortgage loans earlier this year? Now, with home prices again rising and the U.S. consumer essentially ignoring the FOMC, the question comes as to how much higher do interest rates need to go in order to cool off the housing sector? Moreover, there is a growing sense among economists that low single-digit interest rates maintained by the Fed during 2020-2021 may have caused more damage than benefit. 

For mortgage lenders, the prospect of interest rates staying at or above current levels suggests a return to a business model that is predominantly focused on purchase mortgages. Since the cost of closing a purchase loan is three to four times the cost of a refinance loan, the expense structure of the industry must change to accommodate. For many lenders accustomed to reaping profits from refinance transactions, a return to purchase lending likely means the end of the road.

Adding to the already substantial challenge facing lenders in the shift to a purchase loan market is the continuing distortion of the money markets caused by the Fed. Because the FOMC so far refuses to sell its $3 trillion portfolio of mortgage-backed securities, the shape of the yield curve is inverted, with the yields for securities around 10-12 years in maturity far lower than short-term rates. The $3 trillion in MBS owned by the Fed is a dead weight holding down long-term bond yields.

What this means in layman's terms is that lenders are losing money on loan sales into the secondary market. Since the price for Fannie Mae 6s in July is above current prices, lenders are losing money on every loan they carry from close to secondary market sale – the opposite of a normal market. This inverted or "contango" market is usually seen in physical commodities when prices rise suddenly, but by "going big" in 2020, the Fed has managed to disrupt the term structure of interest rates to an alarming degree.

When lenders do actually sell the mortgage loan into the secondary markets, the execution is likely to be less than a point premium.  Indeed, many lenders are forced to sell the servicing with the loan in order to enhance the overall sale proceeds. Given the toppy valuations for mortgage servicing rights, selling is not the worst thing in the world, but the list of IMBs monetizing MSRs is growing as operating cash flows fall. 

For example, United Wholesale Mortgage completed two bulk MSR sales as well as two excess servicing strip sales in the first quarter of 2023, based on servicing assets with a total UPB of approximately $98 billion. Net cash proceeds approximated $650 million from MSR and excess sales in Q1 2023 or 66 bp on the total UPB.  

UWMC reported an operating loss of $138 million in Q1 2023 and a negative mark on the firm's MSR over $330 million – due to falling interest rates!  The machinations of the FOMC have actually increased market volatility so much that firms like UWMC are taking negative marks on MSRs when interest rates are supposed to be rising. What's wrong with this picture?

The mortgage industry faces several threats. In the near term, rising rates are hurting volumes and pricing refinance transactions out of existence. Secondary market execution is poor and likely to get worse, especially as lenders see carry on closed loans forced deeper into the red. How much money will mortgage firms lose before they simply shut their doors?

"The Federal Reserve's Dot Plots indicate that up to two more hikes could be on the table for 2023," writes Erica Adelberg of Bloomberg. "If this occurs, mortgage carry could be even further challenged relative to funds, which could push forward mortgage prices even higher relative to current months." 

But perhaps the bigger existential question is whether the post-COVID world will be one with less interest rate volatility from the FOMC and an effective floor under interest rates that is well above the past decade. How will the industry look a year from now if mortgage rates stay at or above 7% for an extended period of time?  Will the growth in market share of IMBs be reversed over the next decade as they slowly sell servicing assets to survive?  

With interest rates rising slowly and inflation measured by home prices remaining stubbornly elevated, the world of mortgage lending in 2024 and beyond may look more like several decades ago than the past five years. If the FOMC takes the proper lesson from the errors of the COVID period, then the future movement of interest rates is likely to be muted. 

As opportunities for refinancing existing residential loans shrinks relative to the overall business of mortgage lending, the structure of the industry and the flow of mortgages into the capital markets will change. Expenses per loan will rise, headcount in the industry will fall and prepayments on existing loans will fall dramatically. And once again, the mortgage finance industry will be forced to remake itself to fit this new reality.