Rising Rates and The Mortgage Market

The Urban Institute’s Housing Finance at a Glance Chartbook for March focuses on how rising interest rates have been impacting the mortgage market. The chartbook makes a series of excellent points about current trends, although homeowners and homebuyers should keep in mind that rates remain near historic lows:

As mortgage rates have increased, there has been no shortage of articles explaining the effect of rising rates on the mortgage market. Mortgage rates began their present sustained increase immediately after the last presidential election in November 2016, 20 months ago. Enough data points have become available during thisperiod that we can now measure the effects of rising rates. Below we outline a few.

Refinances: The most immediate impact of rising rates is on refinance volumes, which fall as rates rise. For mortgages backed by Fannie Mae and Freddie Mac, the refinance share of total originations declined from 63 percent in Nov 2016 to 46 percent today (page 11). For FHA, VA and USDA-insured mortgages, the refinance share dropped from 44 percent to 35 percent. In terms of volume, Fannie Mae and Freddie Mac backed refinance volume totaled $390 billion in 2017, down from $550 billion in 2016. For Ginnie Mae, refi volume dropped from $197 billion in 2016 to $136 billion in 2017. Looking ahead, most estimates for 2018 point to a continued reduction in the refi share and origination volumes (page 15).

Originator profitability: Of course, less demand for mortgages isn’t good for originator profitability because lenders need to compete harder to attract borrowers. They do this often by reducing profit margins as rates rise (conversely, when rates are falling and everyone is rushing to refinance, lenders tend to respond by increasing their profit margins). Indeed, since Nov 2016, originator profitability has declined from $2.6 per $100 of loans originated to $1.93 today (page 16). Post crisis originator profitability reached as high as $5 per $100 loan in late 2012, when rates were at their lowest point.

Cash-out share: Another consequence of falling refinance volumes is the rising share of cash-out refinances. The share of cash-out refinances varies partly because borrowers’ motivations change with interest rates. When rates are low, the primary goal of refinancing is to reduce the monthly payment. Cash-out share tends to be low during such periods. But when rates are high, borrowers have no incentive to refinance for rate reasons. Those who still refinance tend to be driven more by their desire to cash-out (although this doesn’t mean that the volume is also high). As such, cash-out share of refinances increased to 63 percent in Q4 2017 according to Freddie Mac Quarterly Refinance Statistics. The last time cash-out share was this high was in 2008.

Industry consolidation: A longer-term impact of rising rates is industry consolidation: not every lender can afford to cut profitability. Larger, diversified originators are more able to accept lower margins because they can make up for it through other lines of business or simply accept lower profitability for some time. Smaller lenders may not have such flexibility and may find it necessary to merge with another entity. Industry consolidation due to higher rates is not easy to quantify as firms can merge or get acquired for various reasons. At the same time, one can’t ignore New Residential Investment’s recent acquisition of Shellpoint Partners and Ocwen’s purchase of PHH. (5)

Bringing Housing Finance Reform over the Finish Line

photo by LarryWeisenberg

Mike Milkin at Milkin Institute Global Conference

The Milkin Institute have released Bringing Housing Finance Reform over the Finish Line. It opens,

The housing finance reform debate has once again gained momentum with the goal of those involved to move forward with bipartisan legislation in 2018 that results in a safe, sound, and enduring housing finance system.

While there is no shortage of content on the topic, two different conceptual approaches to reforming the secondary mortgage market structure are motivating legislative discussions. The first is a model in which multiple guarantor firms purchase mortgages from originators and aggregators and then bundle them into mortgage-backed securities (MBS) backed by a secondary federal guarantee that pays out only after private capital arranged by each guarantor takes considerable losses (the multiple-guarantor model). This approach incorporates several elements from the 2014 Johnson-Crapo Bill and a subsequent plan developed by the Mortgage Bankers Association. Fannie Mae and Freddie Mac—the government-sponsored enterprises (GSEs)—would continue as guarantors, but would face new competition and would no longer enjoy a government guarantee of their corporate debt or other government privileges and protections.

