Blog Category: Chrisman's Corner

One of the topics that was on the minds of the participants in last week’s MBA’s Secondary Marketing Conference was non-QM lending. More specifically, what is going on with it? The lending industry has been dealing with the “QM versus non-QM” discussion and decision for quite some time, and non-QM lending has not gained industry-wide acceptance. Qualified Mortgages have become part of the vernacular, and every day companies are weighing the risks of offering the product through retail, wholesale, and correspondent channels. QM, of course, refers to the federal Qualified Mortgage rules that are designed to foster “safe” lending. They ban certain loan features such as negative amortization and interest-only payments; set a 43% ceiling for debt-to-income ratios; and impose a 3% limit on total loan fees, among other requirements.

Of course, doing a QM loan does not shield Optimal Blue’s clients, or any lender, from a lawsuit in the future. It is important to remember, however, that non-QM loans do not equate to subprime loans. Lenders jumping into the non-QM space emphasize that they have no interest in funding subprime applicants who lack the ability to repay their mortgages. Many lenders, for example, offer products that allow debt ratios of 50% and depart from other QM standards for applicants who have strong compensating factors such as substantial down payment and reserves.

As OB’s clients know, several companies are known as the place to go for non-QM: Citadel Servicing, Angel Oak, Luther Burbank, BofI, and a handful of others, to name a few. Some call them “Alternative QM” mortgages for several categories of creditworthy borrowers with special needs. They are targeting near-miss borrowers who almost qualify under standard rules, but not quite. Say they have solid credit scores and good jobs, but have a debt-to-income ratio of 49%. They’re likely to have difficulty making it through Fannie Mae’s or Freddie Mac’s underwriting systems, but worthy of being given credit after taking a hard look at their bank reserves and assets.

Lenders are also addressing self-employed borrowers who have been left behind by QM rules and large lender underwriting guidelines. Business owners, for example, generally can’t show IRS W-2 forms and may have irregular income flows, complex tax situations and periodically high debt levels. Some residential lenders allow them to document their income using 12 months of recent bank statements and to have debt-to-income ratios as high as 50%. Also included in the product lineups are programs helping investors with multiple properties. They face significant hurdles when they apply for mortgages. Investors who own 10 or more rental homes or commercial properties and seek to refinance and pull money out are frequently turned down by conventional lenders. So some lenders evaluate borrowers’ incomes based on the properties’ cash flows and has no limit on total properties owned.

There is still concern about future liabilities, investor options if a closed loan isn’t purchased, reputational risk for offering non-QM product, and the sales job that LOs must give borrowers for the higher rate. Although this may change, non-QM lenders are looking for borrowers with high FICO scores and ample money to put down on the home, earning a low loan-to-value ratio. Ability to Repay, or ATR, is critical, and non-QM loans can be a good credit risk if the borrower demonstrates an ability to repay.

Investors are showing interest in the product. The government, indirectly, wants the industry to increase “private lending” and therefore do non-QM although the agencies have a waiver until they come out of conservatorship to go above the DTI limit. Despite their issuing a tough QM rule, financial regulators really want lenders to do more non-QM to decrease Freddie’s and Fannie’s share of the total mortgage market.

The Fed’s release of the minutes from its meeting last month spooked interest rates. Namely, OB’s clients and others saw them shoot higher as the writing indicated that some members of the Fed believe that the U.S. economy is doing just fine, despite what is occurring in other countries, and that a rate hike in June is certainly on the table.

The sentence that sent bonds reeling was that, “Some members expressed concern that the likelihood implied by market pricing that the Committee would increase the target range for the federal funds rate at the June meeting might be unduly low.” When traders and analysts hit that sentence the FOMC minutes caused a 7 basis point spike in the 10 year and a 6 basis point spike in the 2 year. The Fed Funds futures contracts (which is what the “likelihood implied by market pricing” phrase alludes to) moved from a 10% chance of a June hike to a 25% chance of a June hike and a 60% chance of a hike by September.

Optimal Blue’s clients know that the Fed doesn’t set mortgage rates. But it does influence bond markets. Earlier this year, the futures were basically betting the Fed would be on hold for the rest of the year. The markets were perhaps a little too complacent about another rate hike. That said, the Fed has set up the markets for rate hikes several times over the past year or two only to get cold feet.

In terms of the economy, the members and the staff noted that the labor market continues to improve despite a deceleration in economic growth. Inflation remains well below the Fed’s target, however they attribute that to commodity price movements, which are transitory. The minutes also mentioned that residential mortgage credit was getting a little looser on the government side, but also noted that non-traditional and credit-challenged borrowers still face tight credit conditions. The corporate bond market has improved after a slow January and February.

In this era when every word uttered by the Fed, either by a Governor during a speech or in the minutes of a meeting, are sliced and diced and analyzed, brings up the topic of communication. It is critical that central bankers have the ability to communicate their monetary policy goals and intentions involving employment and price stability to the public effectively and without a knee-jerk reaction like we saw yesterday. The task is complicated in an economy that includes many firms and households in an era of information overload.

The central bank’s primary policy instrument—the short-term interest rate—is near zero, a situation many advanced economies face today. The private sector relies on its perception of central bank economic expectations when it considers changes to its production of goods and services or the prices it charges for them. And central bank short-term policy rate changes (in both low-rate and more normal-rate environments) fulfill an informational role by transferring assessments about risks to the economic outlook.

The Fed runs the risk that readers & listeners may misinterpret the statements, leading to
an unintentional and counterproductive response, especially if the reader or listener has a short attention span! Central banks, with the explosion of new media outlets, have more opportunities
than ever to provide information. Thus, for a central bank to remain relevant, it must carefully ponder what to say.

This week’s minutes, and the reaction, impacted Optimal Blue and its clients. The increased volatility raises hedging costs and nervousness in the residential lending industry. Neither are good things.

Last week we talked about inflation. Or more precisely, the lack of inflation in the economy, and the Federal Reserve Open Market Committee’s thoughts on it. A small amount of inflation is generally thought to indicate a healthy economy, but it is truly a balancing act.

The FOMC’s meetings were in late January, mid-March, April 26-27, and are slated for June 14-15, July 26-27, Sept. 20-21, Nov. 1-2, and Dec. 13-14. Fed Chairwoman Janet Yellen will hold her quarterly news conferences after the March, June, September and December meetings, the Fed said. Why is this important? The bond markets tend to think that the Fed knows more about the economy than it does, and therefore takes its cue from the Fed’s actions.

I bring this up because a group of economists is now suggesting that rates in the United States will drop more. In fact, Citigroup is in the press saying that Treasury benchmark yields may fall to toward record-low levels on slowing U.S. economic growth and demand from overseas investors. The 10-year note yield may sink to 1.5 percent, U.S. rates strategist Jabaz Mathai wrote in a May 6 note to clients. That was after data last week showed the U.S. added fewer jobs than forecast in April, challenging the Federal Reserve’s quest to raise interest rates.

We’ve also written about negative interest rates in several countries. Debt holders actually pay the governments to hold their money! The United States has higher yields than most other developed countries, and this serves to boost the appeal of U.S. debt. This is especially interesting since the U.S. is viewed as the safest of places for investment, so one would think that would drive up prices and drive down rates.

But as we noted last week, there is little in the way of inflation at the moment, and thus there is more room for the Fed to stay on the sidelines,” Mathai wrote. “The longer end of the curve arguably has more room to move. We are partial to the view that a test of 1.5 percent is highly likely.” So once again the Fed is in a pickle, thinking that higher rates are in the cards but being subject to what happens overseas.

There was no expectation leading up the Fed’s meeting in late April that it would shift short term rates higher. And now, given the problems with various economies overseas, the odds of a rate increase in June are only about 4 percent. However, the “smartest guys in the room” are still giving a 44 percent chance for a rate hike by year-end, according to data based on fed fund futures compiled by Bloomberg.

Others, however, don’t see that happening. They think that anti-inflationary issues in the oil market, limited growth availability around the world, and a slow but steady economy here in the United States as having a dampening impact on rates. Economists at Goldman Sachs Group Inc. and Bank of America last week pushed back expectations for the next rate boost to September from June.

Most of Optimal Blue’s clients, and other lenders, for their part, are relatively happy about mortgage rates where they are. The smart ones realize that the focus is on servicing their clients, whether they be builders, real estate agents, or borrowers, rather than trying to guess where rates are going, or even hoping for lower rates. They know that lower rates may very well be caused by a slowing economy, and that is not what is needed.

Optimal Blue clients who have been around a while certainly remember when inflation was a concern. But folks who have been around only 5-10 years may not even give it a second thought. So it is probably a good time for a primer on inflation, measuring it, and how OB’s clients might be impacted.

When we think about inflationary measurements, the majority of us no doubt think about the Consumer Price Index (CPI) as the standard measurement of where prices are trending. According to the Fed, the CPI is a statistical estimate of the change in prices of goods and services which are consumed by… well, by consumers. More specifically, it is a measurement of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

The CPI reflects spending patterns for each of two population groups: all urban consumers and urban wage earners and clerical workers. The “all urban consumer” group represents about 87% of the total U.S. population. CPI is based on the expenditures of almost all residents of urban or metropolitan areas, including professionals, the self-employed, the poor, the unemployed, and retired people, as well as urban wage earners and clerical workers. Not included in the CPI are the spending patterns of people living in rural nonmetropolitan areas, farm families, people in the Armed Forces, and those in institutions, such as prisons and mental hospitals.

But don’t forget the PCE, or Personal Consumption Expenditure, figure. It is currently the preferred method for inflationary measurement at the Federal Reserve. At its core the PCE is the component statistic for consumption in GDP. The PCE consists of the actual and imputed expenditures of households and includes data pertaining to durable and non-durable goods and services. It is essentially a measure of goods and services targeted towards individuals and consumed by individuals.

Although the CPI and the PCE are similar, currently when the Fed reviews economic conditions to decide what actions it will take to influence inflation and employment, it sets aside the an almost 100-year CPI tradition in favor of the PCE. Why? Mainly because the PCE includes a broader range of expenditures than CPI. It’s weighted according to data provided in business surveys, rather than the less reliable consumer surveys used to weight the CPI; it also uses a formula that adjusts for changes in consumer behavior that occur in the short term, something the standard CPI formula doesn’t do. The result is a more comprehensive, if less familiar, gauge of inflation. That’s important for the Fed, which regards a small amount of inflation as a sign of a healthy, growing economy.

When economists refer to “core” CPI, or “core” PCE, they’re referring to the underlying measurement, less food and energy, which can be seasonally biased. Core inflation has been on the rise since late last year, and the trend continues to strengthen. Core inflation has picked up noticeably since the FOMC decided to lift rates last December. The strengthening could be easily interpreted as “actual” progress toward the Fed’s inflation goal. Nevertheless, a number of Fed officials have voiced doubt over the sustainability of the stronger inflation figures.

Not only that, but is the inflation “sticky?” How resistant to price changes is an item? “Flexible” items include new and used cars, clothing and hotel rooms, and items with “stickier” prices include housing, insurance, medical care and food purchased at restaurants. Flexible items ex-food and energy have risen at a faster clip than core sticky items in the three months ending in March.

What does this mean for Optimal Blue’s clients? Inflation, regardless of how it is measured, is not an overwhelming concern of the market. It is, however, something to keep in the back of our minds, knowing that an unexpected uptick in inflation could move rates higher. But we aren’t there yet.

Catchy credit card ad copy aside, net worth is of paramount importance to many people – including Optimal Blue’s clients. Although the Fed’s actions tend to follow the markets rather than set the course for long-term interest rates, certainly what the Fed does impacts interest rates. But does the Fed impact household net worth? And if not, should it? And if a borrower’s net worth is increasing, shouldn’t that help business for OB’s clients?

Let’s take a quick look at general trends in household net worth relative to Fed policy. In a world where populations are steadily aging, the ability to work and produce income is arguably declining. Older people tend to look at net worth rather than income. So household net worth is growing increasingly important for populations at large, as an eventual means of meeting various living expenses. Think reverse mortgages for those 62 years or older. From this perspective, policymakers across the globe would do well to help households grow, or at least preserve, net worth.

The Fed, however, does not have instructions on helping net worth. It is more focused on maximizing employment and maintaining price stability. Granted, doing that can lead to greater net worth in some households. And there are some analysts who believe that household net worth optimization (stability, growth) would appear to be a reasonable, if unstated, mandate for the Fed. The March FOMC minutes, which indicated that “a cautious approach to raising rates would be prudent,” seemed to support the idea that asset price stability (i.e., household net worth preservation) is at least implicitly part of the Fed’s decision process.

A longer term examination of household net worth trends suggests the Fed has frequently reacted to extremes in net worth growth rates, tightening when the rate was too high and easing when it was too low. The longer term perspective also provides some insight into the latest tightening cycle. It indicates that it made sense for the Fed to begin tapering its QE purchases in early 2014, when net worth growth was extremely high, but that raising rates this past December, when growth was sharply lower, seems to have been fairly risky. Moreover, given the collapse in asset prices at the start of 2016, the net worth data suggest it would have been a colossal error to raise rates again in March. Going forward, given the fragility that lingers from Q1, continued “caution” by the Fed indeed seems “prudent.”

Every experienced LO knows that the ratio of household net worth to disposable income factors into the underwriting decision, if only subconsciously. How does a borrower have a high net worth and no income? The net worth-income data encapsulate the Fed’s quandary, showing both why it might want to tighten policy and why it cannot tighten: asset values are at dangerous extremes relative to incomes. But the weak income story is precisely why the Fed needs to preserve or grow asset values – and refrain from excessive tightening. Once again, the Fed seems stuck in the middle.

And plenty of OB’s clients lend in areas where home price appreciation is steadily going up. The home equity net worth data show a more balanced and moderate picture for housing relative to other financial assets such as the stock market. The modest gains in home equity net worth is consistent with some analysts believing that mortgage credit is a relatively cheap asset class. So perhaps property values will continue to increase, therefore increasing the net worth of owners. But be careful about wishing for a good thing: the industry needs first-time home buyers who aren’t priced out of the market.

Optimal Blue clients are continuing to originate loans that are not fixed, and that fit a particular borrower better. The adjustable rate mortgage (ARM) earned a bad rap after the 2006 housing crisis. The problem was, before the crisis, many borrowers were able to qualify for more home than they could actually afford by using interest-only, No Income Verification or No Ratio ARM products. When the housing market tanked and many houses lost value, some homeowners with rising mortgage payments either foreclosed or walked away from their properties. Suddenly those programs became the focal point of government intervention – but…

Many of those programs provide valuable financing for our client’s borrowers. Fast forward 10 years to today. The ARM is back to show potential homebuyers it’s not the villain of the housing market. Some ARM programs are very stable and are a good option while the Fed raises short term rates.

Some don’t believe that, however. This myth stems back to the days of the 2008 recession. All ARM loans have annual and lifetime caps, so there’s built in protection. If stability is what a borrower is concerned with, they should consider an ARM with a longer adjustment period. For example, Navy Federal Credit Union’s 5/5 ARM adjusts only once over the initial 10-year period.

OB’s clients know that interest rates rise and fall in cycles. Even if rates are increasing now, that doesn’t mean they won’t be on the downturn at the next potential adjustment point. Many ARM mortgage holders never refinance to a fixed rate because the many ups and downs of the market happen in-between their adjustment points. Refinancing is always an option for those with ARMs. OB clients help their borrowers calculate closing costs on the loan to make sure there is an improvement. Research and the guidance of a trusted lender will be the winning combo for saving money over the life of the mortgage.

Adjustable rate mortgages are not only for folks who want to be in a home for a few years. ARMs have fixed intro periods that can vary from one to even 15 years. If a borrower thinks they’ll own that home for five or six years, a fixed mortgage rate may have a higher interest rate over that span. So why spend the extra money associated for the added security of a fixed rate? Again, it pays to plan for various scenarios based on how long the borrower plans to own the home.

The term “adjustable” gives the misconception ARMs are unstable. The ARM is very similar to a fixed-rate mortgage; both offer a 30-year term with no prepayment penalty and early payoff options, among other similarities.

The intro rate period (usually a lower rate) and potential rate changes (up or down) over the life of the loan is what makes an ARM unique. Optimal Blue’s clients stress that borrowers should knowing their cap and what the difference in payments are over the life of the loan. These protect borrowers, even if rates are on a roller coaster. Knowledge is power as an ARM holder. That “power” helps borrowers make necessary calculations to figure out a yearly breakeven point should their interest rate increase and the introductory rate savings begin to decrease.

Optimal Blue’s clients encourage their LOs to help their borrowers in researching loan options before closing. Often when one adds up the ARM’s initial savings plus the cost to refinance, an ARM is hard to beat from a financial standpoint – it is definitely a value-add for lenders.

All of Optimal Blue’s clients know that reliable lending decisions use an analysis of things like collateral and credit. But originators and underwriters will often point out that, in the credit decision, relying upon one number (the credit score) may not be accurate. A borrower’s credit score, whether from TransUnion, Experian or Fair Isaacson Corporation (FICO), can make the difference between owning a home and renting. It can also cost (or save) borrowers tens of thousands of dollars on interest since lenders set rates to reflect the quality of one’s credit score.

The algorithms behind the creation of a credit score are not static, however, and are updated from time to time. As credit reporting companies have improved and updated their models to reflect how consumers use their credit, Fannie and Freddie have been slow to “come about,” in part because of the difficulty and cost of changing their automated underwriting programs.

For example, Fannie balked at using the newest model, FICO Score 9, which was introduced 2014 and provides fairer treatment for those consumers whose scores have been lowered by medical bill collection accounts in their credit files or who have files with scant information because they make little or no use of the traditional banking system. According to Fair Isaacson, which owns FICO, applicants whose only major negatives are medical collections stand to see their FICO scores improve by a median 25 points.

But pressure has increased on Freddie and Fannie to modernize their credit standards, both from Congress and a directive from the FHFA (the federal agency that oversees Fannie and Freddie). In late June Fannie Mae will begin incorporating “trended credit data” into its automated underwriting platform. No longer will OB clients and other lenders be limited to making an approval decision on the basis of a single score.

Trended credit data will enhance the static snapshot of a consumer’s credit balances with 24 months of historical data, such as payment and balance. It will help OB’s clients examine and consider how consumers are managing their credit accounts over time. Today, lenders can see consumers’ existing balances on accounts and whether they have paid their bills on time; however, they cannot tell if consumers are consistently carrying debt loads on revolving accounts such as credit cards, or whether they pay their balances in full every month.

For example, a consumer with a large credit card balance who pays it off in full every month could be a better credit risk than a consumer with a large credit card balance who makes only the minimum payment each month. And for consumers who don’t have a large amount of available credit, but pay their balances every month, trended credit data may help originators determine if they are a good credit risk and better their ability to obtain a mortgage loan. Trended credit data should help consumers who don’t have a large amount of available credit, but pay their balances every month, for example.

Legislation was introduced late last year by members of the House Banking Committee that would require federal regulators and the GSEs to adopt alternatives to FICO that are more inclusive and updated models that incorporate non-banking forms of credit, such as rent, utilities, and cellphone payments to supplement a standard credit file.

If passed, the legislation would allow lenders to use scores from FICO’s competitor, VantageScore, which claims it can provide scores on as many as 35 million consumers, many of whom didn’t have enough credit history to have a score. Many are young, just starting out in their careers. Disproportionately, they are minorities.

Last week we discussed how mortgage rates are set. Namely, not by the Federal Reserve, but by supply and demand. If no one wants to borrow money at a certain rate, then rates must drop to attract more borrowers. Conversely if the demand for capital is high, rates will increase if capital is scarce. The same can be said for those offering money to be borrowed.

That being said, what have made headlines recently are negative interest rates. What are those? Europe has turned into the proverbial black sheep of the family; like the cousin most families have, who’s been unemployed for the past two decades, shows up to events he wasn’t invited to, eats all the shrimp appetizers, then asks to borrow $20 bucks on his way out the door.

Nine out of the ten G10 central banks (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, and the U.K.) are priced to cut rates this year, by an average of 25 basis points (BP). The two-tier deposit rate framework could open the door for even lower rates, which is expected to push its deposit rate deeper into negative territory, to minus 40 bps. The aim of course is to head off deflation. Deflation is a general decline in prices, often caused by a reduction in the supply of money or credit. It can also be caused by a decrease in government, personal or investment spending. Deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression.

In case you’re wondering what happens to deposits in negative interest rate environments, you have to let go of conventional wisdom and enter the world of string theory and black holes, where common laws of nature fall apart, and fail to work. An interest rate below zero means that European banks are paying the central bank to hold their reserves, rather than earning interest on those reserves. If the negative interest rates were applied to customer deposits at banks, then customers would actually pay the banks to park cash in bank accounts, rather than earning interest on those deposits. I’m not sure where all the “Occupy Wall Street” people went, but it would be interesting to get their take on it.

Negative central bank rates attempt to accomplish what a traditional lowering of Fed Funds attempts to accomplish, that is to encourage business investment and consumer spending; increase the value of the stock market and other risky assets; lower the value of a country’s currency, making exporters more competitive; and create expectations of higher future inflation, which can induce people to spend.

Would the United States ever experience negative interest rates? Probably not. A few years back if you recall, Fed Funds was close to zero after being slashed six times alone in 2008. The Federal Reserve may have chosen to head into negative territory (which may have violated the US Federal Reserve Act) but opted for a few rounds, or three, of Quantitative Easing.

So while negative interest rates are fascinating to discuss, the likelihood of them happening here is very small. And the impact on mortgage rates is muted even further. Every one of OB’s clients knows that different borrowers have different credit profiles, different states have different foreclosure laws, and different investors have different underwriting criteria. There are exceptions, but it generally perceived that the credit risk of an individual borrower is much greater than that of a government. Therefore mortgage rates will always be above government debt.

Plenty of Optimal Blue clients have spent time staring at agency trading screens on Bloomberg or Reuters over the last few years. If you have, chances are you were either pricing loans, selling loans, or hedging loans. Chances are also pretty good that you noticed volumes in one of the most liquid markets in the world, agency mortgage backed securities (MBS), starting to flatten out. This is an important event, as any significant deterioration in the liquidity of the MBS market could lead investors to demand premiums for transacting in this market, which would ultimately raise borrowing costs for U.S. homeowners.

A little bit of context. An interesting characteristic of MBS trading is the existence of a forwards market which is known to some as: to-be-announced, or “TBA“. Where a pool of loans is being securitized the counterparties know the composite makeup of the mortgage backed security. In the TBA markets, however, these counterparties do not specify which particular securities will be delivered to the buyer on settlement day. Instead, they agree on a few basic characteristics of the securities to be delivered, which include the coupon rate, issuer, term, and face value. Thus, while the agency MBS market comprises over one million heterogeneous MBS pools, more than 90 percent of trading is concentrated in only a small number of liquid forward contracts. Why is this important to OB clients? If your secondary marketing department sells loans on a mandatory basis, chances are they hedge a good portion of the bank’s pipeline with agency TBA forward sales. These short sales of TBA MBS, which mitigate short term interest rate risk, are traditionally bought back before established delivery dates once loans have been committed to investors. Disturbances in liquidity, in any market, traditionally widen the bid-to-ask spread between sellers and buyers driving up transactional costs.

