There are better times ahead for mortgage finance
The mortgage industry's cycles of market and credit risk are a merry-go-round. The business tends to face the same risks over and over again, but these risks frequently come in different order than before. Liquidity, credit, operations and compliance are all key risks today which mortgage lenders must manage daily. But which risk factor comes next?
In this latest cycle, which started in 2012 when the recovery in the mortgage sector really began in earnest, we faced enhanced risks from regulators and also the federal government as evidenced by the remarkable volatility we've seen in mortgage rates. The sharp decline in the yield on long-dated Treasury securities creates a great deal of uncertainty about the economic outlook. The good news is that it seems likely that lower interest rates are here to stay and, hopefully, with less volatility.
Forecasts for mortgage origination rates were revised upwards due to the decline in interest rates. Indeed, unlike past credit cycles, market volatility has not led to an uptick in credit concerns, and loan default rates continue to fall. Delinquency rates are at the lowest level in 10 years, contributing significantly to the profitability of loan servicing operations.
After several tough years for the industry, it sees the possibility of strong servicing results being married to improved lending margins. Strong refinance activity looks to complement the already strong purchase mortgage business for new homebuyers. While over the past three years many lenders have been managing their business in the expectation of a rising rate environment, now some get to capitalize on past investments in a world of extremely low mortgage rates.
Of course, the benevolent conditions that now face mortgage lenders and servicers will not always be with the industry. The Federal Housing Administration recently made some changes in the program for loan refinancing that are intended to protect the taxpayer and also keep mortgage prepayment rates from rising too sharply. Both FHA and the Veterans Administration recently announced restrictions on cash-out refinances. These changes are positive for the industry.
Fortunately, the current interest rate environment better supports term refinancing and purchase loans than cash-out products. The mix of cash-out versus rate and term product is likely to change considerably over the course of 2019, but overall loan prepayment rates are driven by movements in the Treasury market and may be difficult to control.
Lowering monthly payments for homeowners is a pretty good thing. We try to avoid rolling costs into a loan, so that the refinance immediately benefits the borrower. The objective is for the payment to go down, but the loan size should not go up. This makes the borrower a better-quality counterparty to the FHA or the GSEs, which lowers risk to the taxpayer.
The FHA and Ginnie Mae have just put out some new guidelines for the industry in terms of new program requirements, capital and liquidity, servicer and credit ratings and even stress testing. All of these are good things for the industry as a whole. Those organizations that have the capital and liquidity to comply with the new standards can take advantage of low interest rates and serve the goal of homeownership.
While some organizations may find the new Ginnie Mae requirements a challenge, we see the changes as a positive development. By trying to control prepayment speeds, Ginnie Mae is actually helping independent mortgage banks whose primary asset, after all, is mortgage servicing rights.
Those who accuse mortgage servicers of deliberately "churning" a loan portfolio do not seem to appreciate that we are not just lenders, but owners of large servicing portfolios. Since both Ginnie Mae and the GSEs value liquidity in their respective markets, looking out for MSR investors is just as important as meeting the needs of our bond investors. Indeed, while Ginnie Mae is rightly focused on counterparty risk, the big challenge for both the government agency and the taxpayer is fostering a healthy, liquid market for MSRs that can absorb default events without skipping a beat.
We all may not agree with every new policy that comes from the government, but the fact that FHA, Ginnie Mae and the GSEs are trying to protect and expand the mortgage market is very important. Housing is enormously important to the U.S. economy and we need to focus on ways to get mortgage finance to start growing again, after a decade of near-zero growth in total mortgage finance available to the residential sector.
There are a couple of interesting things happening in the servicing market. The industry view is that the value of MSRs is free falling along with Treasury bond yields. Volumes clearly have fallen off in MSR sales over the summer due to concerns about prepayments. Some firms are having trouble extracting value from servicing assets in the current environment. The components that drive the value here are not well understood but may be very rewarding to patient owners with the right skills to capitalize on market conditions.
The market appears to value MSRs generally today at around a three and four multiple based on annual cash flow. The ability to recapture prepayments is part of the analysis, as is the mix between conventional and government servicing assets. Many analysts would tell you that the Fannie Mae and Freddie Mac MSRs are more valuable, but in fact the Ginnie Mae MSRs are often worth more over time due to the powerful impact of the larger escrow balances.
Ginnie Mae issuers make payments both for borrowers and bond holders. Thus the inherent, cash value of the Ginnie loans is more than the inherent value of the conventional loans, which trade at far lower yields. This is one reason why Freedom's been a big supporter of the Ginnie Mae market for many years.
If there is a chance of a recession in 2020, housing will be a big part of helping the nation avoid or moderate any slowdown. Lower interest rates will certainly help to drive lending volumes this year and next, but there also must be a focus on ways to grow the overall market for housing by encouraging new home building and related development activities. The key question for the industry: How do we get mortgage finance to grow again?
There are reasonable changes that can be made in existing regulations that could encourage more risk taking in housing and especially the construction of more affordable homes to meet the rapidly growing demand. But the good news is that the next couple of years should be better for the industry in terms of profits, and less volatile in terms of interest rates, helping lenders better serve both consumers and investors.