The second housing finance reform plan is based on a multiple-issuer, insurance-based model originally proposed by Ed DeMarco and Michael Bright at the Milken Institute, and builds on the existing Ginnie Mae system (the DeMarco/Bright model). In this model, Ginnie Mae would provide a full faith and credit wrap on MBS issued by approved issuers and backed by loan pools that are credit-enhanced either by (i) a government program such as the Federal Housing Administration (FHA) or U.S. Department of Veterans Affairs (VA), or (ii) Federal Housing Finance Agency (FHFA)- approved private credit enhancers that arrange for the required amounts of private capital to take on housing credit risk ahead of the government guarantee. Fannie Mae and Freddie Mac would be passed through receivership and reconstituted as credit enhancement entities mutually owned by their seller/servicers.

While the multiple guarantor and DeMarco/Bright models differ in many ways, they share important common features; both address key elements of housing finance reform that any effective legislation must embrace. In the remainder of this paper, we first identify these key reform elements. We then assess some common features of the two models that satisfy or advance these elements. The final section delves more deeply into the operational challenges of translating into legislative language specific reform elements that are shared by or unique to one of the two models. Getting housing finance reform right requires staying true to high-level critical reform elements while ensuring that technical legislative requirements make economic and operational sense.  (2-3, footnotes omitted)

The report does a good job of outlining areas of broad (not universal, just broad) agreement on housing finance reform, including

  • The private sector must be the primary source of mortgage credit and bear the primary burden for credit losses.
  • There must be an explicit federal backstop after private capital.
  • Credit must remain available in times of market stress.
  • Private firms benefiting from access to a government backstop must be subject to strong oversight. (4-5)

We are still far from having a legislative fix to the housing finance system, but it is helpful to have reports like this to focus us on where there is broad agreement so that legislators can tackle the areas where the differences remain.

Expanding the Credit Box

Tracy Rosen

DBRS has posted U.S. Residential Mortgage Servicing Mid-Year Review and 2015 Outlook. There is a lot of interest in it, including a table that demonstrates how “the underwriting box for prime mortgages slowly keeps getting wider.” (7) The report notes that

While most lenders continue to originate only QM [Qualified Mortgage] loans some have expanded their criteria to include Non-QM loans. The firms that are originating Non-QM loans typically ensure that they are designated as Ability-to-Repay (ATR) compliant and adhere to the standards set forth in the Consumer Financial Protection Bureau’s (CFPB) Reg Z, Section 1026.43(c). Additionally, most Non-QM lenders are targeting borrowers with high FICO scores (typically 700 and above), low loan to values (generally below 80%) and a substantial amount of liquid reserves (usually two to three years). Furthermore, most require that the borrower have no late mortgage payments in the last 24 months and no prior bankruptcy, foreclosure, deed-in-lieu or short sale. DBRS believes that for the remainder of 2015 the industry will continue to see only a few Non-QM loan originators with very conservative programs.

CFPB ATR And QM Rules

The ATR and QM rules (collectively, the Rules) issued by the CFPB require lenders to demonstrate they have made a reasonable and good faith determination, based on verified and documented information, that a borrower has a reasonable ability to repay his or her loan according to its terms. The Rules also give loans that follow the criteria a safe harbor from legal action. (8)

DBRS believes

that the issuance of the ATR and QM rules removed much of the ambiguity that caused many originators to sit on the sidelines for the last few years by setting underwriting standards that ensure lenders only make loans to borrowers who have the ability to repay them. In 2015, most of the loans that were originated were QM Safe Harbor. DBRS recognizes that the ATR and QM rules are still relatively new, having only been in effect for a little over a year, and believes that over time, QM Rebuttable Presumption and Non-QM loan originations will likely increase as court precedents are set and greater certainty around liabilities and damages is established. In the meantime, DBRS expects that most lenders who are still recovering from the massive fines they had to pay for making subprime loans will not be originating anything but QM loans in 2015 unless it is in an effort to accommodate a customer with significant liquid assets. As a result, DBRS expects the availability of credit to continue to be constrained in 2015 for borrowers with blemished credit and a limited amount of cash reserves. (8)