The depth of the TBA market has allowed for a highly liquid market to evolve. This market is used as a conduit to hedge new mortgage production, existing mortgage positions; for pricing new mortgages, and for speculating on the course of interest rates. All of these activities have made trading volumes in agency MBS much higher than that of corporate bonds. How high? According to the Securities Industry and Financial Markets Association, in 2015, agency MBS trading volume averaged approximately $190 billion a day, compared with $27 billion a day for corporate bonds.

What are the drivers of liquidity in the MBS market? There are a few. The first is the gross issuance of agency mortgage backed securities – many of which are issued by OB clients. MBS fluctuates substantially, usually with the level of long-term interest rates, a main determinant of mortgage refinancing. In 2013 when long-term interest rates rose sharply, gross issuance plunged almost 70%. The second important driver of liquidity in the MBA market is security ownership. Currently, out of the more than $6 trillion in agency MBS outstanding, investors in the market include: public institutions, banks, foreign investors, and mutual and pension funds. As most know, the single largest holder of MBS is the Federal Reserve, which has purchased agency MBS in implementing monetary policy to achieve the Federal Open Market Committee’s dual mandate of maximum employment and price stability. The Fed writes, “Agency MBS purchases help achieve this mandate by putting downward pressure on longer-term interest rates, supporting mortgage markets, and helping to make broader financial conditions more accommodative.” While that may be correct, the Fed’s buy-and-hold strategy certainly affects liquidity in the marketplace too.

Trade size, trading volumes and turnover rate (which is total trading volume as a percentage of total agency MBS outstanding) indicate a decline in market liquidity. Causes certainly include increased regulation, which has made it more costly for financial institutions to take on risk; a rise in agency MBS ownership among buy-and-hold investors; and a decline in issuance. However, measures of transaction costs and price impact suggest that liquidity conditions have been relatively stable since 2011.

Optimal Blue’s clients often wonder what happens to their loans after they close. More specifically, they often understand who services the loan – whether their company keeps (“retains”) the servicing or if it is sold to a bank or non-bank servicing company. But what about the actual asset? After all, someone actually owns the “bond” – the interest payments made by borrowers after the loan funds. Who owns those – is it Fannie Mae and Freddie Mac? Some insurance company or pension fund? Perhaps a money manager overseas?

It turns out that all of those can be investors in residential securities backed by mortgages. But OB clients should know that depository banks like Bank of America, Wells Fargo, Citi, and Chase are owners of huge sums of residential MBS, and those figures are open to the public. And these include agency MBS, non-agency MBS, jumbo whole loan pools, and so on.

The National Information Center recently released consolidated financial statements for bank holding companies for the 4th quarter of 2015. Although the information is not as comprehensive as the Quarterly Banking Profile (which also includes savings institutions), which is soon to be released by the FDIC, they provide a good early estimate of changes in bank assets and liabilities.

Agency MBS holdings increased by $52.5 billion for the top 50 banks (ranked by assets) in their “hold to maturity” (HTM) and “assets for sale” (AFS) portfolios during the fourth quarter. Similar to the previous quarter in 2015, demand was strong for conventional and GNMA pass-through securities. Conventional pass-through (PT) security holdings, primarily made up of loans underwritten to Fannie Mae and Freddie Mac guidelines, went up by $17.3 billion, while GNMA PT holdings rose $33.5 billion. Demand was weak for agency CMOs with holdings increasing only by $1.7 billion.

Digging into the numbers reveals some interesting changes. For example, the significant increase in GNMA PT holdings is driven by Bank of America Corporation whose GNMA PT holdings in AFS and HTM portfolio went up by $31.4 billion. Considering the $9.7 billion decline in agency MBS trading assets in Q4, however, it appears the increase was partially driven by classification change. Excluding trading assets, Bank of America Corporation’s agency MBS holdings increased by $39.9 billion. Wells Fargo & Company and Citigroup Inc. added $2.6 billion and $2.9 billion, respectively, to their agency MBS holdings. HSBC North America Holdings Inc. reduced its agency MBS holdings by $1.48 billion.

Holdings of non-agency MBS of the top 50 banks decreased $14 billion, while commercial MBS (CMBS) holdings rose $5.3 billion. Treasury holdings increased $21.5 billion, while agency debt holdings fell $4.8 billion from the previous quarter.

Overall, the allocation of bank portfolios to securities increased $28.8 billion over the quarter. Of most interest to OB clients, in the loan books one- to four-family first-lien residential loans increased $24.9 billion quarter over quarter.

So what does all of that mean? Banks have struggled for several years now finding commercial loans to put on their books. A likely replacement is securities backed by the U.S. Government in the form of Ginnie, Fannie, and Freddie mortgages. And this is indeed what is happening: the yield on these securities is better than the alternatives. And as long as demand is strong for them, and the supply level, it pushes prices up and helps to keep rates low for OB’s client’s borrowers.

Optimal Blue’s clients are filled with loan officers. And every loan officer out there who is worth their salt is talking to borrowers about affordability. And in many cases, helping them to make the decision of whether or not the client should keep renting or to make the move into home ownership.

Axiometrics Analytics found America’s most affordable and least affordable rent markets by analyzing 28 metro areas to better understand where rents are more affordable and may be most affordable in the future. The analysis reviewed rents to income ratios, looking at 30 percent or more of income spent on rent as unaffordable, with Little Rock, Salt Lake City, Las Vegas and Indianapolis ranked as some of the most affordable cities to live in. New York, Los Angeles, San Francisco, Miami and Oakland all ranked as the cities that are least affordable.

Interestingly enough, New York was the least affordable city in 2001, where rent averaged $2,300, while Little Rock was one of the more affordable places to live in 2001, with rent averaging $617, with a rent-to-income ratio of 17.4 percent, whereas the national average reached 27.7 percent. This was during the time of the early 2000 recession and New York job growth was negative 2.7 percent. Over the past 20 years, the best place to rent has been Indianapolis in 2007, where monthly rent was $701, equating to 15.2 percent of income going towards rent.

On the flip side, New Yorkers had a rent-to-household income ratio of 64 percent during this same time period, and the national average was 24.9 percent. New York will remain the least affordable place to live as the expected amount of income that goes towards rent is 50.5 percent, and Los Angeles is expected to become less affordable as rent starts inching towards 48.6 percent of households’ incomes. Little Rock will remain as one of the more affordable places to live in the near future, along with Salt Lake City, Phoenix, Albuquerque, Kansas City and Indianapolis. Other cities that expect to see rent decline include Houston, TX, Miami, FL, Phoenix, AZ and Albuquerque, NM.

What does this mean of OB clients? Taking an extreme look at things, if a potential home buyer is paying $10,000 a month in rent but could buy a home and have a $3,000 a month housing payment that is tax deductible, then it is an easy decision. It is an easy decision IF the client has the money for a down payment – which brings us to the down payment issue.

In some news this week Bank of America announced a 3% down payment program which circumvents FHA. (The program was anticipated, especially as the large banks and nonbanks have been forced to pay large settlements with FHA.) The program has no mortgage insurance, and is backed by a partnership with Freddie Mac and the Self-Help Fund, a non-profit company located in North Carolina.

After making the loan Bank of America sells it to Self-Help which in turn sells the loan to Freddie Mac. At this point BofA has capped annual volume at $500 million – not much when one considers that is about $45 million a month spread out over 50 states.

Still, this is exactly the type of thing that Optimal Blue clients and the industry will see this year: more innovation and programs that don’t fall into the strict government-sponsored lending programs that currently have the lion’s share of business.

The good news is that rates are low and moving lower. The bad news is that the economy is heading south and borrower psychology is worsening.

The “flight to quality” theme has continued all week with equity markets around the world going down. Of course this has created investor demand for the safe haven of treasuries as well as agency mortgage-backed securities. Global concerns continue to weigh on markets as earnings misses from European financial institutions are viewed as potential foreshadowing, and the press is consumed with the chaos overseas impacting our markets here in the United States.

Yes our markets are being moved by what is happening outside of our country. The Hang Seng Index having its worst annual start since 1994, and European markets are reaching their lowest levels since October of 2013. Adding fuel to the “Fear factor” Gold is trading beyond $1,200 an ounce and the price of oil continues to weigh on the markets: oil at $26 per barrel impact jobs and refining here in the United States.

Unfortunately the markets are not happy with Fed Chair Janet Yellen’s testimony on the state of the Fed’s thinking about the economy. In testimony in front of Congress Fed Chair Janet Yellen spoke of tightening financial conditions and uncertainty posing a threat to the US recovery. Recent market activity would likely delay the timeline for additional rate hikes this year, but for the most part she maintained her stance on additional hikes being “data dependent”.

The fixed-income markets around the world, as well as stock markets, are focused on two things: negative central bank rates and bad bank headlines. The Financial Times reports negatively yielding debt globally now exceeds $5 trillion, as central banks struggle to drive more economic growth abroad. The
Riksbank dropped its rate further into neg. territory and SocGen put up bad earnings/guidance. The combination of those two events, coupled w/very fragile sentiment, extreme risk aversion (a function of enormous P&L destruction YTD), and Janet Yellen’s testimony are creating a huge global nightmare.

And let’s not forget China – which is basically closed this week due to its New Year’s holiday. So some of the worst carnage in months is occurring while China is shut and the yuan has been rallying.

Returning to “negative” rates – it can’t be overstated how detrimental negative rates are for the markets. Depositors are basically paying the bank to keep their money there, and on the sidelines away from investment. Negative rates around the world are destroying bank stocks and in turn killing the market. Negative rates appear to be the preferred policy choice of central banks and this has played a key role in crushing bank stocks over the last several weeks. And of course many OB clients sell their loans to banks.

So we have “fast money investors” selling bank stocks. There is anxiety about the China yuan. There is sovereign wealth fund selling. We have decreasing expectations about growth in this country, and weak global demand.

Optimal Blue’s clients, however, are seeing yet another refi market in the offing. Most investors are dreading having their MBS portfolio potentially prepay, and thus MBS prices are lagging in the rally. Capital market’s staffs are dealing with margin calls due to the huge rally in MBS and on the flip side holding their pipelines while originators trying to renegotiate loans. Yes, at some point recent borrowers overcome the hassle cost of refinancing and investors see an increase in early pay-offs.

But is the pain worth the gain? Time will tell as plenty of potential borrowers for OB clients grow concerned about their individual balance sheets are fear more problems are ahead.

Optimal Blue’s clients are noticing that a large portion of aging boomers are choosing to downsize and live in housing communities but that millennials prefer the flexibility of renting over owning. We’re also seeing gross underemployment (some folks working 2-3 jobs) creating economic barriers to potential buyers and that stagnant wages haven’t kept pace with inflation. And thus we are witnessing the American consumer demanding more multifamily dwellings.

According to the National Association of Home Builders, multifamily starts, at the end of 3Q15, were at a decade long high with 425,000 starts. So, where do all the cash flows from this sector end up? In mortgage backed securities, specifically Multi-Family Mortgage Backed Securities (MF MBS), and the agencies have an integral part in the process. FNMA, FHLMC, and GNMA makeup a large portion of the $1trillion secondary market for these products with market shares of 26%, 24%, and 10%, respectively (other market participants include CMBS, banks/thrifts, life insurance companies, and state/local Agencies).

Though most of OB’s clients focus on lending for single family homes and units, it is helpful to know that multifamily loans are made to borrowers under varying terms, such 10 years, 7 years, fixed-rate, adjustable-rate, full or partial interest only periods. During the life of a multifamily loan, the balance is generally amortized over an amortization term that is significantly longer than the term of the loan. As a result, there is little amortization of principal, resulting in a balloon payment at maturity. The borrower usually repays the loan in monthly installments that may include only interest for the entire term of the loan, only interest for a portion of the term and then both principal and interest, or principal and interest for the entire term of the loan.

And just like the vast majority of loans on single family loans, multi-family loans are put into securities and sold in the secondary markets. MF MBS are often issued with prepayment penalties that protect the investor in case of voluntary repayment by the borrower. These prepayment protections are most frequently in the form of lockout periods, defeasance, prepayment penalties or yield maintenance charges.

(Lockout periods…a prepayment lockout is a contractual agreement that prohibits any voluntary prepayments during a specified period of time, the lockout period. After the lockout period, some instruments offer call protection in the form of prepayment penalties. Defeasance: With defeasance, rather than loan repayment, the borrower provides sufficient funds for the servicer to invest in a portfolio of Treasury securities that replicates the cash flows that would exist in the absence of prepayments. Prepayment Penalty: Prepayment penalty points are predetermined penalties that must be paid by the borrower if the borrower wishes to refinance. Yield Maintenance Charges: A yield maintenance charge is the most common form of prepayment protection for multifamily loans/securitizations. It is basically a repayment premium that allows investors to attain the same yield as if the borrower made all scheduled mortgage payments until the maturity of the security. Yield maintenance charges are designed to discourage the borrower from voluntarily prepaying the mortgage note. The yield maintenance charge, also called the make-whole charge, makes it uneconomical to refinance solely to get a lower mortgage rate.)

Much of this doesn’t make sense for OB’s clients on the single family side of thing. But loan servicing is pretty straight forward and very similar to what our clients do for home loans. The mortgage bank or a third party may service multifamily loans going into an agency MF MBS. The master servicer is responsible for day-to-day loan servicing practices including collecting loan payments, managing escrow accounts, analyzing financial statements inspecting collateral and reviewing borrower consent requests. All non-performing mortgages are usually sent to the special servicer. The special servicer is responsible for performing customary work-out related duties including extending maturity dates, restructuring mortgages, appointing receivers, foreclosing the lender’s interest in a secured property, managing the foreclosed real estate and selling the real estate.

So although related there are enough differences between home loans and the process for multi-family that make them “cousins” rather than “siblings.”

The mortgage industry is nearly fourth months into the wave of the future known as TRID. Ultimately Optimal Blue clients are asking, “Will the new regulations actually benefit the borrower?”

For the last 30 years, mortgage lenders relied heavily on 2 documents in an effort to cover the nitty gritty details of a transaction. The Good Faith Estimate (GFE) detailed anticipated closing costs to borrowers. And the Truth In Lending Disclosure (TIL) was designed to indicate the Annual Percentage Rate (APR) of the loan. Albeit comforting to have the familiarity of the old-school forms, in truth, both disclosures were difficult for consumers to understand, creating confusion regarding the ultimate closing costs and actual interest rate of the loan – thus the onset of TRID as we know it.

OB clients know that the CFPB’s goal was to improve accuracy and simplify the information for the borrowers benefit. In addition, the Hud-1 settlement statement was also revamped as the numbers did not always match up with the GFE and TIL. Thus the GFE and the TIL have been replaced by a single disclosure, the loan Estimate designed to make it easier for borrowers to understand the key terms, costs and risks of a mortgage loan earlier in the process.

In order to protect the borrower, there can be no variations in fees charged by the lender as stated on the Loan Estimate. In addition, third party fees are held to a ten percent variation between the Loan Estimate and those reflected on the Closing Disclosure. The only charges exempt from the ten percent cap is any service the borrower can actually control and choose such as homeowner insurance.

One key issue with the new rules is the interpretation of the required time-lines by lenders. Understandably cautious, most lenders are now quoting 45-60 days for loan closing compared to 30 days pre-TRID. Also, with the new rules it’s critical that all parties involved work closely together to keep the loan on track. The expiration of interest rate locks is of particular concern as any change to the loan or closing figures after a Closing Disclosure is issued will necessitate the issuance of a new Closing Disclosure and an additional three business day waiting period. Extension fees are expensive especially with interest rates on the rise.

These changes may seem difficult now but as time passes and issues are ironed-out, mortgage industry folks will rally and conquer beast known as TRID. But it is not a fast process. After it jumped up by three full days in November the average time to close a first mortgage loan stabilized in December at 49 days. The November increase had been attributed to unfamiliarity with the new Truth in Lending Disclosure Rule for applications received after October 3.

Ellie Mae’s Origination Insight Report showed that purchase mortgage closings did take one day longer, 50 days, to close in December but that was offset by a drop in closing times for refinances from 49 to 47 days. The average time to close FHA and conventional loans remained largely unchanged at 49 days, while for VA loans it increased from 50 to 52 days.

And it did impact the financial results of mortgage originators. Most of the large lenders & investors have now reported 4Q15 results. Mortgage banking revenues were down Q/Q as lower volumes were coupled with lower gain-on-sale margins. Some smaller companies have noted that the new TRID disclosures have slowed mortgage volumes.

And it doesn’t stop with investors. For example, title insurers’ earnings have been impacted. While some analysts believe that TRID has been manageable for large mortgage and title companies, it is obvious that it has led to some delays in closing loans across the industry. For title insurers, this will likely result in lower title margins, since revenue is recognized at close.

OB clients know that we will get through this as an industry. But is the consumer truly better off when the mortgage and related industries’ results are negatively impacted, and those costs are passed along?

Without the secondary market Optimal Blue’s clients, and practically any lender, would find themselves “full” of loans in a hurry. It is important for loan originators to realize that the secondary markets provide a pricing mechanism for loans as well as an outlet for the assets, allowing lenders to obtain capital to lend again. Generally speaking investors agree to buy a loan in the future, after it is locked with the borrower and then funds later. What happens when this mechanism breaks down?

Recently, the NY Federal Reserve released a report which studied the recent rise, and net effects of “settlement fails.” A settlement fail occurs, and is recorded, when a market participant is unable to make delivery of a security to complete a transaction. Such a “failure to deliver” can result from the outright sale of a security, or the initiation or termination of a transaction to borrow or lend a security. The party to whom the delivery was due will also record a fail, in the form of a “failure to receive.”

As these “failure to delivers” rarely garner much attention outside the back offices of banks and security firms, this relatively obscure statistic rarely makes the news. Settlement fails, however, are a particular issue for the world’s repo markets, where banks borrow trillions of dollars each day through pledges to sell securities such as US Treasuries or mortgage debt in return for cash, and then “repurchase” these assets back at a later date. Under repo agreements, markets typically see large banks sell a portfolio of, say US government bonds worth millions of dollars, with a promise to buy the portfolio back at a predetermined date. Under these conditions, the initial buyer of the securities, in essence, acts as a lender to the seller. A “fail to deliver” can happen if the seller does not hand over the assets to the purchaser in the agreed time frame, or vice versa. This occurrence may sound like a form of market failure, but it is a relatively regular market occurrence. Why? Historically, before the implementation of a fails-charge, it was used as a form of cheap finance.

Even though settlement fails may be common, it’s easy to see that that they can create liquidity problems for OB clients and other market participants, as well as raising operational and counterparty credit risks. Between the time a trade is negotiated and the time it is settled, counterparties can be exposed to such risks. Settlement fails can exacerbate such risks because prices will tend to deviate further and further from agreed-upon transaction prices as time passes. The extent of risk buildup depends on a number of characteristics of the fails, including the duration of the fail, concentration of fails by security, and the price sensitivity of the securities that have failed to settle.

According to the Federal Reserve, aggregate Treasury security settlement fails have come down since June 2014 as the spike in fails of recently issued securities subsided. Nonetheless, fails in seasoned issues (defined as securities issued more than 180 days prior) continued their upward trend. The volume of settlement fails on any given day reflects the product of the number of issues failing and the average quantity failing per issue. So which of these factors does the increasing volume reflect? According to the Fed, both factors are in play. That is, the number of different seasoned issues failing has been rising over time and the average quantity of fails per issue has also been increasing.

Seasoned fails have been trending upward, and this increase can be explained by more issues failing and in larger quantities, but not by longer fails episodes. Moreover, the fails are increasingly dispersed across securities, with little apparent concentration in particular tenors or vintages of securities. Going forward, the continued growth in seasoned fails bears close watching, even as concerns are somewhat mitigated by the short tenure and wide dispersion of the fails.

As Optimal Blue’s clients know, mortgage pricing is a matter of supply and demand. So this week plenty of heads turned in the industry when the Federal Housing Finance Agency closed a loophole in its membership in its issuance of the final rule on captive insurers. And this will impact both the supply and demand for mortgages.

Remember that the FHFA is the entity that not only oversees Fannie Mae and Freddie Mac but also the Federal Home Loan Bank system. And companies were looking with great interest at the Federal Home Loan Bank (FHLB) system as a possible source of financing. But the announcement, in simple terms, states that the FHLB will be kicking captive insurers, and thus mortgage REITs (mREITS), out of the FHLB.

All is not lost, however, and these things take time to unwind. mREITs that joined prior to September 2014 will have a five-year sunset period. Those joining more recently will have a one-year sunset. Analysts were quick to point out, however, that regardless of timing that this is not good news for the mortgage REIT sector (and mortgage credit availability more broadly). Names that popped up immediately are well known to capital markets staff: Redwood Trust, Two Harbors, Annaly, and Invesco for example. Levering whole loans with advances is the only asset strategy that produces a return above their cost of capital.

Similar to the proposed rule, the final rule prohibits captives operating under the five-year sunset provision from either holding advances in excess of 40% of their assets or renewing existing advances beyond the sunset date.

The FHFA notes that 20 of the 25 captive insurance members with mortgage REIT parent companies gained access to the FHLB system after the proposed rule. “This trend has become a matter of growing concern to FHFA, as it has become increasingly clear that captives are being promoted and used as vehicles to provide access to Bank funding and to other benefits of membership for institutions that are legally ineligible for membership.” The FHFA continues by detailing a litany of structural and operational concerns with the admittance of captive insurers into the FHLB system including the potential for firms without significant housing operations to gain membership, the statutory contours of the Federal Home Loan Bank Act, and the “dramatic increase” in captive insurer membership applications.”

Analysts see FHLB membership as providing benefits to mREITs through funding diversity more than through lowered costs. But anyone hoping for good news in jumbo securitization was disappointed. The non-agency funding of jumbo whole loan conduits and floating rate commercial mortgage financing took a step back, and broker/dealer alternative financing vehicles will be more expensive for those products.

OB clients and other lenders saw FHLB advances as a possibility for the long-awaited possibility of accelerating the “return of private capital” back to the mortgage markets. In a FHA/VA, Freddie, Fannie world jumbo loans have taken a back seat, and the non-QM lending channel has not skyrocketed as some thought it would. Even in jumbo-land most of the loans are of pristine credit quality, and those are being held by banks in their portfolios especially with commercial lending opportunities not being terribly exciting or abundant.

And so where does this leave things for OB clients? As noted, the rule doesn’t take effect immediately so MREITs do have some time to adjust. But with everyone asking about the fabled “private market”, this news of the loss of a financing alternative hinders progress in that front. And that in turn, and in a roundabout way, impacts rate sheets – and not for the better.

It is a safe bet that most of the rank and file of Optimal Blue’s clients have provided their superiors with estimates of business for 2016. And it is also a safe bet that no one said their residential origination volume was going to decline. That would be heresy! But let’s take a look at what the “experts” are thinking for 2016 in terms of interest rates and the housing markets.

Let’s start with the potentially negative news first. One major downside risk is that there is more rapid slowing than expected in China. We saw this in the first week of the new year as China’s economy hit its stock markets, which in turn hurt ours. As one would expect, however, our bond market rallied/improved because of it.

The second potential issue could be the deteriorating American manufacturing sector which is now in recession. If an economy slows, of course, it would lead to lower rates since the demand for capital is less: no one wants to borrow money! Unfortunately if potential home buyers have no jobs that is an even greater problem.

Another fear is of that problems in the Middle East escalate and plague the entire world. Lately the issues between Iran and Iraq have boiled up, and ISIS continues to be a threat to stability.

Let’s turn to housing here in the United States. Many economists think we can expect the 30-year fixed-rate mortgage to average below 4.5 percent for 2016 on an annualized basis. That is indeed good news for OB’s clients. They know that gradually higher mortgage interest rates will present an affordability challenge – but once again if the rate move is due to a strengthening labor market then borrowers will be in a better position to borrow to buy homes.

Most expect house price growth to moderate a bit to 4.4 percent in 2016 driven in part by the reduction in homebuyer affordability and reduced demand as a result of Fed tightening. And watch for housing activity to grow in 2016, despite monetary tightening, with both housing starts and building permits to improve once the weather becomes seasonally better.

Yes, the FOMC did raise the target fed funds rate range from 0.0%-0.25% to 0.25%-0.50%, citing “considerable improvement in the labor market conditions (in 2015).” They further stated they are reasonably confident that inflation will rise, over the medium term, to its 2% objective, and that monetary policy will remain accommodative after the increase supporting further improvement in the labor market and a return to 2% inflation. Many economists believe that the target federal funds rate will reach 1% by the fourth quarter of 2016. There is no perfect time to raise rates and markets will always get nervous, but the underlying health of the U.S. economy points to gradual rate increases over the course of the coming year.

In terms of residential volume, due to the strength of the economy most believe we’ll see an increase in the purchase market in 2016, despite gradually increasing rates. But the flip side is that mortgage origination volume will be slightly down next year due to a reduction in refinances.

The good news is that the Federal Reserve Board is seeing economic growth which should continue to keep the banks happy in terms of the fundamental economic conditions they’re lending to, as well as the equity investors that are looking for continued growth and strength in the economy to support the projects that they’re investing in.

Experienced Optimal Blue clients know that not everyone deserves a home loan. Often loan officers find problems with the collateral, with the borrower’s capacity to pay, and so on. And of course the borrower’s credit history is a primary focus in lending them money. We also know that politicians will often try to influence lenders, especially the agencies, to extend credit to borrowers whose credit is on the edge of what makes sense. So, as an industry, what are lenders seeing in terms of credit trends?

Many reports indicate that lenders appear to be raising the bar on minimally acceptable credit scores. And the number of mortgage quotes received by borrowers with less than ideal credit scores has not kept pace with the growth in quotes received by more ideal borrowers. For example, Zillow reports that for the first time since 2012 obtaining a mortgage today is harder than it was a year ago mostly because lenders are raising the bar on what they think is a minimally acceptable credit score.

Lenders are quick to point out, however, that though it has gotten modestly more difficult to get a mortgage compared to a year ago it remains far easier than during the depths of the recession in 2011. There are a few key factors driving the recent tightening in access to mortgage credit, most notably a shift upward in the minimally acceptable credit scores of successful mortgage applicants.

OB clients who have been around for a while remember that 10-15 years ago the minimally acceptable Fair Isaac credit score among the bottom 10 percent of successful applicants was 635. In the years following the collapse, as lenders drastically tightened standards, the minimally acceptable credit score generally rose above 700. It has dropped for the last few years but it appears to be on the rise again.

Other indicators monitor how many mortgage quotes potential borrowers receive, based on several variables submitted with their request for a quote, including their credit score. Lenders are showing a higher preference for safer borrowers with higher credit scores than they have in the recent past. Borrowers with FICO scores at the lower end of what is generally acceptable (600-640) have seen little change regarding the number of quotes they receive for mortgages.

Not all variables indicate a tightening in mortgage credit. What about the debt-to-income ratio? Qualified Mortgage (QM) rules have constricted DTI ratios in spite of experienced lenders knowing that high DTI borrowers may present a better risk to a lender than a lower DTI borrower when other factors are considered. A borrower’s DTI typically cannot exceed 45 percent (their debt payments cannot consume more than 45 percent of their income) in order to be eligible for a conventional loan backed by Fannie Mae or Freddie Mac. So it is no surprise that acceptable DTI ratios haven’t moved much, especially as non-QM lending has not skyrocketed.

What will Optimal Blue clients in 2016 see in terms of extending credit to marginal borrowers? There are plenty of “experts” that believe mortgage rates will increase next year. (How many times have we heard that?) Debt-to-income ratios may become a problem for borrowers if mortgage rates rise over the next year. More income will be needed to cover even marginally more expensive mortgage payments and those potential borrowers currently bumping up against the 45 percent DTI ceiling may be pushed across the threshold when considering these higher payments.

So while higher mortgage interest rates, if they come to pass, may not translate into big changes in monthly payments, they may help tighten the screws on those potential buyers looking to spend as much as possible on a home while still qualifying for a conventional loan.

With Fannie Mae and Freddie Mac buying the bulk of product from Optimal Blue’s clients, as well as that of the rest of the residential lending industry, what those two agencies do, and what they plan to do, is of paramount importance. So there were many interested parties who pored over the FHFA’s release of its 2016 scorecard for the GSEs and Common Securitization Solutions (CSS). Especially since it may impact rate sheets.

The new scorecard mandates that the government sponsored enterprises (GSEs) prepare for the expiration of HARP by creating a new high-LTV refinance program that will be implemented in January 2017. (Yes, over a year away – but these things take time.) They are also being instructed in implementing “Release 1” of the Single-Security Initiative in 2016. Freddie Mac will start to utilize the Common Securitization Platform (CSP) to perform activities related to its single-class, fixed-rate securities. No Single Securities will be issued under this phase of the program.

In 2018 we can expect to see “Release 2” of the Single-Security Initiative implemented. Both Fannie Mae and Freddie Mac will start to issue Single Securities and commingled re-securitizations.

“Frannie” is also expected to transfer the credit risk on at least 90% of the UPB of single-family mortgages acquired in 2016 for 30y fixed-rate, non-HARP loans with LTVs greater than 60% (so-called “targeted loans”) and explore ways to transfer credit risk on other types of single-family mortgages outside of this “targeted loans” category. Along those lines Freddie & Fannie will explore ways to expand the investor base for credit-risk transfer transactions.

In a nod toward politicians who believe that these agencies should help the consumer, the FHFA is requiring that the GSEs further increase access to credit for borrowers by removing impediments that may be preventing qualified borrowers from obtaining a loan. Supporting this objective, the GSEs are to enhance their rep and warranty frameworks by completing an independent dispute resolution process for lenders who do not believe that their loans have breached the GSEs’ rep and warranty policies, as well as provide lenders with feedback on the quality of their loan originations shortly after the loans have been sold to the GSEs.

Analysts were quick to point out that the new high-LTV refinance program will benefit certain borrowers. FHFA Director Mel Watt had already expressed his intention in May 2015 to let HARP expire at the end of 2016. The bi-partisan omnibus spending bill also contained a provision that would terminate the Making Home Affordable program (of which HARP is a component) at the end of next year, essentially sealing the fate of the long-dated program. It is possible that it will be open to some pre-HARP borrowers, effectively serving as an extension of HARP for this subset of homeowners.

It is also possible that OB clients see post-HARP borrowers able to use the new refinance program – especially borrowers who refinanced through HARP but may not yet qualify for a refinance under a full underwriting process, since this subset of borrowers would likely benefit the most from a new streamlined refinance process.

But capital markets folks were most interested in the single security news. “Release 1” is scheduled for 2016 and “Release 2” (the actual introduction of the Single Security) scheduled for 2018. The scorecard requires that the market be notified of the precise implementation date of the Single Security at least 12 months in advance so that stakeholders can prepare for the change. The FHFA will also develop a process to evaluate new or updated GSE policies that may affect prepayments and buyouts on TBA mortgages, as well as monitor issuance and prepayments between the two agencies to alleviate concerns by some investors that with the introduction of a Single Security and the ability to deliver either Freddie or Fannie pools into the same TBA deliverable.

The Federal Open Market Committee meeting is upon us. We’ve seen oil plummet in price, impacting both bond and stock markets. The residential lending industry is still grappling with the implementation of “Know Before You Owe.” So what might Optimal Blue’s clients expect regarding mortgage-backed securities heading into 2016?

First off, in spite of whatever the Fed does to short-term rates in the next few meetings, most expect that it will continue with its program of full reinvestment of pay-downs at least until the middle of 2016. It may scale these back toward the end of 2016 if its rate increases are having the desired impact. The agency MBS sector could gradually reset to a new range of spreads in anticipation of an end to Fed’s reinvestment program once the Fed starts the hiking cycle. When one looks at the historical spread between agency MBS and Treasury securities, current MBS spreads are currently about 25-30 basis points “tighter” than where they traded in the past.

Most estimates by the MBA, Fannie Mae, and Freddie Mac point to a similar residential loan volume for 2016 versus 2015. But what about “net” issuance, since investors are likely to replaced pools of loans being refinanced by other pools of newly issued securities? Although a portion of the recent pickup in net supply of agency MBS is simply because of the seasonality in the housing market, the outstanding balance of first-lien residential mortgage debt has been increasing again and many analysts expect the annual net issuance of agency MBS to be very high at about $185 billion going forward even if banks increase their mortgage loan holdings by $50 billion per year.

Mortgage originations are finite, and for all the market-share gyrations out there it is still expected to be about $1.2 trillion in 2016. As the volume of MBS available for relative value trading is limited, the short-term performance of MBS is likely to be strongly driven by the direction of interest rates and implied volatilities. If the economy weakens and rates rally such that servicers are forced to buy MBS, the lack of “true float” in the MBS market could cause a sharp tightening of spreads even from their current rich levels in the short term. One argument against that is if the economic outlook continues to improve and the rates market sells off, spreads are likely to widen in the short-term as carry offered by MBS worsens and no major investor group is likely to be interested in buying MBS at current spread levels.

We’ve talked about supply – but what about demand for MBS? Domestic bank holdings of agency MBS increased by about $115-120 billion and their residential mortgage loans increased by about $40 billion over the first ten months of 2015. The strong demand from domestic banks is one of the important reasons for why MBS spreads have remained very tight over the past several months, and it is hard for MBS spreads to materially widen as long as this demand source doesn’t go away. But once the Fed starts tightening the market will be entering an uncharted territory from bank demand perspective as there are several unknowns on how the drivers of bank demand will evolve. As domestic banks own close to 28% of all outstanding balance of agency MBS and that there is very limited float available in this market, their activity in the MBS market is going to have a decisive influence on the direction of MBS spreads in 2016.

There is also the question of demand by domestic money managers and mortgage REITs. The demand for MBS from this group, at least the money managers, has been very good in 2015. And overseas investors have provided a strong demand for MBS and were net buyers of about $74 billion agency MBS from 2H’14 to 1H’15. While a major portion of the net demand during this period came from China and Taiwan, more recently, China seems to have stepped away from the market while Japan has started adding agency MBS.

No one can predict the future with any certainty, especially the financial markets. Stock prices go up and down, sometimes randomly, as do interest rates. Certainty is hard to come by for investors, but for owners of securities backed by mortgages it is especially important. How long will they receive the monthly payments? How long until the borrower pays off the mortgage? These factors influence the price of a mortgage-backed security, thus impact the price that borrowers see on rate sheets. And so it is important for Optimal Blue’s clients to know what factors investors hone in on in determining prepayments.

There are sharp differences in the prepayments of new production high LTV collateral based on loan purpose. High LTV purchase loans when “in the money” (rates have dropped since the loan funded) have had relatively high prepayments. Much of this is due to the fact that these borrowers have undergone a full underwriting process, demonstrating their ability to qualify for a refinance under today’s stricter underwriting guidelines, and accrete additional incentive to refinance as their homes appreciate in value because of the possibility of lowering or eliminating their mortgage insurance premium.

In contrast, high LTV refinance loans have continued to exhibit strong “call protection” – they don’t pay off early. The bulk of these borrowers refinanced through the HARP program, which has very limited underwriting requirements, based only on recent pay history and verbal verification of employment. They have not demonstrated the ability to qualify under a full underwriting process. Furthermore, many of them would have to get additional mortgage insurance to refinance outside of the HARP program (borrowers can refinance through HARP only once), further dampening their economic incentive.

What about loans funded through broker or correspondent channels, also known as third-party originations? Generally speaking there is higher rate sensitivity for loans that have gone through a third-party origination channel. The magnitude of the TPO effect differs by loan age (it is most pronounced for loans that are 6-18 months old) and TPO channel (broker vs. correspondent). One of the explanations for the higher prepayments of broker and correspondent loans is that these borrowers tend to respond very aggressively to solicitation offers for lower rates. Many of them have refinanced several times with the same broker and respond to very small changes in rates.

Borrowers who have refinanced through a TPO channel are more likely to be serial refinancers. In contrast, the use of a TPO channel for the purchase of a home provides a less pronounced empirical signal about a borrower’s refinancing behavior. In other words TPO effects are largely limited to refinance loans. So if pools of loans contain large numbers of refinances originated through brokers, investors will be hesitant to purchase them at the same price as other pools.

What about FICO – does it influence prepayments? Recent prepayments for lower FICO collateral (i.e., FICO<700) have been higher than expected. Credit scores affect prepayments in the model in several ways. They affect borrower mortgage rates through LLPAs. They also affect the level of roll rates in the CDR model. However, their principal influence is on the level of refinancing activity predicted by the model. Higher-than-expected prepayments on lower FICO pools suggest that credit scores are less of a barrier to refinancing than assumed in the model. In addition to weakening the generic FICO effect, investors also look at the FICO effects for specific products. For example, conforming jumbo collateral has shown relatively modest refinancing impairment due to borrower FICO. Rather, the fact that they are jumbo borrowers seems to be a stronger credit signal than their credit score. So the impact seems less for the effect of FICO on the refinancing sensitivity of jumbo collateral. These factors and more are exactly the components that help make up the price an investor is willing to pay for a mortgage!

Optimal Blue’s clients are accustomed to politicians influencing the housing and mortgage markets, even if the particular politician’s influence is minor. The latest example of this occurred recently when former neurosurgeon and Republican-presidential hopeful Ben Carson suggested eliminating the mortgage interest deduction. Is it something for Optimal Blue’s clients to lose sleep over? No, but it is worth a discussion since eliminating the tax break pops up in the press occasionally, and most other countries don’t have a similar tax break yet their citizens still buy houses.

Other GOP candidates also support tax simplification by doing away with most itemized deductions. But they also expressly say they would retain the mortgage interest and charitable donation deductions. There is talk of a flat tax, fewer deductions. Wouldn’t it be nice if people could do their own taxes again? Carson has used 10% as his target tax rate, but when you reduce the rates that much (the current top rate is nearly 40%) you have to come up with the lost revenue somewhere. Doing away with deductions, mortgage interest and otherwise would help make up the U.S. Treasury shortfall.

The mortgage interest deduction is one of the most popular tax breaks in the system although it is a break that’s used disproportionately by wealthier taxpayers. Current law allows for interest on a loan up to $1 million to be deducted. Critics say that this makes the deduction basically a subsidy for oversized houses and encourages people to buy homes that are bigger than they really need or could afford without the write-off. But it also helps those who rely on the tax break and who need the deduction to help cover what they’re spending.

Over 70% of the deduction benefits go to the top 20 percent of income earners. The next 20 percent receive much of the rest—nearly 20 percent. Where does this leave the 60 percent of Americans who are on the middle and bottom rungs of the income ladder? They get a mere 9 percent of the benefits. In dollar terms, roughly $63 billion goes to the top 40 percent of income earners, while $1 billion goes to the bottom 40 percent.

The deduction for mortgage interest does not provide direct subsidies that help people with the initial purchase and associated costs. Rather, it subsidizes the ongoing debt associated with owning a home. Subsidizing debt can encourage people to take on more debt and buy bigger, more expensive homes, as mentioned above. So many believe that the mortgage interest deduction should be changed to limit current deductions and use the revenues to provide a credit for first-time homebuyers. Such a reform would be more progressive and would subsidize the home purchase, not the debt incurred. More efficiently and equitably promoting homeownership, and thus wealth building, can help more people get a toehold into the middle class and increase economic mobility.

The housing industry, and those trades it touches, is a unified and powerful front ready to vigorously defend the mortgage and other home-related tax breaks. The National Association of Realtors, the Mortgage Bankers Association, and other special interest groups have had great success in beating back previous tax reform proposals that also floated killing the home-loan interest deduction or replacing it with a tax credit. So although it is estimated that the deduction cost the country nearly $70 billion in 2013, the benefits to voters outweigh the cost. Given the political climate don’t look for any changes for at least several years, if at all.

The world’s economic community is abuzz with the news from last Friday. Namely, the employment data was strong, U.S. hiring swelled in October by the largest amount all year, and unemployment dropped to 5.0 percent, increasing the likelihood that the Federal Reserve will raise interest rates next month for the first time in a decade. It was a strong and balanced report. What are the numbers, and could they impact mortgage rates?

Federal Reserve Chair Janet Yellen turned heads recently when she reiterated that December’s Federal Open Market Committee meeting was very much “live” for a potential interest rate liftoff. Jobs numbers and wage growth had been particularly underwhelming in recent months, so few were terribly confident the domestic economy was ready to take off its low-interest training wheels just yet.

According to the Bureau of Labor Statistics the U.S. labor market added an astounding 271,000 jobs in October. That’s the single best month for job growth so far this year, and much better than what most analysts were expecting (somewhere between 180,000 and 185,000 job gains last month). The unemployment rate dropped to 5 percent – its lowest level since April 2008.

And so a December short-term rate liftoff doesn’t sound nearly as far-fetched as it did a few weeks ago. In fact even before Friday’s report, expectations for a Fed rate increase in December were building. Fed chief Janet Yellen and other top officials said this week that the economy is generally healthy and a move at next month’s meeting is a “live possibility.”

A sizeable portion of the mortgage workforce, which obviously includes Optimal Blue’s clients, has never seen a rate increase. The Fed cut the short-term rate it controls to a record low of nearly zero in December 2008 to try to stimulate growth during the recession.

The strong jobs report for October means the Federal Reserve may be weeks away from raising interest rates. Does that mean anything for mortgage rates? Perhaps not! The reason is that there’s an unprecedented shortfall in the safest assets, especially Treasury bills. And money managers that need risk-free assets, like funds that focus on government obligations that are most sensitive to changes in Fed policy, still need to keep buying them. The shortage means some key money-market rates will probably remain near historic lows even if the central bank increases its benchmark from near zero next month.

As a share of U.S. government debt, the amount of bills is the lowest since at least 1996, at about 10 percent, and the Treasury is just beginning to ramp up issuance of the securities after slashing it amid the debt-ceiling impasse. So the thinking is that the demand for high-quality short-term government debt securities is insatiable and there is just not enough supply.

And OB clients are reminded that short term rates aren’t the same as long term rates. The Federal Reserve, and the Federal Open Market Committee, does not control long term rates. Among the most well-known rates they set are overnight Fed Funds, the Prime Rate, and the Discount Rate. These are certainly not 15-year and 30-year mortgage rates. And that is what senior management is reminding their loan officer staffs. Analysts are talking about a flattening yield curve where short-term rates move higher and longer term rates remain relatively stable. And that would be good news for home buyers and those refinancing.

With all this talk about the Fed, more specifically the Federal Reserve Board, and whether or not it is going to change short term rates, a reminder is due OB clients about what the Fed actually does, and who does it, and how long they’ve been doing it. Optimal Blue clients should keep in mind that the Fed does plenty of other things besides voting on short-term interest rates. It looks at changes in margin rules, some banking penalties, the approval of banks, etc. – things that impact the strength and stability of the banking system in the United States.

The Federal Reserve System was founded by Congress in 1913 “to provide the nation with a safer, more flexible, and more stable monetary and financial system.” Over the years, its role in banking and the economy has expanded. In general the Federal Reserve’s duties fall into four general areas. “It conducts the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates. It supervises and regulates banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers. It maintains the stability of the financial system and containing systemic risk that may arise in financial markets. Lastly it provides financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation’s payments system

The seven members of the Board of Governors are nominated by the President of the United States and confirmed by the U.S. Senate. There are only five now (Yellen, Fischer, Tarullo, Powell, and Brainard, with two vacancies). The Chairman and the Vice Chairman of the Board are named by the President from among the members and are confirmed by the Senate. They serve a term of four years. A member’s term on the Board is not affected by his or her status as Chairman or Vice Chairman.

Under the heading “Monetary Policy” the Fed has several tools at its disposal in order to “promote maximum employment, stable prices, and moderate long-term interest rates.” For example the fed sets the Federal Funds Rate. The Federal Funds Rate is the rate banks use to lend money to each other overnight, and it has been near zero for eight years in an attempt to stimulate our economy. If upcoming economic reports are strong, the Fed could still decide to raise the Fed Funds Rate at its December meeting. The key takeaway is that when the Fed Funds Rate does rise, home loan rates could follow suit, depending on overall market and economic conditions.

But are things picking up here in the U.S.? In housing news, the Commerce Department reported that New Home Sales fell 11.5 percent in September. The Northeast was the hardest hit with a near 62 percent decline from August. High demand, limited supply and increasing home prices influenced the drop. Despite the decline, year-over-year sales are up 2 percent.

Third quarter economic growth also slowed, according to the Bureau of Economic Analysis. Initial readings suggest Gross Domestic Product grew at a 1.5 percent pace in the third quarter, below expectations and well below the second quarter’s reading of 3.9 percent growth. After nearly $5 trillion dollars spent to help our economy since 2008, it seems to be stuck around 2 percent growth, much to the Fed’s dismay.

The Federal Open Market Committee doesn’t have a crystal ball in terms of rates, or events overseas that impact our economy. In fact critics say the Fed follows the markets rather than set the tone for the markets. And the bright side to the recent disappointing reports is that home loan rates remain near historic lows for OB’s clients and their borrowers. But it is good to know the Fed’s role in the economic machine when it eventually acts.