The DBRS analysis is reasonable, but I am not so sure that lenders are withholding credit because they “are still recovering from the massive fines they had to pay for making subprime loans . . ..” There may be a sense of caution that arises from new CFPB enforcement. But if there is money to be made, past missteps are unlikely to keep lenders from trying to make it.

Treasury Gives RMBS a Workout

The Treasury has undertaken a Credit Rating Agency Exercise. According to Michael Stegman, Treasury

recognized that the PLS market has been dormant since the financial crisis partly because of a “chicken-and-egg” phenomenon between rating agencies and originator-aggregators. Rating agencies will not rate mortgage pools without loan-level data, yet originator-aggregators will not originate pools of mortgage bonds without an idea of what it would take for the bond to receive a AAA rating.

Using our convening authority, Treasury invited six credit rating agencies to participate in an exercise over the last several months intended to provide market participants with greater transparency into their credit rating methodologies for residential mortgage loans.

By increasing clarity around loss expectations and required subordination levels for more diverse pools of collateral, the credit rating agencies can stimulate a constructive market dialogue around post-crisis underwriting and securitization practices and foster greater confidence in the credit rating process for private label mortgage-backed securities (MBS). The information obtained through this exercise may also give mortgage originators and aggregators greater insight into the potential economics of financing mortgage loans in the private label channel and the consequent implications for borrowing costs.

While this exercise is very technical, it contains some interesting nuggets for a broad range of readers. For instance,

The housing market, regulatory environment, and loan performance have evolved significantly from pre-crisis to present day. Credit rating agency models appear to account for these changes in varying ways. All credit rating agency models incorporate the performance of loans originated prior to, during, and after the crisis to the degree they believe best informs the nature of credit and prepayment risk reflected in the market. Credit rating agency model stress scenarios may be influenced by loans originated at the peak of the housing market, given the macroeconomic stress and home price declines they experienced. The credit rating agencies differ, however, in how their models adjust for the post-crisis regime of improved underwriting practices and operational controls. Some credit rating agencies capture these changes directly in their models, while other credit rating agencies rely on qualitative adjustments outside of their models. (10)

It is important for non-specialists to realize how much subjectivity can be built into rating agency models. Every model will make inferences based on past performance. The exercise highlights how different rating agencies address post-crisis loan performance in significantly different ways. Time will tell which ones got it right.

Housing Finance at A Glance

The Urban Institute’s Housing Finance Policy Center really does give a a nice overview of the American housing finance system in its monthly chartbook, Housing Finance at A Glance. I list below a few of the charts that I found particularly informative, but I recommend that you take a look at the whole chartbook if you want to get a good sense of what it has to offer:

  • First Lien Origination Volume and Share (reflecting market share of Bank portfolio; PLS securitization; FHA/VA securitization; an GSE securitization)
  • Mortgage Origination Product Type (by Fixed-rate 30-year mortgage; Fixed-rate 15-year mortgage; Adjustable-rate mortgage; Other)
  • Securitization Volume and Composition (by Agency and Non-Agency Share of Residential MBS Issuance)
  • National Housing Affordability Over Time
  • Mortgage Insurance Activity (by VA, FHA, Total private primary MI)

As with the blind men and the elephant, It is hard for individuals to get their  hands around the entirety of the housing finance system. This chartbook makes you feel like you got a glimpse of it though, at least a fleeting one.