If money were no object would you rather rent something or own something? I’m sure most of you would say “own.” How about if money was an object, you needed what was most affordable? In terms of the housing market, in the majority of areas owning is more affordable than renting in the current housing market. According to a recent report by Goldman Sachs, however, owning is not as affordable as it looks, but renting is worse. What should Optimal Blue clients do with that information?

Goldman Sachs measures housing affordability in their Housing Affordability Index (HAI), which “takes into account a mortgage insurance premium and expectations about future income growth, suggests that housing is not as affordable as it looks for the marginal homebuyer. But because households have to live somewhere, the relevant question is how it compares with rental affordability.”

Instead of assuming that homebuyers can afford a 20% down payment, HAI measures based on marginal homebuyers who can afford a 5% down payments and have to pay a mortgage insurance premium. In addition, the HAI “recognizes that households make home-buying decisions not only on today’s income but also on their expectations of future income.” Goldman says that the HAI levels are around where they were in the mid-1990s. After all, a household has to live somewhere, whether it owns or rents the unit.

Even if buying a house is not as affordable as it looks, households may still decide to own if renting is even less affordable. As OB clients know, here is the main reason that renting is more expensive than owning: the rent to income ratio is high. Before 2000, renters spent 1/4th of their income on rent. In recent years that number has spiked to 1/3rd of income going towards rent. Rent has climbed by 30% from 1989 to 2013 while real income of renters has little changed during this entire period, which means that rent becomes less and less affordable.

“Although simple to calculate, the rent-to-income ratio among renters may be a misleading measure of rental affordability because of a number of mix shifts over time. First, as the homeownership rate increases, the remaining pool of renters may have lower incomes, leading to worse measured rental affordability. The decline in renter income from 2000 to 2005 may be partially related to the sharp rise in the homeownership rate during that period.” Most OB clients are familiar with “tiny houses” in areas such as San Francisco and Manhattan. Tiny houses are when families live in smaller than desired units because they cost significantly less.

To address the issues Goldman, “measured the rent and income of a fixed group over time. On income, we use the median household income among the 30-40 year olds, including both homeowners and renters. In this way, the income measure is not affected by the fluctuating homeownership rate. Moreover, this is the age when many people transition from renters to homeowners, so the rent vs. own decision is the most relevant to this age group.”

With all of the factors accounted for the rent to income ration can be used to measure affordability. We all remember the housing crash. During that time it was exponentially more affordable to rent rather than to buy. After the financial crisis is came back around for owners making the more economical choice. With the upcoming rate hike from the Fed people are worried that it will affect the housing market but Goldman Sachs says that it won’t have any affect and 2016 looks promising with owning remaining on top of affordability. And that bodes well for Optimal Blue clients!

Every once in a while someone will ask, “What happened to mortgage-backed securities?” First of all, they are alive and well. But are they being bought and sold, and is the pricing accurate? This last question is very important for Optimal Blue clients.

There is evidence that liquidity in fixed income markets, including the agency mortgage-backed securities (MBS) market, has declined since the housing market crisis and could pose risks to the financial system if left unaddressed. The “experts” say that this can be attributed to tougher regulation, specifically the requirement for financial services firms to hold more capital and reduce the amount of risk taken.

But not everyone agrees. For example, financial regulators argue that tighter regulations don’t impact mortgage origination volumes. So what are the recent trends in the agency MBS market? Agency MBS liquidity has declined since the crisis, yet remains at the pre-bubble levels of the early to mid-2000s. This this drop is driven by several factors, of which tighter regulation is one, but by no means the only one or even the primary one. The factors driving this decline, such as limited supply, an increase in all-cash buyers, or individuals paying off their mortgages, are unlikely to ease any time soon, suggesting current levels of liquidity are here to stay.

The “glory days” of 10 years ago where residential volumes zoomed above $2 trillion per year are gone. The euphoria in the run-up to the financial crisis, which was caused by ever-increasing house prices, investor complacency, weak capital requirements, inadequate oversight of financial firms, and unchecked leverage, led to a strong increase in demand for all asset classes, including agency mortgage-backed securities. The result was not only an asset price bubble, but also a “liquidity bubble,” which burst along with the asset price bubble.

If excessive risk-taking led to an increase in liquidity previously, then it should be no surprise that a reduction in risk will cause liquidity to decline. Part of this reduction in risk and liquidity is no doubt driven by tighter regulation, but it is also driven by an extraordinary shift in MBS ownership pattern as well as weak mortgage originations and issuance activity. The new regulatory safeguards have had their intended effect of reducing the amount of risk taken by financial firms. But for OB clients and others to expect a reduction in risk without causing some impact on liquidity is trying to have it both ways.

Optimal Blue clients know that capital markets have fundamentally changed during the last few years. These changes are a direct outcome of the excessive risk-taking before the housing crisis and the subsequent policy, regulatory, and industry response to reduce that risk. Although the days of market panic are long gone, the after-effects of the crisis—including the near-universal focus on de-risking among consumers, industry, and regulators—continue to drive the trends described in this brief. There are also no signs yet that these trends will reverse materially in the foreseeable future, leading us to believe that present levels of liquidity are here to stay.

And lest we forget, the Fed continues to be a player. The Fed’s ownership share of outstanding agency MBS is unlikely to budge until the Fed changes course. Even though the quantitative easing program has ended, the Fed continues to reinvest principal pay downs from its agency MBS and agency debt holdings to purchase new mortgage-backed securities. This means the dollar volume of Fed’s holdings will remain constant at roughly $1.7 trillion as long as this policy remains in place. The only other way Fed’s ownership share could shrink is for total MBS outstanding to grow faster than Fed’s purchases. This seems highly unlikely given the anemic level of net new issuances in recent years and a struggling purchase originations market.

So many analysts gravitate toward the idea that net new issuance volume would not only have to increase substantially from the current level, but would also have to remain elevated for a number of years before it could put a meaningful dent in Fed’s ownership share. And few think that this will happen.

A large number of Optimal Blue’s clients are still seeing a large portion of their business come from refinancing. These take the form of conventional, FHA, streamlines, etc., but suffice it to say that the end of the refi era has not happened.

But that isn’t to say that OB clients, and other lenders, are seeing as much refi business as they were earlier this year. Last week’s MBA refinance index release indicated that overall refinance activity is around 3% lower than what was seen prior to the introduction of TRID on October 3rd. Many analysts believe that the recent rally in mortgage rates (down to about 3.75%) should prevent refinance activity from declining to the levels seen prior to the introduction of TRID when mortgage rates were at 3.85%.

This is because, per analysts, that the TRID introduction is unlikely to have caused a large change in the number of applications that originators are willing to accept. One important metric that has been largely ignored by the market is the average loan size of the refinance loan applications. The average loan size of the MBA refinance loan applications spiked last week (prior to the introduction of TRID) and remained high this week. This indicates that the total UPB of applications is still 5% higher than application volumes seen prior to the introduction of TRID.

Since the average loan size was almost unchanged from the previous week near peak levels of $304K, on a nationwide basis one can expect that the prior week’s spike in the refinance index was the result of a pull forward of applications that would have otherwise shown up this week. This is not a surprise to any of OB’s client’s lock desks. Thus, the introduction of TRID appears to be unlikely to have caused lenders to accept a materially lower number of applications in total.

In other words, if 30-year mortgage rates remain around current levels of 3.75% then we can see the MBA refinance index gradually drift higher.

That being said, however, OB clients know that rates are not the sole determinant of refi business. Discussions with LOs indicate that “life changes” are an important piece of the refi puzzle. Events like a divorce, consolidating a 1st and a 2nd into one payment, and ARM into a fixed-rate loan, borrowing to unleash equity for various reasons, and so on are popular reasons. It is not an LO saying, “I was standing in a supermarket line with a gal and she was asking me what I did for a living and I told her and she said her rate was 6% and asked if I could save her any money…”

Still, many LOs say their biggest impediment to new business is their old clients that they’ve put into 3.50% 30-year fixed-rate loans. The sales pitch has to be very convincing to move a borrower out of that rate and into something else. And thus OB clients have other tools and arguments at their disposal to help borrowers refinance. Once a borrower heads down the path where the application is taken and a rate lock put in place, the loans are more “sticky” than they were in the past. Lenders normally report 80% or better pull through consistently.

So will refinancing change in a post-TRID world? Probably not noticeably. Borrowers still want to borrow, lenders still want to lend, regardless of the process.

Much of mortgage banking, and for that matter law as well, tries to answer the “what if’s”. What if something goes wrong? What if a borrower doesn’t make their payment? What if a document isn’t signed? Optimal Blue clients that sell loans to investors know that much of the seller agreement revolves around addressing items before they go wrong.

Many of OB’s clients sell loans directly to the agencies, and thus Fannie Mae and Freddie Mac announcing updates to their representation and warranty framework that governs the rights and responsibilities lenders face when selling loans to the GSEs attracted a lot of attention. One of the things that keep lenders up at night is repurchases, and if repurchase requirements are vague that is bad. Although the changes don’t take effect until January they were still welcomed by sellers.

Fannie gave out a list of potential alternatives to repurchase that it could offer in the event of underwriting defects. In addition, Fannie Mae provided specific guidance on what kinds of loan defects could lead to a repurchase request or an alternative remedy. The Bulletin reminded its clients that, “The remedies framework is specifically related to corrections of identified origination defects, and available repurchase alternatives. This framework provides clarity on the process followed in categorizing origination defects, lender corrections of such defects, and available remedies. In addition, it provides more transparency regarding Fannie Mae’s discretion on loan-level decisions when reviewing a loan during a quality control review. The remedies framework does not affect any servicing duties, responsibilities, or obligations.”

Freddie Mac spelled out its process. After completing a full-file quality control review, Freddie Mac will categorize defects in one of three ways: Findings, Price-adjusted loans, and Significant defects. It would be wishful thinking to believe that OB clients will never have any of them. Mortgages with defects categorized as “Findings” will not require a Correction or a Remedy (as defined below) from the Seller. Loans categorized as “Price-Adjusted Loans” require the Seller to pay the applicable post-settlement delivery fee (“delivery fee”) that should have been paid to Freddie Mac when the Mortgage was delivered. If a Mortgage has one or more defects categorized as a “Significant Defect,” Freddie Mac will require the repurchase of the Mortgage, or may offer the Seller/Servicer a repurchase alternative.

Fannie did the same. Fannie Mae will categorize defects in one of three ways, mirroring Freddie: Findings, Price-adjusted loans, and Significant defects. Mortgage loans with defects categorized as “findings” will not require a correction or a remedy from the lender. Loans categorized as “price-adjusted loans” require the lender to pay the applicable loan-level price adjustment fee (LLPA) that should have been paid to Fannie Mae when the loan was purchased or securitized by Fannie Mae. If a loan has one or more defects categorized as a “significant defect,” Fannie Mae will require the repurchase of the loan, or may offer the lender a repurchase alternative.

There is indeed some good news. Key terms are now clearly defined and lenders are afforded the right to correct loan-level defects before facing financial remedies. OB clients know that the standard process for “fixing” loans is to first try to correct the problem, and if that doesn’t work to go back to the borrower and try to refinance them – often at a loss. Lenders will have greater access to repurchase alternatives as well as representation and warranty sunset relief.

Old agreements stand. “In adopting the remedies framework, we are not discharging Sellers from responsibility for underwriting and delivering investment quality Mortgages in accordance with the terms of the Purchase Documents.” But the Bulletins should help OB clients going forward!

Yes, the sun came up the next day after the changes caused by “Know Before You Owe” were implemented. Borrowers still need to borrow, lenders still want to lend. But there are some things for Optimal Blue clients to keep in mind and remember.

First off, compliance folks are fond of saying, “Start old, stay old.” If a borrower’s application was taken October 2nd, the day before implementation, even if the disclosure were sent out afterward, OB clients (and others) should use the old process and forms. And the loan should be closed on the old forms: the process and paperwork are based on the application date.

The industry has begun to use the term “Loan Estimate”. Lenders cannot require verification documents from consumers before issuing an LE, and are required to obtain consumers’ consent to receive electronic loan disclosures and documents, and have contingency plans for alternative delivery methods. The lender will provide an LE within three business days after receiving the six pieces of information constituting an application.

Some mortgage costs can increase at closing, but others can’t. It is illegal for lenders to deliberately underestimate the costs on a borrower’s LE. However, lenders are allowed to change some costs under certain circumstances. The CFPB reminded borrowers that if their interest rate is not locked it can change at any time. And “even if your interest rate is locked, your interest rate can change if there are changes to your application information or if you do not close within the rate-lock timeframe.”

OB clients and others need to prepare the LE with reliable data and information collected based on good faith efforts (no padding fees). And any revisions to the LE must be issued within three business days of receiving information constituting valid changes of circumstances in order to reset tolerance baselines.

There are costs that can increase by any amount. These costs are not controlled by the lender, and can increase by any amount at any time. They include prepaid interest, property insurance premiums, or initial escrow account deposits, fees for services required by the lender that borrowers have shopped separately for, if they choose a service provider that is not on the lender’s written list of providers, and fees for third-party services that the lender does not require.

There are costs that cannot increase at all. If there is a “change in circumstances,” these costs can change by any amount, but otherwise they cannot change at all. For example fees paid to the lender, mortgage broker, or an affiliate of either the lender or mortgage broker for a required service, fees for required service that the lender did not allow borrowers to shop separately for, when the provider is not affiliated with the lender or mortgage broker, and transfer taxes.

There are costs that can increase by up to 10 percent. If there is a “change in circumstances,” these costs can change by any amount. If there is no change in circumstances, then the total of these costs cannot increase by more than 10 percent: recording fees, and fees for required services when the borrower has chosen a third-party service provider on the lender’s written list of providers (if the provider is an affiliate of the lender, the cost cannot change at all).

Lenders are not allowed to issue any revised LE after issuing the Closing Disclosure (CD), and must ensure that consumers receive the last revised LE and the CD at least 4 business days and 3 business days before consummation, respectively.

There has been plenty of press warning borrowers that they will encounter lengthier waits to close on the purchase of their home. Will real estate agents or builders know that? Good question and LOs are wondering if their clients will realize it. Thirty-day waits are now common in some markets. But 45- or 60-day waits may become more common as OB clients and all lenders familiarize themselves with the new rules.

National Cheeseburger day was September 18th. The day after was a letdown for many connoisseurs and followers of that burger. There are some similarities between that feeling and the feeling that traders, analysts, and bankers had after the Fed left short term rates alone after its last meeting. Is that a bad thing for Optimal Blue clients? No – and some would argue it makes little difference anyway.

So, it was a “no go” for the rate change in September. Now the world has to wait for a Christmas present from the FOMC. Remember when you were a kid and you wanted something you were really passionate about like the newest gadget or a cool toy and instead you got socks? Hopefully the FOMC doesn’t give us socks for Christmas and raises the rate everyone is hyped up for, like that latest toy. And OB clients should remember that there are a few more Fed meeting before the end of the year, and Chairperson Janet Yellen has recently indicated that the Federal Open Market Committee is still targeting a rate bump before year end – if the economics of the world can handle it.

While a great majority of the FOMC expects a rate increase by the end of the year, others believe there is some uncertainty in that idea. The fact that global developments were brought into the discussion during the September meeting is a sign of uncertainty. One group opined, “We believe that a resolution of the global picture is unlikely to provide much guidance in the short run… Perhaps the global issue is just a temporary reason for no action. If so, this simply adds to uncertainty given that the global situation has made a sudden appearance and that these developments are difficult to quantify and unlikely to change much before the end of the year—yet a great majority expect to raise the funds rate by the end of the year? Uncertainty persists.”

What else did the FOMC do during its last meeting? There were a lot of expectations being lowered. The committee lowered its expectations for inflation over the next three years and economic growth in 2016 and 2017. The FOMC also lowered its expectations for the overnight Federal Funds rate over the same period. You know what they say about expectations: keep them low so when it happens you can only be impressed.

The FOMC continues to set expectations for the market. But there is a pattern of consistent overestimation and lowering expectations. If one looks back at the press releases and minutes the FOMC has consistently overestimated the path of the federal funds rate. This appears to indicate that whatever the link is between the funds rate and economic growth, the link is weaker and that other factors are influencing both.

Overall this suggests the potential growth rate of the economy has shifted downward. Moreover, the lower path of nominal GDP growth over the next three years presents a challenge to financial markets as lower nominal GDP would be consistent with lower growth of corporate profits. If that is true, OB’s clients can expect mortgage rates to stay low – much as they’ve done since the FOMC meeting. That is not a bad thing, although it might be better if the Fed indeed saw reasons in the U.S. and global economy to raise rates.

When the Fed failed to make a change to policy, the markets took this as a reflection of concern by the Central Bank regarding the prospects for growth. Now, I’m going to grab a cheeseburger to boost my mood.

Optimal Blue’s clients use a variety of secondary market execution strategies. Some sell everything on a best efforts flow basis while others securitize their own loans. On the other end some investors prefer to originate loans for their own portfolios, some buy blocks of whole loans, while others prefer to buy mortgage-backed securities (MBS). Why should OB’s clients be interested in hearing about why MBSs are seeing renewed interest? Because the demand for mortgages impacts the rates that LOs and borrowers see on rate sheets.

Investors know that MBS generally have tended to offer a high degree of liquidity and a relatively low correlation to risk assets. The U.S. residential and commercial MBS markets exceed $7 trillion and make up about 30 percent of the Barclays U.S. Aggregate Bond index and 12 percent of the Barclays Global Aggregate index, according to the Securities Industry and Financial Markets Association (SIFMA) and Barclays, respectively. It is no surprise to OB’s clients that the largest and most liquid component of MBS exposure are mortgage bonds guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. There also are sizable private-label residential and commercial MBS markets.

But agency MBS valuations are not cheap at current levels. These securities are accompanied by both interest rate and prepayment risk. And prices have been inflated by the accommodative policies of the Federal Reserve, which owns more than $1.75 trillion in agency MBSs.

One factor contributing to the price movement of MBS is prepayment risk: borrowers can pay off the loan any time they like. Given that the typical U.S. 30-year mortgage loan can be prepaid at any time, MBS investors — the lenders — are “short a call option” to the borrower to prepay, or call, their mortgage at their discretion. Being short an option creates the exposure to volatility but over the long term, investors have earned attractive compensation for incurring this risk.

Excess returns from agency MBSs have had among the lowest correlation to risk assets of any fixed-income sector and, relative to like-duration Treasuries, the primary risk factor in agency MBS is prepayment risk. The credit quality has improved dramatically. Even within the credit component of the MBS market, any originator or underwriter can tell you that this component of loans, and therefor for pools of loans, has improved dramatically in recent years.

Liquidity is another key distinguishing factor of the agency MBS sector, especially in an environment in which regulation has reduced the role of intermediaries. The demand for a purple 747 will directly impact the price, just as with MBSs diminished liquidity can result in wider bid-ask spreads and more fragility during periods of market dislocation. Although liquidity in agency MBSs may be weaker than historical levels, according to SIFMA, on average, the sector continues to trade more than $200 billion in securities a day with decently small bid/ask spreads..

But not everyone agrees all the time about the value of a given asset, and that is what helps make a market. The complexity of the mortgage market (pools of various LTVs, credit scores, geographic breakdowns, loan amounts, etc.) has facilitated consistent, excess return potential – there is opportunity! Prepayment risks are intricate, and sophisticated MBS investors often disagree materially on the value of embedded call options. Given the large footprint of investors not driven by total-return goals, the agency MBS market is constantly dislocated and mispriced.

OB clients should be aware that the MBS market offers the potential for investors to outperform Treasuries without drastically increasing the correlation of their fixed-income holdings to their equity exposure. The agency MBS sector historically has demonstrated a tendency to successfully address these goals while also providing attractive opportunities for active managers to generate excess returns. And that helps continue to keep mortgage rates low!

Remember when you were a kid and you used to build towers out of blocks as high as they could possibly go until they all came crashing down prompting your mother to tell you to not build your tower so high and the blocks wouldn’t fall? This is the scenario of the inventory investments for the second half of the year. In the first quarter, inventory investments increased $112.8 billion and increased another $110.0 billion in the second quarter, which is the largest back-to-back inventory accumulation on record. That’s a tall tower of blocks. What does that mean for mortgage rates for Optimal Blue clients?

Most economists believe that in the second half of 2015 inventories will unwind and they say that the higher the inventories go, the greater the eventual toppling could be and the greater the potential drag on GDP growth. And if GDP declines because of it, we can expect rates to follow.

A substantial inventory adjustment in the third quarter could affect the timing of expected FOMC tightening. What kind of drag is coming? Well due to lag time on reporting of inventories most economists seem to think that in the third quarter the “inventory build” will be $75-85 billion which, if that is correct, would result in 0.7% drag on GDP. To put that into perspective, in the first quarter when people were complaining about slow growth of GDP at 0.6%, inventories held GDP in the positives with a 0.9 percentage point boost. Without the growth in inventories, first quarter growth would have been negative.

For the OB clients who are optimists, however, there are more optimistic forecasts as well, with $100 billion, which would only result in a 0.2% drag. For example, Wells Fargo’s team notes, “The average inventory change in 2013 and 2014 was $61.4 billion and $68.0 billion respectively; if we penciled something in that range, the resulting drag would be about 1.0 percentage point. A $50 billion inventory accumulation would exert a 1.5 percentage point drag and “no change” in inventories would mean a 2.7 percentage point drag, or enough to swamp even an optimistic forecast for broader economic growth outside of inventories.”

So where did all of the buildup of inventories come from? Some people would be quick to jump to the conclusion that with more crude oil being pumped then Niagara Falls has water the energy sector is the primary culprit for the recent buildup.

But there is more to it than that. Energy is clumped into the “other” inventories, which includes mining, utilities and construction sectors, and therefore some of the influence of the energy sector. Inventory building has also picked up in the manufacturing and trade sectors.

But the most significant increase in the first quarter came from motor vehicles and part industry, where manufacturers and wholesalers saw inventories rise by the most in the series’ 18-year history. Some of these buildups aren’t unintended with many of the inventories keeping pace with sales. “So if the inventory build in some of the standout sectors is not necessarily unintended, what about the inventory build for the U.S. economy as a whole? Is it possible that the largest back-to-back inventory build on record is justified?” The aggregate I/S ratio for all manufacturing and trade sectors have shot up over the past year. Taken at face value, the run-up in the aggregate I/S ratio suggests that the build in real inventories in the first half of the year is unintended.

Overall, the back-to-back $110 billion+ gains are unprecedented and set us up for an inventory unwinding that could be painful for growth in the second half of the year. And OB clients know that what is painful for the economy is often beneficial for rates.

As rates have come back down and the chances of a September Federal Reserve move diminish, we find ourselves heading into the last week of August. This is also the traditional wind-down of the purchase season, as real estate agents know. Although the relationship between an LO and a real estate agent is often times complex, actually LOs and agents have a lot in common in dealing with clients and telling them what, or what not, to do during the process.

Experienced LOs of Optimal Blue clients typically tell borrowers not to schedule a vacation two weeks before or after the scheduled loan funding. Everyone in the residential real estate world knows that the weeks prior to and after a targeted closing date are a whirlwind of activity. Usually documents must be found, or re-sent as the case may be; papers must be signed, and so on. An already stressful process is going to become even more stressful.

Values have been increasing in many parts of the nation, but real estate agents and loan officers often deal with parties who believe that the house is worth more than those of the neighbors. In neighborhoods with unique homes this might be the case, but in many subdivisions it is not. Sellers, of course, think their house is larger, nicer, and in a more desirable location. Houses and apartments are worth a similar amount as to what comparable ones have recently sold for, in spite of what Zillow or Trulia may have estimated. Setting appropriate expectations are a very important component of what agents and loan officers do with their clients.

Real estate agents will often tell borrowers that, during the “walk-through,” it is not worth fighting over a broken appliance or missing light fixture. The client is going to spend hundreds of thousands of dollars or more to buy a home so these items are of little consequential or incremental value. Some, however, believe that items like that are indicative of other problems – it is a judgment call. Real estate agents spend a fair amount of time reminding clients that they are going to spend many thousands of dollars more updating items; repairing items and making this house their home. A buyer’s agent may even pretend that these items are important and “fake” indignation at their state of repair. But, though they are doing this to placate a client’s emotional response and coax them to the closing table, this is really just much ado about nothing.

Loan officers will usually inform buyers that scheduling is critical, and to keep in mind that the actual closing of one property and the purchase of another do not always coincide. Though it is everybody’s dream to sell their property in the morning and buy their new property in the afternoon, this is almost impossible to achieve. In a house transaction there are usually at least six parties involved and with a co-op 8 on each transaction. With busy schedules, vacations, holidays, etc., having this many people lined up on the day and time that work for a borrower is usually an insurmountable task. There are plenty of borrowers, or sellers, spending time at motels and hotels around the nation waiting for a day or two for the deal to close.

Optimal Blue’s clients are filled with stories of deals gone awry. Again, selling and buying a house is very stressful. So, when stress can be avoided by an LO or agent setting expectations, it is time well spent.

If you would like to know how to pick a lock like they do in the movies, I would suggest consulting YouTube (although that may not be the most productive use of your time, it probably will be very (not) necessary for your entire life). If you would like to know more about rate locks and how their expirations can affect you, continue reading. Virtually every Optimal Blue client accepts rate locks. Residential lending is one of the few businesses where consumers can lock in a future price now.

How important is the rate lock expiration date? It is very important if rates have stayed the same since an OB client’s borrower locked in their rate and terms, extremely important if rates have climbed since a borrower locked, and somewhat important if rates have improved since you locked.

Most lenders offer different options for lock periods: 15, 30, 45, or 60 days are the standard while 90 and 120 days but those usually require a deposit. Most believe that with TRID approaching in early October that the 30-day rate locks will become rare. But with each longer period that we lock the price of the loan is incrementally higher, i.e., a 15 day lock may cost 1.25 points, the 30 day lock 1.375 points, etc.

If a transaction is at the lock deadline date and the parties are not able to fund the loan, then the lender will have to extend the rate lock to retain it. At that point it depends on the market if there will be an additional fee to extend the rate or not. This is where the importance of the rate lock deadline comes in. If the market has improved, many lenders, in order to remain competitive, often get a short term extension at no cost. If the market has remained the same then a very short time extension at no cost may be possible depending on the loan amount, type of loan, if loan docs are out and signed and how many days are required.

Often, even if the market is the same, a fee to extend is still required. While it may seem obvious, what borrowers don’t want is for the market to worsen and to need an extension; there will most certainly be a fee associated with the extension. For OB clients generally the cost is more expensive to extend a loan after it is locked than it would have been to pay for the longer lock period up front.

For example if a borrower has a $400,000 loan that is at 80% loan to value and could have locked on May 15th for 1.375 points for 45 days, but instead locked it for 30 days at 1.25 points, and here we are on Friday June 12th and we are not ready to close yet because the buyers of the home do not yet have loan approval, and the lender needs the equity from the current home to close, then the lender cannot fund on Monday June 15th when the lock expires. Continuing, today the rate for the same loan is considerably higher than it was on May 15th by 0.25%. It looks like the OB client needs 10 more days to get the buyers’ loan approval, their loan docs, and then fund both loans. This lock extension in the current market will probably cost the borrower 0.25 points, or $1,000 on a $400,000 loan.

Had they locked the loan for 45 days at the beginning of the transaction the cost up front would have been only 0.125 points, $500, more than the lock the borrower decided they needed. People will then ask, “What if I let my rate expire and rates improve?” You will not get the rate improvement unless a significant time as elapsed, usually 90 days or more. Essentially, buying the longer loan lock is insurance to not go over.

Optimal Blue clients, and anyone in residential lending, have had their fill of government. Unfortunately election season is officially upon us – it seems to become longer and longer. Regardless of your views of President Obama, it is almost time to elect a new leader. But how does the election process work, and why should lenders care?

Think back to your class in government in high school. The highly advanced Electoral College anyone? The election process was born in 1788 from indecision between letting a popular vote decide the president and letting Congress make the decision (glad that didn’t happen… Federal Government shut down of 2013 anyone?). The two sides eventually formed the Electoral College.

Now, let’s get down to business by breaking down the different parts of the election process. The primary process: The primaries decide who is going to represent the two major parties in the Presidential Election. It’s all about money and support, and some of the candidates actually discussing things like Dodd-Frank, the CFPB, and housing issues.

A candidate starts by forming an exploratory committee to determine if a critical mass of support and the necessary funds needed for a presidential campaign can be raised. Coinciding with a candidate’s exploratory committee are fundraising organizations, known as Political Action Committees (PACs) which help raise funds to promote actual campaigning.

Before the presidential debates, there are primary debates in which the primary candidates of each party debate others in the same party. The primary voting (caucus) follows, and the date varies by state. Some states are in January; some are in June so most candidates try to strategically campaign in the early caucus states to build momentum. If candidates don’t get wins/good showings in the early caucuses, they will start to lose money and have to exit the race (and they usually start to endorse another candidate in their party so they “stay” in the race). The Democrats and Republicans eventually decide who is going to represent them in the general election. When a representative from each party is chosen, the most important part of the process comes: red, white and blue balloons fall from the ceiling in celebration!

Now comes the final hoorah: the general election. There are the Presidential debates in which the representatives square off to tell the country their plans for the future, aka telling America what they want to hear and maybe, probably not doing it. Housing and job issues are typically of paramount importance. For example, OB clients know that each client will have a different idea about Freddie Mac and Fannie Mae.

Eventually, in November of 2016, will be the voting. An interesting demographic to note is the change in voter age and race since 1984. The age of voters was evenly split among the 3 age brackets in 1984 and now is a large majority voter’s aged 55+. The race of voters has changed from 87% white to 76% white.

The first part of voting is the popular vote in which all of the votes from every person are tallied up to see who got the most votes. One would think that would decide who the president is but they would be wrong. All of these votes go into the Electoral College, which seems to work unless you’re Al Gore – then you hate the system. The Electoral College is essentially a winner take all system for states. The candidate with the most votes in each state gets all of the Electoral Votes for that state (except Maine and Nebraska). The number of Congress seats in each state determines the number of Electoral Votes for each state.

Through the entire process housing, and therefore lending, will act as a lightning rod for comments and speeches. Generally politicians know little about how the lending process works, what a warehouse bank does, or the different between a broker and a banker. But OB clients and everyone else will have to endure the race.

In January of last year the residential lending world was divided into two pieces: QM and non-QM. Although Qualified Mortgages held the position as the leader, many thought that non-QM loans would accounts for hundreds of billions in originations. Instead, we find that non-QM lending is limping along, and that QM loans still rule for Optimal Blue clients as well as most lenders. What happened?

Starting a new program is not as simple as throwing a switch. Lenders are still very concerned with potential litigation risk down the road. Certainly anyone can sue anyone else at any time, for whatever reason. But many lenders still hesitate to offer a product that is still, and mistakenly, confused with subprime. There is “performance risk” – are these loans going to perform poorly compared to QM loans? What will early defaults be like? And lastly there’s “reputational risk.” Many lenders have made fine names for themselves in originating QM loans, and don’t want to “mess it up” by becoming known as a non-QM lender.

That being said, other lenders believe that the future is in non-QM lending. Many minorities, the source of new home ownership, are seen as falling into non-QM programs. The risk culture of a lender may lend itself to non-QM programs, as might the “credit culture” of a given lender. These lenders may be more inclined to view (in order) LTV, FICO, and DTI as drivers of loan performance.

Light was shed on the QM versus non-QM topic last week when the Government Accountability Office (GAO) released a report examining the effects of the CFPB‘s regulations establishing standards for qualified mortgage (QM) loans and the final qualified residential mortgage (QRM) rule jointly issued by six agencies. The GAO found that these regulations would have “limited initial effects” because recent loans already largely conformed to criteria set forth by the QM rule.

“Mortgage Reforms: Actions Needed to Help Assess Effects of New Regulations,” was conducted by the GAO at the request of Congress amid concerns that risky mortgage products and poor underwriting standards were contributing factors to the housing crisis of 2008. Unfortunately for any politician who wants to encourage home ownership, these QM criteria have also helped contribute to a decline in home ownership percentage.

Optimal Blue clients know that QM regulations address lenders’ responsibilities to determine a borrower’s ability to repay a loan and include prohibitions on risky loan features, such as interest only or balloon payment, and limits on points and fees, according to GAO. QRMs are securities that are collateralized exclusively by residential mortgages, and they are exempt from risk retention requirements. According to GAO, securities collateralized solely by QM loans are also exempt from risk retention requirements.

And don’t forget: the QRM rule is scheduled to go into effect in December 2015. GAO’s report estimated limited effects of these regulations on availability of mortgages for most borrowers. The report also found that litigation and compliance issues would be at the root of most cost increases for borrowers, lenders, and investors. The QRM regulations were not expected to have a significant initial effect on availability or securitization of mortgages, according to agency officials and observers, because QM loans were expected to comprise the majority of loans originated. GAO stated, however, that the size and viability of the secondary market for non-QRM-backed securities remained in question.

The GAO recommended that “CFPB, HUD, and the six agencies responsible for the QRM regulations should complete plans to review the QM and QRM regulations, including identifying specific metrics, baselines, and analytical methods. CFPB, HUD, and one QRM agency—the Federal Deposit Insurance Corporation—concurred or agreed with the recommendations. The other QRM agencies did not explicitly agree with the recommendations, but outlined ongoing efforts to plan their reviews.”

Thus we find that non-QM lending is a work in progress, and will continue to be subject to debate.

For months the markets seem to have been focused on the debt problems of Greece, and on whether or not the European Economic Union would survive. Sure enough, the parties involved came to an agreement. And whether or not it is merely kicking the proverbial can down the road, the problems have been removed from the headlines.

So now what? It seems that in the last week or two we’ve begun focusing on what is happening in this country again. More specifically, what the Federal Reserve Open Market Committee is up to. After all, the austere group meets this week. The Fed Funds rate has been camped between 0 and 0.25 percent since 2008. Many in residential lending have never seen it higher. And top Fed officials, including Chair Janet Yellen, have telegraphed for months that they expect to finally raise it by the end of the year.

It would stun the markets if an increase came this week, so what about September? Analysts say the most likely way is for the central bank to raise its target rate in September. But there is a contingent that has argued for “liftoff” in December or later. But they are not mutually exclusive: the Fed could raise its target rate in September and leave it unchanged for the rest of the year, or the Fed could raise rates a second time in December and still average a 0.35 percent fed funds rate for the quarter.

The central bank has stated it believes the increase in the fed funds rate to more normal levels will be gradual – but that is pretty subjective. And it isn’t shocking news to anyone that the changes are based on data as the economy changes, and then it comes down to how the economy actually performs compared to expectations and official projections. Inflation, for example, is not expected to hit the Fed’s target of 2 percent until 2020 – but we see housing and minimum wages going up all the time around the country. Forecasts from Fed officials are based on what they believe should happen, but other forecasts are based on what is most likely happen – and there is a difference.

And once again we remind Optimal Blue readers that there is little direct correlation between Fed Funds and mortgage rates. Yes, they are influenced by many of the same factors. Generally, an expanding economy causes the demand for capital to increase, and supply and demand dictates that rates would increase as a result. But overnight Fed Funds’ rates are set by the FOMC.

So what about mortgage rates? They are still being helped by the Federal Reserve buying billions every week of agency MBS. This, combined by demand from banks, insurance companies, money managers, and the like, lead to the general supply & demand trend being in balance. Specifically on the Ginnie Mae security side of the market, it also doesn’t hurt that we’re now several months removed from the Mortgage Insurance change and compensating interest change. And lenders are going through their loan level price adjustment (LLPA) changes and removing the adverse market fee that we’ve had for years.

So experts believe, with good reason, that mortgage rates would be higher if the Federal Reserve was not weighing on the demand side of the equation. True. But the fact of the matter is that they are, and will be for the foreseeable future. And the MBA just ratcheted up its 2015 volume estimates… something must be working!

Well, the Greek issue is settled, right? Maybe the better claim is that Greece is out of the headlines…for now. There are certainly many experts who think that the deal reached over the weekend is merely kicking the proverbial can down the road. Certainly the deal has stocks rallying everywhere, but let’s take a look at how the announcement impacts the bond markets, interest rates, and thus Optimal Blue’s clients.

Early Monday morning the European Union leadership formally announced the achievement of a EU80B debt deal with Greece. The arrangement has strict conditionality, and Greece will be required to pass through its parliament a series of reforms by Wednesday (July 15) before substantive negotiations can even begin. Tsipras wound up “caving in” on nearly every demand of the EU leadership, including the creation of a EU50B trust fund into which Greek state assets earmarked for sale will be placed (this fund, thought of as an escrow account, will be beyond the control of the Athens government).

The one concession granted to Tsipras concerned Greece’s debt. The Prime Minister secured a stronger commitment by creditors to restructure the country’s massive debt load. While the Greek political climate is more amenable to compromising with the rest of Europe (since Prime Minister Tsipras is now presiding over a quasi-unity government), the country’s financial outlook is even bleaker than before. In fact one senior EU official calculated the cost to the Greek state of the last two weeks of political and economic turmoil at EU25-30B.

There will probably be two Greek deals: an interim (1-3 month) one would help it cure the International Monetary Fund arrears and make the upcoming ECB payments (the first of which hits 7/20). A second deal needs to be put in place that will last 2-3 years.

Greece will achieve more debt relief – and has critics saying that this is merely kicking the can down the road. The net present value of the country’s debt load will most likely be reduced again. OB clients can think of it as a loan modification and principal reduction, should it happen as expected.

Unfortunately for anyone with money in a Greek bank, the Greek banking system has suffered irreparable damage and a best case outcome will probably see a wave of recapitalizations and consolidation. Greece will still be subject to strict auditing by the troika and as a result any slippage (either in economic growth or the pace of reform implementation) could result in financing being withheld again.

So Greece will have capital controls that will probably stay in place. The Greek shipping industry is nervous about the new tax proposals since higher taxes (in theory) could drive that industry out of Greece. Greeks may not be able to retire at such a young age, and pensioners will probably be impacted – but it merely moves them closer to practices carried out in much of the rest of Europe (and the U.S.).

Given that Greece has the economic size of Indiana or Michigan, the Greek saga never inflicted substantial damage on growth or financial markets. It is almost as if the press had little else to talk about: conjecturing about the “what if’s”! And so the U.S. bond market can switch its focus from Greece and the Eurozone to the Fed’s outlook on raising interest rates later this year. Thus the “flight to quality” bid is removed from our markets. And if there is indeed economic peace in Europe, we’ll either focus on China’s problems or our own economy – stay tuned!

Optimal Blue clients know that without a secondary market for the mortgages they originate, things become grim very quickly. Mortgage banks borrow money from others (warehouse lines) to fund a loan and pay them back when the loan is sold – to an investor. Yes, banks put some loans into their portfolios – but not all of them. There is no way a company like Wells Fargo or Chase could put every loan they originate onto their own books. So yes, selling loans into the secondary markets where they usually end up being put into securities is a fact of life for residential lenders.

A lot of attention is focused on Greece, but let’s not forget that a couple weeks ago Barclays Plc announced that it is ending trading in $700 billion of U.S. mortgage bonds that were issued before the financial crisis, the latest move by global banks that are adapting to new regulations. Barclays will no longer regularly buy and sell these particular residential securities, which lack government backing, in an effort to refine its strategy meant to improve the return on equity.

One of the issues causing the change is the shift to adjust to rules introduced after the financial crisis that were intended to curb the risks of another meltdown, including demands from regulators for larger capital buffers. And these non-government loans are required by various regulators in various countries to have more capital. And given that most of the debt has been cut to speculative- grade levels, U.K. regulators now require banks including Barclays to hold even more capital against such junk-rated securities relative to other bonds. Barclays is not the first. Royal Bank of Scotland Group Plc’s investment bank said in November that it would completely exit the U.S. mortgage market.

So will this spillover into our market? For U.S. banks, ratings on mortgage bonds have become less crucial since lenders can use an alternative approach to calculating capital requirements that ignores the grades and in many cases reduces the amount needed for junk-rated mortgage bonds that are trading at discounts. On the supply side issuance has dropped as companies either aren’t originating the product or banks are squirreling it away in their portfolios. Some recent Chase figures showed that more than $700 billion of pre-crisis debt remains outstanding.

The margins are certainly good, but there are reasons. For example, the securities can be more expensive to trade than other debt, requiring work such as tracking potential legal settlements and using models to assess future loan performance. Supply and demand often go in fits and starts, and the lack of government backing causes investors to demand more yield.

On the jumbo side of things, there are many who believe that, when eventually they come along, higher rates will tighten spreads between jumbos and treasuries. But volumes should decrease too. And that perhaps hybrid jumbo production will increase. But the lending market continues bear the brunt of the high percentage of all cash buyers accounting for 30-40% of some markets. For some paying all cash is required to have an offer accepted, others believe that the return on their money is better in real estate than in a bank. And for others it is just “too much hassle” to obtain financing.

Every Capital Markets person in the last month has mentioned “Greece” during a meeting. And they are probably sick of talking about the country and the situation. But it is relevant to our markets and therefore Optimal Blue’s clients, so let’s take a look.

Greece: a great vacation destination due to cheap prices from a plunging economy. However, from a business standpoint, the high-stakes Greece debt crisis is the biggest worry there is to global investors. The crisis in Greece is overshadowing what usually would be on everybody’s mind: the June Job report and what it means for the Federal Reserve’s interest rate hike plans.

Instead, global investors everywhere are worrying about Greece and its creditors having not yet reached an agreement regarding the terms under which the final €7.2 billion tranche of the country’s current bailout program will be released. The question that needs to be answered: Greece did not reach an agreement by its June 30th deadline to pay back the IMF. So will it be forced to leave the Eurozone? This has already affected the banks in Greece; the European Central Bank said it wouldn’t increase its cash lifeline to Greek Banks, which will force the banks in Greece to be closed Monday. But, how will this affect the US?

Short term, stocks and bonds are likely to be volatile. We have certainly seen that. And it will affect the European economic outlook and global financial markets that will have a spillover effect in the United States.

How can a little country like Greece who has no real connection to the US other than vegetable trading, affect our stocks? The worry is that Greece heading towards default will prove contagious, which could affect the markets in Europe, which in turn affects us. However, while this is a large tragedy for Greece, there is no reason for widespread panic; it won’t affect US stocks as much as everyone fears.

With such a large debt at stake, however – $1.8 billion- if Greece is declared in default, creditors will have to deal with it and that will place a large amount of uncertainty. The big money repositioning itself will create the big moves. Bonds, which are safe investments in countries not directly exposed to the problem rose in prices. The bottom line with the stock market though is that the crisis in Greece will disrupt the stability of the market. A negative global outlook can have negative effects on our market and with this much uncertainty in the air it is hard to predict how large of an affect it will have.

If the Greek crisis is prolonged, a flight-to-safety in U.S. Treasury bonds could bolster the dollar, crimping exports and economic growth. This is bad timing because the Federal Reserve needs to see a positive outlook in the US economy for them to consider an interest rate hike. This was proven when Federal Reserve chair Janet Yellen said, “I do see the potential for disruptions that could affect the European economic outlook and global financial markets,” she said. “To the extent that there are impacts on the euro-area economy or on global financial markets, there would undoubtedly be spillovers to the United States that would affect our outlook as well.”

The situation in Greece, while it may not directly impact the US, is not something we can ignore. Greece seems poised for a likely default or exit from the European Union, which, either way there will be global ramifications which will impact the US financial markets and exports. With the US having continued growth, now is not the time to ignore the situation in Greece with the looming interest rate hike and to sustain growth.

Most hedging companies, and their clients, as well as lenders who hedge their own rate-lock pipelines do not use Treasury securities to hedge. After all, who wants to explain basis risk to their CFO or CEO when it moves against them? But some companies use Treasury hedges to some extent, and certainly movements in mortgage rates and prices are pegged to U.S. government securities. So sometimes OB clients wonder what has been happening there.

Certainly the difference between MBS and Treasury security movements is due in part to supply and demand. During the past week, 30-year production coupon passthroughs were in line with their Treasury hedges. The industry originates about $3-4 billion a day and the Fed buys $1-1.5 billion a day, (Remember – the MBA expects the industry to originate about $1.2 trillion this year over 250 business days.) Some analysts think that one important consequence of the dovish outcome from the June FOMC meeting is that the likelihood of the Fed ending or even tapering its pay-down reinvestments before June 2016 has decreased significantly. Thus, it appears likely that the range-bound movements of MBS spreads seen over the past few quarters will continue in the second half of 2015 as well.

Although the FOMC made no changes to monetary policy last week, many think it presented a more pessimistic outlook for 2015 than was expected. Are the Fed Governors turning skeptical about the economy’s prospects for growth despite the recent improvement in some key economic data? Perhaps – this skepticism may be reflected in the FOMC’s interest rate forecasts. In her press conference, Chair Yellen stressed that most of the Committee still expects to raise short-term rates later this year, but now almost half of the FOMC participants expect only one (or zero) hike this year.