FHFA Wins on “Actual Knowledge”

Judge Cote issued an Opinion and Order in Federal Housing Finance Agency v. HSBC North America Holdings Inc., et al. (11-cv-06189 July 25, 2014). The opinion and order granted the FHFA’s motion for partial summary judgment concerning whether Fannie and Freddie knew of the falsity of various representations contained in offering documents for residential mortgage-backed securities (RMBS) issued by the remaining defendants in the case.

I found there to be three notable aspects of this lengthy opinion. First, it provides a detailed exposition of the process by which Fannie and Freddie purchased mortgages from the defendants (who included most of the major Wall Street firms, although many of them have settled out of the case by now). it goes into great length about how loans were underwritten and how originators and aggregators reviewed them as they were evaluated  as potential collateral for RMBS issuances.

Second, it goes into great detail about the discovery battle in a high, high-stakes dispute with very well funded parties. While not of primary interest to readers of this blog, it is amazing to see just how much of a slog discovery can be in a complex matter like this.

Finally, it demonstrates the importance of litigating with common sense in mind. Judge Cote was clearly put off by the inconsistent arguments of the defendants. She writes, with clear frustration,

It bears emphasis that at this late stage — long after the close of fact discovery and as the parties prepare their Pretrial Orders for three of these four cases — Defendants continue to argue both that their representations were true and that underwriting defects, inflated appraisals and borrower fraud were so endemic as to render their representations obviously false to the GSEs. Using the example just given, Goldman Sachs argues both that Fannie Mae knew that the percentage of loans with an LTV ratio below 80% was not 67%, but also that the true figure was, in fact, 67%. (65)

S&P on Risky Reps and Warranties

Standard & Poor’s posted New Players In The RMBS Market Could Present Unique Representations And Warranties Risks. It opens, S&P

believes that new entrants into the residential mortgage-backed securitization (RMBS) market that make loan-level representations and warranties (R&Ws) may present additional risks not present with more established market players. Many of these new entrants not only lack historical loan performance data, but have not yet established track records for remedying any R&W breaches. This can call into question their ability or willingness to repurchase under R&W provisions. In light of this, mitigating factors may exist that could alleviate the risk of a potential R&W breach. (1)

This all sounds pretty serious, but I am not so sure that it is.

S&P explains its concerns further:

We believe it is important for investors and other market participants to evaluate the quality and depth of various factors that mitigate the risk of R&W breaches occurring in U.S. RMBS transactions, including those that would be remedied by new entities with limited histories and the risk that comes with their willingness or ability to do so. Specifically, we believe the quality and scale of third-party due diligence, the depth of operational reviews, and a transaction’s overall expected losses, are critical for assessing the risk of a breach and if a new entity would be remedying it. We consider all of these aspects in our assessment of the credit characteristics of loans that are securitized in U.S. RMBS deals. (1)

One assumes that every party to every transaction would consider the counterparty risk — the risk that the other side of a deal won’t or can’t make good on its obligations. Regular readers of this blog also know that many well-known companies have attempted to avoid their responsibilities pursuant to reps and warranties clauses. So, when S&P states that “the quality and scale of third-party due diligence, the depth of operational reviews, and a transaction’s overall expected losses, are critical for assessing the risk of a breach and if a new entity would be remedying it,” one wonders why this is more true for new players than it is for existing ones.

Further undercutting itself, this report notes that “post-2008 issuers have been addressing many of these potential R&W risks, including newer players. The level of third-party due diligence in recently issued U.S. RMBS for example has been more comprehensive from a historical (pre-2008) perspective in terms of the number of loans reviewed and the scope of the reviews.” (1)

So I am left wondering what S&P is trying to achieve with this report. Are they really worried about new entrants to the market? Are they signalling that they will take a tough stance on lowering due diligence standards as the market heats up? Are they favoring the big players in the market over the upstarts? I don’t think that this analysis stands up on its own legs, so I am guessing that there is something else going on.  If anyone has a inkling as to what it is, please share it with the rest of us.