Returning to the influence of supply and demand on the spread, agency MBS spreads have held up extremely well, even as the Fed had first tapered its MBS purchases and then ended the QE 3 program altogether last October. During 1H’15, MBS spreads have widened by 10-11bp in January but tightened back and have been trading in a narrow range since then. The shape of the yield curve has changed materially over the past 18 months, however, so the actual material change is somewhat subjective.

So where is the “equilibrium level” of MBS spreads? If the Fed continues its pace of buying securities, this debate will have to be revisited next year. It appears likely that the range-bound movements of MBS spreads seen over the past few quarters will continue in 2H’15. This is actually good news for any OB clients that use Treasury securities to some degree.

Good news for mortgage pricing is that demand for MBS from domestic banks and overseas investors turned out to be a lot stronger than expected in 1H’15. If this source of demand continues in 2H’15, it will be very difficult for MBS spreads to widen, therefore helping pricing

Agency MBS in the retained portfolios of the GSEs declined by about $60 billion during the reference period, but they are likely to decline by only about $30 billion in 2H’15. In addition, the Treasury sold about $25bn agency MBS during the reference period, but it is not involved in the market now.

But all is not rosy. Assuming that the 10-year Treasury yield remains above 2.30% for the remainder of this month, estimates peg paydowns on the Fed’s portfolio in July to decline to about $20bn. Thus, the Fed’s reinvestment needs will decline to only $20bn per month by early August (versus the $30-35bn range recently). While MBS spreads should benefit from the timing mismatch between the Fed’s reinvestments and originator selling over the next few weeks, the situation will change for the worse in early August.

Due to the time of year, the net supply of agency MBS is likely to be $15-20bn per month over the next three months. The net supply of agency MBS from organic growth is likely to be around $45-60bn in 2H’15 versus $20bn during the reference period. And GSEs are likely to reduce their agency MBS holdings by $30bn between now and the end of the year because of the new (additional) 90% cap on their retained portfolios suggested by the FHFA.

No one can predict the future, but it doesn’t look too bad for agency MBS prices versus those of Treasury securities.

When the market has been volatile, as it has been for the last month or so, Capital Markets and lock desk personnel are inevitably asked, “How important is the lock expiration date?” Often this question comes from newer LOs, but it is good for Optimal Blue clients to remind everyone in the “food chain” of a loan about the importance of time. And to remind them that rate & price locks are unheard of in most businesses.

A lock expiration date is important if rates have stayed the same since you locked in your rate and terms. The secondary marketing group has planned on that loan funding by a given day, and often times will have committed that loan to an investor – even if it is the bank’s portfolio department. And the expiration date is extremely important if rates have climbed since an LO locked, and somewhat important if rates have improved since they locked.

Most lenders insist that certain minimums be met in order to lock in a rate. Many require the following: a) to know the borrower is approvable for the loan desired, b) the loan amount, c) the sales price, d) the property address, and e) estimated closing date. With this information the originator can obtain an accurate quote for based on the borrower’s credit score, loan amount, loan to value, and the length of time the OB client needs to lock in the rate.

Most in the business know that lenders have the option of locking in a rate and price for a specific period of time, 15, 30, 45, or 60 days. Some offer extended rate locks for longer periods but many lenders require a deposit for borrowers to lock for 90 or 120 days, or perhaps even longer. With each longer period that the lender locks the price of the loan is incrementally higher/worse, i.e. a 15 day lock may cost 1.25 points, the 30 day lock 1.375 points, etc. The reason for this is that, basically, a dollar is worth more to you (or anyone) now than it is at some future date.

If the lender is at its lock deadline and is not able to fund the loan then the lender has to extend the rate lock to retain it. At that point it usually depends on the market if there will be an additional fee to extend the rate or not. Capital markets departments see a common occurrence of LOs trying to game the system by locking a loan in for 30 days, at the better price, in spite of knowing it will take 45 days to fund the loan.

If the market has improved LOs can sometimes receive a short term extension at no cost. If it has improved dramatically they may be able to “float down” the rate, specific terms and conditions apply to do this however.

If the market is the pretty much the same as it was when the loan was locked loan officers may be able to negotiate a very short time extension with the lender at no fee. This has many variables however depending on loan amount, type of loan, if loan docs are out and signed and how many days are required. Sometimes, however, even if the market is the same the circumstances will require a fee to extend the rate lock period.

If the market has worsened and rates are higher and we need to extend the rate then there most certainly will be a fee associated with the extension of the rate lock—and generally the cost is more expensive to extend a loan after it is locked than it would have been to pay for the longer lock period up front.

Uh oh. Rates have moved higher. Everyone in the world knows that commodity prices fluctuate, as do stocks and bonds. Rates have been moving higher, gradually, for several months. And although there are still those that think rates should be lower, they are what they are.

When rates began to rise Optimal Blue clients watched savvy investors use valuation as their guiding light, and they paid attention to how central banks are reacting. Interestingly enough, valuations remain demanding and central banks have yet to show much concern about recent moves. But some investors are trimming back on mortgage-backed securities ahead of more volatility – why?

The odds favor a change in short term rates later this year (probably not this month). It will be the first time in roughly a decade that rates have been moved higher. Investors who focus on agency mortgage-backed securities are especially concerned about what policy makers do after liftoff: the unwinding of the Fed’s balance sheet, including its $1.72 trillion in MBS – about a year’s worth of production. And as the Fed reduces its $4.5 trillion portfolio, MBS investors can expect a double dose of volatility as soon as the end of this year. The Fed holds about 20 percent of marketable U.S. Treasuries and about 30 percent of the agency fixed-rate MBS market. Since mortgage securities trade at a spread over Treasuries, their yields will get bumped twice as the Fed reduces its balance sheet.

We can expect rate sheets to show it: homebuyers will face higher mortgage rates. But nothing is certain. Policy makers said they will lift rates in 2015 if unemployment continues to fall and inflation shows signs of rising toward their 2 percent target. And who can say with certainty if and when those things will happen? After an initial rate hike it is thought that the Fed will eventually begin reducing their balance sheet by no longer reinvesting in Treasuries and MBS (to the current tune of $1-1.5 billion a day).

Remember that short term rates are set by the Federal Reserve whereas long term rates are purely set by supply and demand. Shortly before lowering short-term rates to near zero late in 2008, the Fed began using bond purchases to press down longer-term yields in a bid to further stimulate the economy. The quantitative easing (QE) ended in October 2014. And yes, the economy was stimulated, but wage growth has been missing. And if rates creep higher and wages don’t, well…OB clients know what that means.

Unfortunately mortgage-backed security prices have not done well relative to Treasury prices in recent weeks. Put another way, the mortgage basis took a beating as realized rates volatility picked up again. But current rate levels are supportive for demand from domestic and overseas yield-based investors and a steeper curve supports CMO (collateral mortgage obligation) based demand for MBS. The supply for agency MBS should also drop significantly as the refinancing activity has collapsed and the peak for purchase apps are behind us. And this will counteract some of the rate move.

In the last few weeks we’ve been reminded that, other things being equal, our bond markets and interest rates are greatly influenced by what happens overseas. To the extent that Greece makes progress in righting its financial ship, our rates will creep higher. But if there is uncertainty and drama, we can all look for a continued flight to quality keeping our rates in check.

Residential lenders, including both banks and mortgage banks, tend to be a nervous lot. This is easily understandable. Just like farmers, who usually have too much rain or not enough, or are dealing with fewer crops when prices are good or an abundance of crops when prices are down, Optimal Blue clients have plenty of concerns. Some of these can be managed while others cannot.

One concern which is entirely out of the industry’s hands is the state of the economy, and therefore rates. In the last few weeks rates have slid higher as the economy is showing signs of picking up, and it is a good idea for OB clients to know why rates have crept up.

Last week’s holiday-shortened week saw first quarter GDP revised down minus .7 percent compared with an initial reading of plus 0.2 percent. A bigger negative contribution from net exports was one of the factors behind the revised contraction. However, the economy is expected to improve in the second quarter because of better than expected economic data for the second quarter months. Yet many lenders, including OB clients, continue to question the numbers: they just aren’t seeing the economy rolling along.

Last week, all major indices finished in the red due to mixed economic indicators. The S&P closed at 2,107 while the Dow ended the trading week at 18,010. In major economic indicators released last week, Durable Goods Orders were down for the month of April but Goods ex transportation were up. Strength in nondefense capital goods excluding aircraft reflects strength in business investment which has been soft of late. The housing sector saw some good news last week. For the month of April, New Home Sales came up strong at 517,000, up 6.8 percent. Pending Home Sales jumped a much higher than expected 3.4 percent in April following a revised 1.2 percent gain in March. Also, for the month of March, the FHFA house price index rose a lower than expected, 0.3 percent.

But overall, it looks like the recovery in the housing market is finally getting some traction. Once again, however, OB clients in various parts of the nation are seeing different stories. In urban areas there is no inventory. In the suburbs there is more inventory, but things are slow in many areas.

Moving on to the bond markets last week, Treasuries saw some demand due to mixed economic data, some weakness in equity markets, and uncertainty over Greece’s debt negotiations. At the end of the week the 10-year note settled at 2.12 percent down 9 bps from the previous week. Towing the same line, conforming mortgages rates also loosened up a bit. At the end of the week the Conforming Fixed 30-year rate leveled out at around 3.67 percent, while the Conforming Fixed 15-year rate finished at around 2.90 percent.

This week, investors are already busy tracking the latest developments on the Greek debt situation as well as digesting a busy economic calendar. We did have a spate of news upon which to chew Monday – most of it showing that the economy continues to book along and thus nudge rates higher. We learned that Personal Income was +.4% in April while spending was flat. PCE, a measure of inflation, rose 0.1% over the prior month and 1.2% over the prior year on a “core” basis. Construction Spending was +2.2% in April, creeping above $1 trillion – up about 5% versus a year ago. ISM Manufacturing showed that economic activity in the manufacturing sector expanded in May for the 29th consecutive month, and the overall economy grew for the 72nd consecutive month. And when you combine all that with a glob of $25-30 billion in corporate debt supply hitting the market, well, rates went up.

We will have the Employment Report on Friday – something that the press always focuses upon. Overall it seems the economy is doing okay – but time will tell, of course.

The old saying is that “no tree grows to the moon.” Anyone renting, or hoping to purchase their first house, is hoping that adage is true sooner than later. Most indices show that home prices keep rising, but sharply declining homeownership means less and less households are benefitting. And the divergence highlights the transmission challenges faced by the Fed and why hiking rates is necessary, but hard to justify. And what does it mean for Optimal Blue clients?

So home prices and rents are up, and homeownership is down. Most of OB’s lender clients agree that not everyone deserves to borrow money and/or own a home. Home prices and rents keep rising, but sharply declining homeownership means less and less households are benefitting and more and more households are being priced out of homeownership and forced to pay higher rents. Similarly, home prices are up by 25% from the bottom in December 2011, while personal income has only grown by 13%. In the past (think housing bubble/crisis), large divergences between home price growth and income growth had disastrous consequences. And OB clients and the industry certainly don’t want that.

At the moment most experts don’t think that disaster is looming, but the divergence is at least cause for concern, particularly for the Fed, who has pursued an asset/real estate inflation policy for the past six years. The Fed may feel compelled to rein in home price inflation but, at the same time, acknowledge 1Q GDP was a bust for more than just transitory reasons and take note, at least tacitly, that the economic surprise index is hovering at the lowest levels since mid-2012, just before QE3 was rolled out.

Rising home prices have the positive effect of increasing household wealth, but the higher prices also have the negative effects of creating affordability problems and putting housing out of reach for a larger share of households. And so LOs are seeing that the declining rate of homeownership means that less and less households are benefitting from the post-crisis rise in home prices. Moreover, the combination of higher home prices and declining homeownership is driving up rents for those boxed out of homeownership. Read: Millennials in urban areas like San Francisco, Denver, and Seattle.

Home prices have certainly been helped by lower rates. The Case Shiller national home price index was up 4.2% year over year and is now up 25% from the low in December 2011. Over the same timeframe the Census Bureau reports that median asking rents are up by 12%. Meanwhile, the homeownership rate continued its sharp decline, dropping to 63.7% in 1Q 2015 – the lowest rate since 1988. Someone needs to tell Bill Clinton! Since the low in home prices in December 2011, the homeownership rate has dropped by 2.3% on an absolute basis.

The divergence between the two since December 2011 is striking. In the pre-crisis era, when credit flowed freely, rising homeownership was followed by rising home prices, which in turn was followed by more increases in homeownership. We all know how that story ended. In the post-crisis era, where credit is tight, the feedback loop has been eliminated. Rather than fueling homeownership, rising home prices are having the opposite effect: reducing affordability and forcing households out of the ranks of homeownership.

So many experts are predicting something has to change: rent increases will stop, housing prices will drop, or incomes will catch up. Each one will impact the economy in different ways, and each one has different implications for OB’s client’s business models.

Capital Markets staffs at Optimal Blue clients are sometimes asked, “Why are there different securities for Fannie loans versus Freddie loans? And while we’re talking about this, why have different mortgage-backed securities for all the different programs – couldn’t they be combined into one MBS?” That is a legitimate question, and in fact the agency that oversees Freddie and Fannie – the FHFA – is moving in exactly that direction. And it is a good thing.

The FHFA released its Progress Report on the development of the single GSE (government sponsored enterprise) security detailing the progress made since FHFA requested comment on the effort last year. All parties involved know that this is a multi-year project with lots of moving parts involving both the primary markets (differences in DU and LP, differences in documentation and credit quality, and so on) and in the secondary markets (reps & warrants, payment processing, handling delinquencies, investor reporting).

Progress is being made. It has been determined that each Enterprise (read: Fannie & Freddie) will issue and guarantee first-level Single Securities backed by mortgage loans that the Enterprise has acquired. The Enterprises will not cross-guarantee each other’s first-level securities. And the Federal Home Loan Banks will not be an eligible issuer of Single Securities.

The key features of the new Single Security will be the same as those of the current Fannie Mae Mortgage-Backed Security (MBS), including a payment delay of 55 days. And these First-level Single Securities will finance fixed-rate mortgage loans now eligible for financing through the “To-Be-Announced” (TBA) market, and this includes Multiple-Lender pools. Lenders will continue to be able to contribute mortgage loans to multiple-lender pools. The loan- and security-level disclosures for Single Securities will closely resemble those of Freddie Mac PCs.

Each Enterprise will be able to issue second-level Single Securities (re-securitizations) backed by first- or second-level securities issued by either Enterprise. The report reads that, “In order for a legacy Freddie Mac Participation Certificate (PC) to be re-securitized, the investor would have to first exchange the PC for a Single Security issued by Freddie Mac, so that the payment date of all of the securities in the collateral pool backing the re-securitization would be the same. To clarify the counterparty risk posed by commingled re-securitizations, this Update provides an analysis of the counterparty risk exposure of investors under the Enterprises’ current securitization programs and the Single Security.”

What about when loans go bad? There isn’t much change. “Current Enterprise policies and practices related to the removal of mortgage loans from securities (buyouts) are substantially aligned today and will be generally similar and aligned for purposes of the Single Security.”

All in all there are sixty pages of updates, and as was mentioned at the beginning of this write up it will take years to sort through. One of the goals is to continue to make progress with issuing a single security while at the same time minimizing market disruption. For example, no one wants an investor – let’s say a bank in Japan – to have paid a certain price for a U.S. MBS only to have it plummet in price due to a change in its structure.

As a reminder, the goal of the single security project is to increase secondary market liquidity by allowing the GSE securities to be fungible for purposes of TBA delivery. Hopefully a single mortgage-backed security (versus F&F issuing separate bonds as they have always done) by both firms could reduce homeowners’ borrowing costs. And wouldn’t that be nice to be able to say.

Optimal Blue clients know that without an investor for securities backed by mortgages, or the mortgages themselves, there would be no demand for that asset. And if there was no demand in the secondary markets then there would little reason for a lender to offer a program to borrowers. And so lenders are keenly aware of changes to agency guidelines for products, both from Fannie & Freddie but also from the FHA & VA. They don’t provide a secondary market for the loans, but their programs do dictate the characteristics of the loans entering the pools.

So it is good to remind our clients of some upcoming changes: the FHA is changing some of its underwriting guidelines effective June 15th (applicable to loans with case numbers assigned on or after that date). Some of the changes are favorable and some are less favorable. Those in the primary market (LOs, processors, and underwriters) know about them, and it is important for others as well since they will change the loan characteristics.

Let’s start with “deferred obligations.” Under the current rule, loans deferred more than 12 months from closing do not have to be counted in the DTI ratios. Under the new rule, which most view as unfavorable, all deferred obligations, regardless of when they will begin must be included in the qualifying ratios. The lender must obtain evidence of the deferral, the outstanding balance, the terms of liability and the anticipated monthly payment. If the actual monthly payment is not available for installment debt the lender must utilize the terms of the debt or 5 percent of the outstanding balance to establish the monthly payment. For student loans, if the actual monthly payment is zero or is not available, the lender must utilize 2 percent of the outstanding balance to establish the monthly payment (this change for student loans will bring FHA’s guidelines on par with conventional loans).

Another change – mostly favorable – is for installment debt. Under the current rule, installment debts lasting less than 10 months must be included in the amount of the debt and will affect the borrower’s ability to pay the mortgage during the months immediately after loan closing, especially if the borrower will have limited or no cash assets after loan closing. In the new rule that goes into effect next month, closed-end debts do not have to be included if they will be paid off within 10 months if, cumulative payments of all such debts are less than or equal to 5 percent of the borrower’s gross monthly income. The borrower may not pay down the balance in order to meet the 10 month requirement. Of course the “work around” is to pay the car down before the credit report is pulled.

Moving on to revolving debt, under the current rules if the credit report shows any outstanding balance, but no specific minimum payment, the payment must be calculated as the greater of 5 percent or $10.00. Under the changed rules – also viewed as favorable – lenders are focused on the section that deals with 30 day accounts (like American Express that has to be paid off monthly). Thirty day accounts that are paid monthly are not included in the DTI, if the credit report reflects any late payments in the last 12 months, utilize 5 percent of the outstanding balance as the borrower’s monthly debt to be included in the DTI. The lender must use the balance on the account monthly for the previous 12 months and document the balance. Additionally, the lender must document sufficient funds are available to pay off the balance as well as meet reserve requirements and funds needed to close the loan.

We realize that this is a little “in the weeds”, but it is important for our clients to see the trends in agency production – especially when they impact both the primary and secondary markets.

What the heck is “CRT”? Is it yet another acronym in a sea of acronyms that make up mortgage banking lingo? Well, it is an acronym, but it is important for Optimal Blue clients to know what it is, since the demand for securities backed by mortgages directly impacts rate sheet pricing and programs in the primary markets.

Back in 2013 Freddie Mac announced a new bond that sells off some of the default risk of its residential mortgage holdings to private investors willing to gamble on its pool of loans. This is something that the FHFA has been encouraging both Freddie and Fannie to do: share the risk on $30 billion each of their portfolios and try to bring more private capital into the markets.

The so-called “risk-sharing” residential mortgage-backed securities (RMBS) were marketed to investors. The Structured Agency Credit Risk (STACR) bonds sell some of the risk of future losses on pools of residential mortgages to investors. Those mortgages underlying the “stackers”, as the bonds have come to be known in the industry thanks to their acronym, were all originated in the third quarter of 2012.

“Freddie Mac Structured Agency Credit Risk (STACR) debt notes are unsecured and unguaranteed bonds issued by Freddie Mac whose principal payments are determined by the delinquency and principal payment experience on a STACR Reference Pool consisting of recently- acquired single family mortgages from a specified period. Freddie Mac transfers credit risk from the mortgages in the Reference Pool to credit investors who invest in the STACR debt notes. Freddie Mac makes periodic payments of principal and interest on the Notes, and is compensated through a reduction in note balances for defined credit events on the Reference Pool, based on a fixed severity approach.”

So generally speaking Freddie Mac, for example, holds the senior-most risk in the deal as well as the first-loss pieces. Even though Freddie Mac is currently government-run, it could take losses on the transaction. Some of the triggers potentially causing such losses include loans that become 180 or more days delinquent, or the occurrence of a short sale prior to the 180-day delinquency. The deals generally have a senior/subordinate structure, with principal paid pro-rata between senior and subordinate classes, meaning that all tranches receive their proportionate shares of principal payments during the life of the securities.

So how are things going? Freddie Mac recently upsized and issued its first actual loss CRT (credit risk transfer) deal. The deal was issued on seasoned collateral vs. other recent stepped severity deals. Prices on GSE CRT bonds have done well due to strong demand for the new issue actual loss deal.

What does all this mean? What investors will pay for these bonds, just like any other fixed income security, depends on several factors including the direction of rates, the chance of losing money, and the liquidity of the instrument. In the case of these securities that prices have done well for those very reasons. Houses are appreciating which limits losses from delinquencies and foreclosures, interest rates are steady, and as more bonds are issues we can expect the liquidity to only increase.

Investors are keenly interested in increasing their returns, and if these bonds are viewed as safe and liquid while at the same time offering a better yield than alternative fixed income bonds, then that is a good thing for the markets. And in turn for borrowers in general.

Optimal Blue clients know that rate sheet prices are basically composed of security prices, loan-level price adjustments, servicing values, and profit margins. So it of interest when any of those change much, and by choice, so folks took notice when the FHFA announced the completion of its review of the guarantee fees (G-Fees) charged by the GSEs. FHFA found “no economic reason” to alter the baseline G-Fee; however, it has ordered the removal of the 25bps Adverse Market Delivery Fee and the targeted adjustment of fees charged for certain loan types.

And so the comprehensive Fannie Mae and Freddie Mac guarantee fee review is finished, and it looks like not much is going to change. The 25 basis point adverse delivery fee is gone, but there are new fees imposed, so it looks to be more or less a wash. Borrowers with lower credit are going to pay slightly less, while high balance investment properties & cash-out refis will become slightly more expensive.

Borrowers with weaker credit will pay slightly lower fees, while most others will see prices remain the same. Certain riskier loans, such as those on investment properties, those over $417,000 and cash-out refinances will become incrementally more expensive. “The FHFA has determined that current fees, on average, are at an appropriate level,” the agency said in a statement. Even with the changes, fees on average remain about twice 2009 levels – and we all remember the increases under Ed DeMarco meant to crowd in private capital. Watt is repudiating, in some measure, that approach.

The companies will eliminate an “adverse market” fee of 25 basis points that they began charging all borrowers after the financial crisis. They’ll raise fees by the same amount for borrowers with credit scores above 700 and at least 20 percent equity in their homes, meaning the changes will be a wash. Borrowers with weaker credit or less equity won’t see an increase, so their payments will fall by 25 basis points. Mortgages over $417,000 will go up 25 basis points, and some higher-risk loans will increase 37.5 basis points.

The 25 basis point AMDC will be removed for all loans, but offset by 25bp increase for <80 LTV, >700 FICO loans, effectively leaving their LLPAs unchanged for those borrowers. This leaves only >80 LTV and <700 FICO borrowers with a 25bp reduction. Approximately 41% of conventional issuance falls under this criteria. The equivalent rate decrease for these borrowers is about 5 basis points. Investor, Jumbo, cashouts and those with secondary financing see their LLPAs increased 37.5bps (about 7bps rate equivalent increase). For TBA securities – used by plenty of Optimal Blue clients for hedging and delivery – the cheapest to deliver loans fall into the <80 LTV > 700 FICO bucket so there should be no impact. The market was pricing in a possibility of higher LLPA reductions so the announcement should be supportive of higher coupons.

For jumbo conforming product the 37.5bps LLPA increase stands to raise borrower costs by 7bps resulting in a 2-4 CPR decline in speeds. Model estimates indicate upside up to a quarter point, especially in 3.5s and 4s.

Analysts say that these changes reflect a highly market sensitive and gradualist regime at the FHFA, in contrast to broader market concerns about Watt’s new leadership. It appears that there are limited policy options to lower borrowing costs given lack of GSE capital. Starting in September there will be modestly higher borrowing costs for a handful of better-credit borrowers and modestly lower costs for marginal credit and leveraged borrowers. One thing it does, however, is remove uncertainty as to what may happen with Agency pricing – and that is a good thing.

Optimal Blue clients, and everyone else for that matter, have 3 ½ months left until August 1st, and at this point anyone and everyone in the residential lending business knows what that date signifies. Asking lenders what exactly is happening can result in a hodgepodge of information. So let’s take a step back and review the GFE and its purpose.

To better comprehend the upcoming TILA-RESPA Integrated Disclosure changes it’s important to understand the context of the Good Faith Estimate, which will be replaced by the new Loan Estimate in August. When a loan originator takes an application and prepares the Good Faith Estimate (GFE), lenders are required to disclose all fees to the applicant within 72 hours of an application in order to help consumers compare rates and fees among other lenders.

The lender is also bound by the quote in order to prevent any last minute changes to the price of the loan. The borrowers receive the fees in the form of a three page document called the Good Faith Estimate (GFE). The GFE is published by the Department of Housing and Urban Development (HUD) and outlines the closing costs and fees associated with a mortgage loan and is valid for ten days. Final loan costs must be within ten percent of the costs shown on the original GFE, so it has to be accurate.

The GFE includes a summary of the loan to include the loan amount, term of the loan and initial monthly payment. It also includes escrow account information, pro-rated annual property tax and homeowner’s insurance costs and the estimated loan costs, including lender fees, title fees and third-party costs.

Multiple dates are listed on the GFE since the terms do not last indefinitely. The GFE lists the number of days of the rate lock and the lender does not have to honor the rate if the loan does not close within the expected timeframe.

The subsequent section of the GFE is the summary of the loan and escrow account information. This section details whether or not the loan is a fixed-rate, adjustable-rate or balloon loan and includes the initial loan amount being borrowed, loan term designated in years, interest rate and initial monthly principal and interest payment. This section also provides notes on whether or not the interest can rise, whether the loan balance can rise, whether the monthly payment can rise and whether the loan has a prepayment penalty.

The escrow account information in this section includes how real estate taxes and homeowners insurance will be paid. The summary of settlement charges is included on the bottom of the first page of the GFE which summarizes the loan changes that can be found on the second page.

The second page of the GFE entails the adjusted origination charge which encompasses lender-charged fees, processing fees, underwriting fees, other fees and any loan discount point for a lower rate. Other settlement service charges are located on the remaining sections on the second page of the GFE such as the cost of services the lender chooses, cost of title search and title insurance, cost of recording fees and homeowners insurance, as well as the cost of pre-populating escrow account for taxes and insurance and per diem interest charges.

Finally, the last page of the GFE is to help consumers understand the document and “get more” from the GFE experience. It provides instructions on how to read the Good Faith Estimate and how to compare home loan options from other competing lenders. The very top of the last page includes the scenarios where a fee can change. These fees include the initial escrow deposit and daily interest charges and the cost of any services the borrower selects. The “Trade-Off-Table” is also included on the last page of the GFE and helps consumers choose between loans with high costs and low costs and can compare closing cost options.

Borrowers can then use the “Shopping Cart” to compare mortgages side by side, either by the same lender or from different companies. The upcoming TILA-RESPA Integrated Disclosure changes will undoubtedly alter the look of the GFE but the overall guidelines and information included on the document will generally remain the same.

The Congressional schedules vary somewhat between the House and the Senate. The Senate returns “to work” next week through May 25, and includes much of June, whereas the House returns next week for much of April but only works in Washington DC for two weeks in May.

I mention this because of the unfortunate inextricable link between DC and the mortgage industry. Most in the mortgage industry believe that the current administration will be unable to pass any meaningful legislation dealing with resolving Freddie Mac and Fannie Mae’s fate. But there are other aspects of residential lending that Congress will attempt to impact, for better or worse, and it is good to be aware of them.

First, Richard Shelby – a conservative Democrat – may produce a bill to reform Dodd Frank. The odds of it going anywhere are unlikely. But it is thought that there will be some focus on community banks, and potential provisions may be tacked on that negatively impact big banks. Will some politician try to cap them at $500 billion in assets? The anti-big bank rhetoric is still out there.

The House Financial Services Committee moved ahead with the often tedious work of marking up 11 key regulatory relief bills, of which several could have a big impact on mortgage lending and mortgage finance. For those who don’t remember Civics from high school, “marking up” is the process by which congressional committees and subcommittees debate, amend, and rewrite proposed legislation. So it makes things tick.

Among the bills under discussion are, first and foremost for the industry, H.R. 685, the Mortgage Choice Act of 2015 – it died last year; H.R. 1408, the Mortgage Servicing Asset Capital Requirements Act of 2015; H.R. 1529, the Community Institution Mortgage Relief Act of 2015, and H.R. 1195, the Bureau of Consumer Financial Protection Advisory Boards Act.

The Mortgage Choice Act of 2015 by U.S. Rep. Bill Huizenga, R-Mich., is receiving the most attention. It would amend and clarify the qualified mortgage definition in the Dodd-Frank Act thereby improving access to credit and qualified mortgages for low and moderate income borrowers while protecting consumers from bad loans. In addition it adjusts the Truth in Lending Act definition of fees and points by exempting points and fees any affiliated title charges and escrow charges for taxes and insurance from the qualified mortgage cap on points and fees.

Congress just can’t stay away from housing, and vice versa. Bill Huizenga was quoted as saying, “The goal is to help low and middle income borrowers as well as prospective first-time homeowners realize a portion of the American Dream: owning their own home.” But there is something going for it: most housing financial and housing trade groups support the Mortgage Choice Act, including the Mortgage Bankers Association, the National Association of federal Credit Unions, the Mortgage Lenders Association, the Consumer Mortgage Coalition, the Credit Union National Association, the National Association of Home Builders, the Real Estate Services Providers Council, the Realty Alliance and the National Association of Realtors. And any time NAR is behind something…

Many in the industry hope that House Financial Service Committee Chairman Jeb Hensarling is successful in some of the “regulatory relief bills” proposed. He is not a big fan of the all-encompassing powers that the CFPB possesses through Dodd-Frank. No, the CFPB is not going away, but some changes would be welcome.

But we can’t forget what ranking Committee Democrat Maxine Waters, D-Calif. has said about some of the bills – they are problematic. “Countless times last year, our members worked with you on proposals that would provide relief for community banks, make technical fixes to Dodd-Frank and reauthorize important programs,” Waters said.“ But we have ended up seeing little real legislative progress – progress that requires thoughtful negotiations, open communication, and a willingness to compromise so that legislation can actually be signed into law.”

Good luck!

Among the bastions of capital markets folks, the talk often turns to “specified pools.” Namely, what is the price pick up for assembling pools of various LTVs, loan amounts, states, whatever – however a lender can slice and dice a pool and sell it. The pool has specific types of loans in it with specific characteristics.

But not all that many lenders put pools together. Buying loans from smaller lenders, Freddie and Fannie stand to reap the benefits of putting together “specified pools” that trade for higher prices than regular pools. The larger banks also have the ability to put together specified pools, earning that price pick up, but also have the ability to retain whatever loans they chose.

After languishing for much of 2014, activity in specified pools has exploded in the last three months. This is not surprising, as rates rallied from 2.2% in late December to as low as 1.64% by the end of January, igniting refi fears. Since the lows, rates have sold off some and refi concerns have abated, but interest in specified pools remains high, for several reasons.

Rates are still at a level where prepays on 4/4.5s should remain elevated. And despite what plenty of economists are saying, a further rally in rates cannot be ruled out, given central bank printing worldwide currencies and weakening US economic data; any meaningful rally will bring lower coupons into the refi window. And the carry in specified pools is now higher versus TBA for higher coupons; negative carry versus TBA was a big impediment for many investors.

Over time investors have expressed interest in particular specified pools. For example, some will pay up for pools filled with loans from certain states, or filled with loans of certain debt-to-income ratios. The prepayment protection provided by loan balance collateral is very well understood – properties with higher LTV loans on them will have to appreciate more in order to approach refinancing. As such, it commands some of the highest pay-ups. Higher prices should generally mean greater callability, so pay-ups should increase with prices.

And certain states have different laws governing the foreclosure process (judicial versus non-judicial proceedings) so in the event of a borrower not making their payments the timeline for recovering monies changes. And loans from certain states have a track record for prepaying more quickly – the location of the property backing a loan is a significant determinant of refinancing propensity. And there are costs associated with refinancing.

For example, New York mortgages tend to prepay slower, all else being equal, because New York imposes a recording tax whenever a new mortgage is created and recorded on a property. As such, New York homeowners who refinance with another lender are often required to pay this recording tax, which amounts to 1% or more of the new mortgage balance (the tax assessment varies on the city or county where the borrower resides). While the tax can be waived under some circumstances, both the original and the new lenders must cooperate to assign the original mortgage to the new lender, a process that is both cumbersome and time-consuming. As a result, this mortgage recording tax often more than offsets the prepayment effect of higher loan sizes typically associated with New York pools.

A borrower’s credit score also influences the ability to refinance, and thus investor’s perceptions of agency paper backed by these loans. These pools consist of borrowers who have FICO scores of less than 700 at the time of origination, and the “call protection” (lower odds of refinancing) in this collateral, is well known. This better “callability” stems from the credit-impaired nature of the borrowers, which takes time to cure and manifests itself in a slower refinancing ramp for the first few years.

All of Optimal Blue’s clients, and the lending industry and financial markets in general, are impacted by movements in interest rates. Whether they are short term or long term, rates impact a wide range of business models. Or do business models impact rates?

That question is certainly a good one, but what caught everyone’s attention was last week’s Fed’s announcement. As has, unfortunately, become practice over the last several years, every phrase is dissected and every word compared to the last statement in order to portend the movement in rates. And this is certainly of interest to investors in MBS.

As expected, the Fed removed the “patient” word from its policy rate guidance last week, ending the forward rate guidance introduced during the financial crisis. This gives the Fed the flexibility to start hiking from June 2015, but several dovish signals pointed to a later hike, likely in September. While lower rates could ignite supply concerns in the agency MBS market, a dovish Fed is not necessarily bad for agency MBS.

Most agree that things will be gradual and well broadcast. Expectations are for two short term rate hikes instead of three by the end of this year. The Federal Open Market Committee downgraded its assessment of economic activity to “has moderated somewhat” from “expanding at a solid pace.” And diving into the weeds a little, the summary of economic projections indicated a reduction in the committee’s estimate of long-run unemployment (NAIRU) and lowered the core PCE forecasts for 2015 and 2016. Given the reduction in NAIRU, many analysts see a much lower likelihood that the committee will raise rates in June, as labor markets are unlikely to fully close the gap in the next several months. Accordingly, they have revised the forecast of the first rate hike to September.

So the Fed isn’t being patient, yet in the post-meeting news conference Janet Yellen stressed that the U.S. economy isn’t going gangbusters. The market treated the initial Fed communication as dovish and rates rallied significantly across the curve post-FOMC. The 10-year was briefly around 1.90%, raising concerns of a supply pick-up in the agency MBS space.

Optimal Blue clients were pleased, but no investor wants to buy a mortgage-backed security at much of a premium if they think it is going to pay off in three months. The bulk of agency MBS investor macro concerns in the coming months will likely stem from the Fed actions. A significant improvement in rates is the biggest risk for agency MBS.

But there are reasons why existing mortgages might just stick around for a while. First, the 10-year is still 30-35 basis points wider than the lows in January. Mortgages just have not followed Treasury rates downward. Second, originator capacity constraints caused the primary-secondary spread to widen around the lows and the industry sees no reason to expect anything different if rates were to rally further. For lack of a better term, lenders are swamped. Lock desks are overwhelmed, and suddenly April and May are looking like great months.

To sum things up, although lower rates would, at some point, ignite supply concerns in the agency MBS market, a dovish Fed also signals significant caution on their part when making big policy changes. Most believe that the Fed will give the markets plenty of lead time for any change in short term rates. And we are all reminded that the Fed does not set long term rates: mortgage prices are set by supply and demand factors.

The vast majority of home loans, and the use of Optimal Blue’s pricing engine, comes from either banks or non-depository mortgage banks. Both entities have seen their regulatory burdens increase as the weeks, months, and years have passed. And margins, supposedly, continue to be squeezed. So are banks losing money?

Hardly. FDIC-insured institutions earned $36.9 billion in the fourth quarter of 2014. But this is down $2.9 billion from a year earlier. The drop in earnings is due to a $4.4 billion increase in litigation expenses but banks were more profitable in the fourth quarter of 2014 compared to last year. Community banks performed the best in the fourth quarter, as earnings were up 28 percent from the previous year. Loan and lease balances increased $149.4 billion in the fourth quarter to $8.3 trillion and over the past year, loan and lease balances increased 5.3 percent. Full year earnings equaled $152.7 billion and total net income for 2014 was $1.7 billion less than what the industry had reported in 2013, which marks the first decline in annual net income in five years.

Bank analysts are also focused on the return on assets. The average return on assets dropped to 0.96 percent from 1.09 percent a year earlier and the average return on equity fell to 8.56 percent from 9.76 percent. For more information regarding the FDIC’s fourth quarter earnings, click here.

But as we all know, banks are only one piece of the residential lending puzzle. Looking at the overall market, Zelman and Associates came out with their January Mortgage Originator Survey revealing that credit and demand aligned for a strong start to the new year.

Purchase volumes accelerated in January and refinance applications increased 55% year over year. Survey respondents experienced a 12% increase in purchase applications over a year ago versus a 6% increase in December. The credit quality index declined in January to 66.2, the lowest level since mid-2012 and 29% of lenders reported incremental looser underwriting standards.

And lenders are focused on first time home buyers – because without those other homeowners can’t move up. The entry-level mortgage credit availability index rose to 61.1 from 59.2 in December as the loose credit environment has benefited most borrowers due to policy changes to encourage first-time home buying such as the cut in MI premiums and the new 3% down payment program. Boomerang buyers are also on the comeback, as lenders ranked the quality of these buyers at 51.9, indicating average credit profiles. This cohort has focused on repairing their balance sheets and is now able to reenter the housing market.

But it takes two to tango. What are potential borrowers thinking? The TD Bank Mortgage Service Index indicates that consumer home buying confidence is up 10 percent over last year. The survey found that 30 percent of Americans consider now to be a good time to buy, compared to 20 percent in 2014 and 29 percent are likely to purchase a home this year, up from 21 percent in 2014. The amount of consumers who have purchased a home within the past two years have increased by 5 percent since 2014, but two in five consumers feel there is lack of inventory in their price range and 44 percent are not familiar with home affordability programs.

The survey also found that only 28 percent of consumers are successfully using mortgage affordability programs. The majority of buyers (86 percent) felt they had an adequate amount of resources to educate themselves about the home buying process and 51 percent believed banks could offer more relevant, helpful information online whereas, 49 percent believed banks could provide better frontline training to prepare loan officers to better explicate options. More first-time homebuyer’s desire better educational resources, as 52 percent of this cohort felt banks could offer additional home financing seminars and workshops and 58 percent look for additional information online. Come on banks!

There is a whole crop of people who have been hired into the residential lending industry since January 2008. Why do I pick that month? That is the month that Bank of America announced its purchase of Countrywide Financial. Yet even though these folks have never sold a loan to Countrywide, never used its front end system, never looked at its underwriting guidelines, the impact of the company on the industry, and on Bank of America, continues to make news.

Last week a New York appeals court approved the Countrywide trustee’s proposed $8.5 billion rep and warranty settlement in its entirety, with all judges concurring. I have lost track of the billions, but as of last summer Bank of America’s mortgage business had lost more than $50 billion since BofA bought Countrywide Financial for $2.5 billion.

Those of us around back then remember that after announcing the deal, then-Bank of America chief executive Ken Lewis called it a rare chance to become No. 1 in home loans. Instead the bank’s shareholders, employees, and borrowers have spent seven years paying the price for Countrywide’s lending practices, as has the industry, through accounting writedowns, bad loans, and loss of operating income. Lewis has said regulators didn’t pressure him to buy Countrywide – so it was his choice. Ouch! The acquisition started as a $2 billion investment by Bank of America in Countrywide in August 2007 at a time when crashing credit markets had spurred rumors that the lender could face bankruptcy.

Bonds covered by recent settlements also show Countrywide’s lopsided role in the losses. Of the loans packaged into securities by Bank of America and companies it later bought from 2004 to 2008, about three-fourths of those that soured were originally issued by Countrywide. Bank of America produced just 4 percent, with Merrill Lynch accounting for most of the rest. Interestingly, in 2001 Bank of America had exited the business of making subprime mortgages and in the autumn of 2007 the bank had stopped obtaining mortgages through brokers. But that channel was a major business for Countrywide.

So the latest news from the New York appeals court approving Countrywide trustee’s proposed $8.5bn rep and warranty settlement in its entirety was the latest in a long saga. As a trustee, BNY Mellon properly exercised its discretion in settling all the claims, including repurchase claims against loan modifications that were previously excluded. The court said that the issue for its determination is whether the trustee exercised its discretionary power reasonably and in good faith and that it is not the task of the court to decide whether it agrees with the trustee’s judgment.

What does it mean? The appellate division’s verdict should remove the biggest hurdle for trusts finally to receive the $8.5 billion payment, close to four years after the settlement was originally struck. This was the only ongoing proceeding in the Countrywide settlement after the New York Supreme Court lost jurisdiction over this case. There is the possibility of a further appeal in the New York Court of Appeals, which is the highest appellate court in New York.

But for an industry trying to regain its footing, any settlement is a good thing. Any ruling closes a chapter on the mess that the industry found itself in years ago and has been digging itself out of one loan at a time since. This verdict might also be a positive for JPM and Citigroup’s rep and warranty settlement. Although the objections against JPM and Citigroup are of a somewhat different nature (unlike in Countrywide’s case, the trustees were not active participants in the negotiations that were held between institutional investors and JPM/Citigroup), this verdict likely clarifies the standard against which trustees will be judged. As such, analysts believe that the likelihood of faster progress on the approval process in the JPM and Citigroup settlements has risen.

The competitive primary markets continue to be discussed CEOs of lenders. Some investors, such as Chase, are using their book to subsidize pricing – much to the benefit of companies that sell to them (unless operational or suspense issues bog things down). In other segments, non-bank companies continue to grab market share. Companies such as Freedom, Walter, are making advances in the correspondent channel, in spite of many scratching their heads over the pricing methodology, whereas in the wholesale channel Stearns, Provident, United, MB grew market share at the end of 2014.

But it is hard to have a presence in the primary markets without investor demand for a company’s product in the secondary markets. And investors are acutely aware of how certain lender’s loans are on their books, and how they perform. So the investment banking and investor community took notice when news came out that speeds on Quicken pools have been printing substantially higher than those on other pools, even after adjusting for various borrower characteristics. And yes, plenty of lenders are going to see loans paying off early, but it is of interest to see what might be happening here. What are the potential drivers of prepayment speeds? First, lower mortgage rates are not the reason for higher speeds – besides, analysis indicates that Quicken’s rates are similar to or higher than the cohort in general.

But in Quicken’s case it has a better technological platform, aggressive marketing, a focus on refis, and different views on the treatment of MSR (mortgage servicing rights) relative to origination levels seem to be the reasons.

As an issuer and servicer, Quicken has grown significantly over the past three years and is now among the top originators across most MBS products. But its loans have a reputation for faster-than-industry-average early payoffs. Wall Street actuaries and computer data indicates that the main difference between Quicken and other pools appears to be the much larger share of refi loans in Quicken pools. On other dimensions (FICO, LTV), there appears to be little difference.

So we circle back to the primary markets, and the fact that among other things, when one types “mortgage” into Google more often than not up pops Quicken. Does it have great pricing? Not necessarily. In fact when one hears other LOs discussing Quicken the issue of pricing is not at the forefront.

Instead what is at the forefront are operational, especially quick response times and short closing times. Quicken has a very good technological platform relative to other originators, especially the integration into its marketing efforts and borrower “experience”. After a potential borrower submits some basic information online, Quicken is said to call back the borrower on the phone number provided within minutes. Throughout the loan application process, borrowers are able to upload most documents online and view the progress of their loan application online as well. The process is not as cumbersome as with other lenders, leading to greater satisfaction and less hesitation to a future refinancing offer. So not only does Quicken capture that borrower before anyone else, it has a good chance of getting that borrower to close a loan.

Quicken is also able to redirect its marketing efforts towards its borrowers as soon as there is any substantial rate incentive – like the brokers of old. And for some loans in process Quicken is said to seek a deposit (anywhere from $300-700) from borrowers that is credited back at closing or otherwise refundable (less appraisal and other processing cost) in case of no closing. This encourages borrowers to close loans even for small payment savings.

But what is good in the primary markets does not necessarily translate to investors wanting these loans, and this may be reflected in the markets. Time will tell, but for now it is hard to argue with Quicken’s success.

What the heck is “M-PIRE”? Besides being “Millennial for “empire”, the program permits property owners to access more capital than a traditional Fannie Mae mortgage because it counts projected energy and water savings toward underwriting requirements. This is not to be taken lightly as energy and water costs can account for as much as 20-35% of a property’s operating expenses.

I mention this because in the last several months this program and other slightly off-the-beaten-path securitizations have sprung up. Risk sharing between Fannie and Freddie in the capital markets has come to the forefront of the industry. Issuance is robust from last years $10.8 billion mark; in January Freddie Mac completed an $880 million offering, and as Jody Shenn of Bloomberg writes, it is, “The first in which some of the bonds exposed investors to principal losses before homeowner defaults exceed certain levels.” This is an important deal perimeter moving forward. Shenn continued, “Bond buyers are flocking back to the market for securities used by mortgage giants Fannie Mae and Freddie Mac to share their risks with investors. Fannie Mae sold $1.5 billion of the debt (recently), through which it can potentially transfer some of its losses from guaranteeing $50.2 billion of loans, the Washington-based company said in a statement. One portion of the offering carries a yield that floats 4.55 percentage points above a benchmark rate, down from the 5 percentage point spread that investors demanded on similar notes in a November sale.”

And last week Fannie Mae announced its first Capital Markets Risk Sharing transaction of 2015. The credit risk sharing transaction of 2015 falls under its Connecticut Avenue Securities (CAS) series. The $1.47 billion note offering priced last week is scheduled to settle on February 26.

The Fannie Mae M-PIRE mortgage product is available to affordable and market rate cooperative and conventional rental housing owners in the five boroughs of New York City. The loan offers an efficient and cost-effective way to both make improvements and comply with NYC energy requirements (Local Law 43 Clean Heating Oil, Local Law 84 Energy Benchmarking, and Local Law 87 Energy Audits and Retro-commissioning).

And Greystone turned some heads earlier this month. Most see Greystone as a multifamily and healthcare mortgage lender. It announced it has closed the first Fannie Mae M-PIRE (Multifamily Property improvements to Reduce Energy) loan for a Bronx rental building. The Fannie Mae M-PIRE mortgage product is available to affordable and market rate cooperative and conventional rental housing owners in the five boroughs of New York City. The loan offers an efficient and cost-effective way to both make improvements and comply with NYC energy requirements.

What does all this mean? The Agency’s Credit Risk Sharing initiatives aim to reduce their mortgage default (credit) risk by offering new opportunities for financial institutions to invest in the credit performance of F&F’s single-family book of business. The Agencies point out that the deal structure provides an additional avenue for sharing their mortgage credit risk, adds a layer of defense against loss to existing credit risk policies and processes, and seeks to reduce the government’s participation in the mortgage market.

From Fannie’s perspective the risk sharing enhances their ability to manage credit risk and allows them to share credit risk on their guaranty book of business with private market participants. Many think that this is good for tax payers (since we own Freddie and Fannie) and helps move Fannie toward the objectives set forth in FHFA’s 2013 Conservatorship Scorecard.

If the Agencies are able to do this, it will make the possibility of their demise even more remote – and the industry can certainly live with that!

The lending industry is well aware of the Consumer Finance Protection Bureau. It is aware of its examination manual, its targeted industries, and its enforcement actions. Senior management of hundreds of lenders in the United States wonder if their lending policies and procedures are “up to snuff”, or if the CFPB will find some issue years from now which results in a multi-million dollar fine and all but closes the business down.

So it was with great interest last week that the CFPB announced actions against three mortgage companies for alleged violations of Regulation N which sets forth advertising requirements for mortgage companies. Titled “The Mortgage Acts and Practices Advertising Rule”, among other restrictions Regulation N bars any commercial misrepresentation of the relationship between a credit provider and a government. And that is what the CFPB focused on.

According to the CFPB, the three mortgage companies (All Financial Services, Flagship Financial Group, and American Preferred Lending – two Utah and one California) wrongfully depicted their affiliation with the U.S. government in direct mail advertisements and were the recipients of one civil suit and two consent orders.

But the industry was also aware that this is the first its heard from the Bureau or the FTC regarding their joint “sweep” of roughly 800 mortgage-related advertisements since the two agencies issued warning letters to several institutions in late 2012. And that may actually be good news: “Hey, if they didn’t fine me for my advertising, it was fine.”

The facts articulated in the two consent orders are markedly similar. Per the CFPB (none of the companies admitted any wrongdoing, by the way) Flagship Financial Group sent more than one million direct mail advertisements claiming to be a “HUD-approved” lender when, in fact, it was not. Oops. Thousands more Flagship mailers allegedly opened with a reference to an FHA press release, “HUD No. 12-045,” and instructed recipients to phone an “assigned FHA loan specialist.” According to the order, Flagship’s name was buried in a disclaimer on the reverse side of the ad.

Along those same lines the CFPB tells us that American Preferred Lending sent 100,000 mailers featuring an FHA-approved lender logo and a reference to a web address, FHAdept.us. While American Preferred is authorized to originate FHA-insured loans, it enjoys no greater affiliation with the government than any other lender authorized to engage in the same activity. The Bureau determined that these representations connoted the authors’ affiliation with the U.S. government, and, as such, they violated Regulation N. Flagship and American Preferred agreed to pay penalties of $225,000 and $85,000, respectively, and both are required to establish compliance plans subject to the Bureau’s approval.

All Financial Services, the recipient of the civil complaint, supposedly sent thousands of mailers with arguably misleading allusions to an affiliation with the government, including an official-looking seal and a heading that read, “Government Lending Division.” But All Financial also allegedly misrepresented the terms of its reverse mortgage product by saying that no monthly payments “whatsoever” would be due “as long as you and your spouse live in the home.” According to the Bureau, this representation fails to depict the actual cost of the product, which does require payment of taxes and insurance, and it masks the reality that payment could be due on death of the borrower, even if the borrower’s spouse remains in the home.

The Bureau’s announcement does not indicate whether these actions effectively conclude the joint sweep effort, or whether additional actions based on the same investigation(s) may be forthcoming. So it is too early for all the residential lenders out there to breathe a sigh of relief. At least noting the issues with these actions helps give the industry more information than it had before.

Experienced lenders know that mortgage rates are determined by supply and demand – not the Federal Reserve – and supply and demand are influenced by many factors. A couple of those factors have been in the news lately, so we thought it would be a good time to discuss them in a little more depth.

Demand by investors is determined by the assets the investor wants, perhaps to match liabilities or to hold outright, and the perception of how long those assets will be on their books. Of course no investor wants to pay a high premium for a loan, or pool of loans, that is only in their portfolio for a few months.

So investors tune in with great interest when prepayment speeds are released once a month. Aggregate prepays in January decreased by 14% for Fannie 30-year collateral to an 11.6 CPR (Constant Prepayment Rate) and by 13% to 9.0 CPR for Fannie 15-year collateral. Aggregate GN I prepays decreased by 16% to 14.0 CPR whereas aggregate GN II prepays decreased by 17% to 14.0 CPR. What the heck happened to the surge in business caused by the drop in FHA mortgage insurance premiums, or the move to 97% by the Agencies?

Analysts believe that the decrease was likely driven by a combination of lower applications, weaker turnover activity and lower day count. Really – fewer days? Ginnie Mae prepays declined slightly more than conventional loans (Freddie & Fannie) which is likely due to some FHA borrowers not being able to close on time after cancelling their prior case number.

Let’s not forget the Fed, which continues to invest money from its early payoffs. The paydowns on the Fed’s MBS portfolio are estimated to be around $22 billion, which should reduce reinvestment demand compared to the current cycle. Many expect conventional prepays to increase nearly 20% in both February and March. The February increase is primarily due to the sharp rally in mortgage rates over the past 4-6 weeks and the corresponding increase in the refi index.

Moving over the supply side of the equation, at the originator level, is the drop in Treasury yields being fully reflected in the rate sheets that borrowers see? The answer is mostly “no”. Primary-secondary spreads have widened recently (to an average of about 105-115bp) nudging analysts to discuss the capacity constraints in the origination market. While the rally so far has not resulted in mortgage rates reaching new historic lows, primary-secondary spreads have widened. The smaller widening this time, versus that of previous rate drops, suggests that the industry may not be as close to capacity limits.

From a company perspective, lenders may have some higher origination capacity, utilizing their staff more than three months ago, even at the same level of employment and greater competition among lenders that could keep primary-secondary spreads down. Adding margin into rate sheets is a key tool for originators, large or small, to control application volumes during times when there were capacity constraints in the system. However, monthly originations of Agency MBS recently are about $90 billion on average, compared to the $140 billion and $160 billion during Q4 2010 and Q4 2012, respectively, the prior instances when we were at or very close to full capacity.

At the same time, employment in the mortgage industry as reported by the BLS appears to be lower by only about 5-6% from its peak levels in July 2013. And in talking to lenders, employees are indeed busy – a welcome relief to the alternative especially for smaller non-bank lenders.

“How about these rates?” I am asked that relatively often these days. Loan officers everywhere are enjoying another wave of refinancing – any anyone who predicted the end of refinances is dead wrong. In fact mortgage rates have continued to move lower through much of January. When will it stop?

Rates sheets moved well past recent lows and back to levels not seen since May of 2013 when Ben Bernanke, other Fed officials, and the press began talking about tapering. Yes, the Fed was thinking about mapping out an exit from QE stimulus, which sent markets into the tailspin that was effectively the prologue to the taper tantrum. Indeed, QE is long over, and in fact Europe is going to give it a shot. Toward the end of QE in October, and to this day, economists have been jawboning a rate hike being imminent this summer. But rates are back to where they were before markets really began adjusting, reminding us of the power of global economic turmoil and a troubling lack of inflation for core economies. Sure enough, European bond markets posted gains recently, dragging both US treasuries and MBS along for the ride.

And borrowers and loan officers have seen rate sheet pricing improve dramatically. A month ago rates were hovering around 4%. Now we have a prevalence of 3.5% as a conforming 30-yr fixed quote for low LTV loans to top borrowers. Certainly average borrowers can obtain 3.625-3.75% loans. As Mortgage News Daily pointed out, “The important part is the day-over-day change and the relationship to recent levels. In other words, no matter what you were quoted in the past few weeks, if your scenario is the same, today’s rates are better.”

But at some point rates will go up. Right? Maybe it will be this summer, maybe years from now. Since late December any move toward higher rates has temporary. Capital markets crews are seeing borrowers who want to keep floating in the hopes of further gains would be to set a limit at slightly higher rates than today’s quote and keep floating until that limit is reached.

And we’ve seen plenty of intraday price improvements from lenders using Optimal Blue. And some LOs are telling clients to wait until later in the day and wait for an improvement. Or not even lock in – it is easy to think that anyone who has floated instead of locking is better off. And they have been – for now.

And although Treasury yields continue to head down, mortgages have tended to lag. The mortgage basis continued to underperform as rates rallied further. The lag with Fed purchases continues to exacerbate the effect, although a sell-off could result in a sharp reversal. Convexity flows from servicers could provide some support to the basis – is there any value to premium pools? It is very expensive to refinance a mortgage, and some expect LLPA (loan level price adjustments) matrices to be flattened by the FHFA, with the base g-fee remaining untouched.

But where do we go from here, and is there any news from the U.S. economy that might help answer that? Certainly developments over the past several months have provided a mixed picture for the current state of capital spending for the U.S. economy. What we are seeing now is weakness in core spending as well. The durable goods report this week showed broad-based weakness across most sectors. The retrenching in certain segments of the economy is certainly a reaction to the oil shock. But the fourth decline in five months for durable goods and the fourth straight drop in core capital goods is an unambiguously negative signal for business spending.

But wait! We learned last week that new home sales rose to the fastest annualized pace since 2008. Single-family housing starts increased 7.9 percent in 2014, overall starts are above the 1 million mark, and the builder’s NAHB index remains near the current cycle high.

So yes, the U.S. economy is clicking along, but problems with oil and overseas should continue to help rates. Stay tuned…

All the lenders out there have seen their pipelines grow since the start of the year. (If a lender hasn’t, well…) Treasury rates have come down significantly, mortgage-backed securities lagged, came back, lagged some more, tightened, and on and on. But no one is arguing with these rates, and the fact that they are having an impact on current refinance volumes which means they are having an impact on servicing portfolios and therefore investor’s demand for products. Let’s dig into that.

Investors are nervous. There is an increasing risk of a new all-time low in mortgage rates. Mortgage rates tend to lag rapid declines in Treasury yields, but eventually catch up. And the new low on the 30-yr Treasury bond yield suggests to many that a similar outcome is possible for mortgage rates.

But we may go farther. The new low of 2.37% for the 30-year bond yield recently opens up significant downside potential for rates from a technical analysis perspective. It also increases the chances that a new low in mortgage rates will also be observed sometime in 2015. A survey of rate sheets shows that most are 3.625-3.875% for a 30-year fixed-rate mortgage. This is just under 45 basis points above the all-time low of 3.375% in December 2012. The historical pattern shows that mortgage rates tend to move lower much more slowly than Treasury yields but eventually catch up.

But few traders base their thinking on 30-year bond rates. Heck, even the 10-yr T-note, the traditional benchmark, may have a duration too long for MBS comparison. Currently, the spread between the 30-yr mortgage rate and the 10-yr yield is 208 basis points, which, with the exception of the 2008 crisis experience, is near the wide end of the range of the past 15 years. The low end of the range in the past few years was 150 basis points. Assuming the 10-yr remains at about 1.75%, reversion to this 150 basis point spread would bring the mortgage rate down to 3.25%, which would be a new low for the rate. If additional downside in rates suggested by technical analysis is realized, the 30yr mortgage rate could potentially see a sub-3% handle sometime this year.

The term “new low” has special meaning for mortgage rates and refinancing risk since it typically translates into a media effect in which lenders effectively get free advertising from the media for their mortgage products and the benefits of mortgage refinancing. Most analysts think that given lackluster Q4 earnings for banks and somewhat dim prospects for the future due to a flattening yield curve, it is only a matter of time before banks and non-depository lenders ramp up capacity to take advantage of what could be yet another historic refinancing wave, a wave which may have already started based on the latest MBA refinancing index.

Although agency MBS have underperformed in 2015, there is a growing school of thought that believes the market has come close to pricing in the risk of substantially lower mortgage rates and the risk of a major refinancing wave. And thus many investors have begun to sell their higher coupon holdings and put the money into 2.5% or 3% securities.

This move has not been lost on capital markets staffs or loan officers. They have seen the price movements caused by the 97% LTV FHFA change, the FHA MIP change, and now the move down in rates. And no investor wants to be the last on their block to react.

Last week in Florida I had the chance to listen to presentations from a couple private mortgage insurance companies. (They were speaking at a company’s event for its loan officers.) As one would expect, the discussion revolved around the FHFA’s news of the 97% LTV program for Freddie and Fannie, and also the move by HUD and the FHA to cuts the mortgage insurance premium by 50 basis points. And as one would expect, although the news is generally good for lenders and Realtors, the devil is in the details about whether or not it will have much impact on Optimal Blue’s clients.

The Obama administration, never one to shy away from these things, estimates that by lowering the FHA’s annual mortgage insurance premiums by half a percentage point as many as 250,000 new buyers will be able to purchase a house. But these buyers will generally have lower credit scores and thus present a higher risk profile, causing industry analysts to question whether or not the FHA is once again adversely selecting against itself.

If borrowers have a FICO credit score of 620 to 719 and a down payment of 5% or less, the FHA is likely to become their first choice in terms of monthly payments. It will cost them less in principal, interest rate and mortgage insurance charges compared with what they’d pay for a conventional loan eligible for purchase by Fannie Mae or Freddie Mac with private mortgage insurance. But for borrowers with a higher FICO score, given similar credit scores and down payments, the monthly payment is going to be lower with a conventional loan. So FICOs matter.

But Optimal Blue’s clients have LOs dealing with borrowers with other factors that might influence them to opt for an FHA loan over a conventional mortgage. For example, in general FHA loans are more flexible when it comes to underwriting conventional loans with DU or LP. For example, when it comes to debt-to-income ratios conventional lenders using private mortgage insurance typically will not approve a borrower if the ratio of their recurring monthly debt payments to documented monthly gross income exceeds 45%: QM versus non-QM.

But FHA loans may allow higher DTIs if other aspects of the loan (steady income, reasonable financial reserves, and so on) are strong. Some lenders say they can do FHA loans on borrowers with debt ratios higher than 50%. And the FHA’s criteria are more sympathetic in the way it treats student debt. Buyers whose student debts have been deferred for 12 months or more won’t have them factored into the FHA decision making process whereas conventional lenders include them.

But FHA borrowers still must contend with an upfront premium of 1.75% that typically is added onto the principal they’re borrowing and then financed over the term of the loan. (Remember that the FHA’s changes impact annual premiums, not the upfront premium.) Unlike private mortgage insurance on a conventional loan, which by federal statute can be canceled once a borrower’s equity position reaches 20% of the home’s value, FHA’s premiums on most loans continue for the life of the mortgage. That add-on to principal stays with a borrower for years beyond the date they’d be able to cancel their private insurance payments, which in some scenarios can be as early as four to five years, so building equity is faster with a conventional mortgage compared with an FHA loan.

And so we find OB’s clients, and servicers who are slicing and dicing their servicing portfolios, looking at a refi pool of borrowers with low credit scores and high LTVs, with possible debt issues, that may benefit the most from this move. And now it is Fannie & Freddie’s turn to react, if at all.

Everyone (and their brother) is yammering about the changes that President Obama, and the Federal Housing Administration, announced last week regarding lowering the FHA’s mortgage insurance premiums (MIPs) by 50bps. Given that HUD, and Congress, wants to reduce government’s role in lending, and given that FHA loans account for about 10% of current production, many think that the hoopla is unwarranted and possibly exaggerated. But before addressing that, let’s sum up the changes.

The lower MIPs are effective as of January 26th. Mortgage Letter 15-01 announced the reduction in annual MIP rates by .5 percentage points, effective on loans with terms greater than 15 years and case numbers assigned on or after January 26, 2015. This new rate will not be applicable for the single family streamline refinance transactions that are refinancing existing FHA loans endorsed on or before May 31, 2009, nor Section 247 mortgages (Hawaiian Homelands).

So the change, based on case number date, is effective 1/26, and does not impact 15-year FHA loans. Loans with LTV<=95% continue to see a 5 bp lower MIP (so go from 130 bp -> 80 bp), and loans with LTV>90 still need to pay the MIP for the life of the loan, and loans with LTV<=90 still must pay MIP for 11 years. By most reckoning this would mean that loans in process would be assigned the 135 bp levels but the FHA is temporarily allowing the old case # to be canceled within 30 days of the new MIP effective date. Analysts think that many case numbers will be canceled and reassigned in the last week of the month which will delay loan closings for the month, so prepayment speeds will be slower than expected this month but faster in February, and March pools will be the first with an appreciable amount of new-MIP loans. Analysts think that FHA purchase endorsements will rise 60%, from 50K to 80K loans per month as over 3 million borrowers enter the refinancing window. But (as noted below) the possible FHA mortgage improvement is partially negated the impact on Ginnie pricing. With the move FHA loans regained their competitiveness in the high LTV, below 740 FICO portion of the credit box and the move forced many analysts to change their 2015 forecast. We can now think that the FHA supply will rise dramatically, some of it coming as prepayments overshoot estimates. As one would expect, the private mortgage insurers are not thrilled with the news. They don’t play in the conventional conforming and jumbo markets. And as one would expect, given the probably change in supply dynamics, after the release of President Barack Obama’s plan to make housing more affordable by cutting mortgage-insurance premiums charged by a federal agency bond investors responded by pushing up interest rates on the same loans. The announcement caused Ginnie Mae-backed mortgage securities (used by lenders to package and sell FHA-insured loans) to fall the most since June. That boosted yields on securities that guide FHA borrowing costs to a greater degree than other mortgage debt, signaling a larger increase in rates on the loans for borrowers. Soon after the news investors sold Ginnie Mae bonds as the initiative threatens to increase supply and make it worthwhile for more homeowners to refinance existing loans. Prepayments on mortgage bonds trading for more than face value damage holders by returning their principal faster at par. Steady increases in FHA premiums in recent years proved a boon for Ginnie Mae investors, as they often locked borrowers into their mortgages even as rates fell. This slacked off, however, as the markets settled down. The move is truly positive for real estate and lending, but the general feeling is that given the change and the number of impacted borrowers, it may not result in another dramatic wave of refinancing – especially as the cost to the borrower of originating a loan as continued to mount.

Although, as “they” say, “past performance is not an indicator of future results”, many noteworthy events that occurred in the mortgage industry in 2014 will have a ripple effect in 2015. It is important to think about 2014 and shift that thinking into 2015. Of course various Optimal Blue clients have different strategies, embrace different programs, and expect different results. But certain changes impact all lenders – no one operates in a vacuum. Here is an initial look ahead for the industry this year at the program level.

The Fannie Mae 97% LTV Program was implemented at the end of last year, but the full impact of this program will be evident in 2015, hopeful that a low down payment option will lure young adults and boost the first time homebuyer market. This change has been embraced by many lenders already. There are some, however, that believe this level of LTV is too high, and harkens back to a time of sketchy guidelines and lending. Both Freddie and Fannie, however, are behind it, and any company trying to compete for loan officers will have to offer it – or an alternative – in spite of marginal gains in market share.

The FHA’s Mortgage Insurance Premiums may also be lowered in 2015 as FHA’s market share could decline about 80% this year due to Fannie Mae’s 97% LTV program. Borrowers will lean towards Fannie Mae’s program due to FHA’s high MI premiums. This may, in turn, cause the FHA to reduce its premiums or restructure MIP to make it more affordable for borrowers and to compete with Fannie Mae’s new program. The 400.1 Origination through Post-Closing Handbook, with a tentative effective date of June 2015, will encompass changes to FHA underwriting policy, unless HUD reconsiders and revises these policies based upon recommendation and feedback from industry professionals.

The updated RESPA & TILA rule will be in effect August 2015 with new Loan Estimate Disclosure and Closing Disclosure Forms that all lenders will be required to utilize. If there is one hot button for the MBA and compliance teams, this is it. August will be here before you know it, and OB clients are in full swing for this change.

Last year proved to be the best year for VA loan production and this auspicious trend should continue in 2015. As more veterans return home, they will take advantage of the favorable home financing terms offered by the VA, such as 100% LTV. There are now more veterans than at any time in recent memory, and lenders are embracing VA programs and encouraging LOs to pursue that business channel.

The big question mark out there is interest rates. No CEO bases the future of their company or employees on rate forecasts, and “experts” notoriously missed 2014. Some think tanks now place a higher than 50% chance of a worldwide recession by the end of 2015. They cite rising deflationary risks overseas, a high US reliance on exports, increased overseas exposure by US companies, and high US household exposure to the stock market are all contributing factors. The last thing that lenders need is a recession, as this lowers the number of qualified borrowers, even if it means lower rates. LOs must be careful what they wish for!

But rates are unlikely to stay near 0% in the short term. The Federal Reserve does not set mortgage rates; it sets short term rates like the Discount Rate and Fed Funds. The industry hopes that any changes in 2015 are gradual.

With the return of the 3% down payment option, low interest rates and more lenient underwriting standards, 2015 will be the year where Millennials emerge as stakeholders in the housing industry and the return of first time homebuyers. This year proves to be a promising year for the mortgage industry.

This year the Christmas and New Year’s holidays fall in the middle of the week: both Christmas Day and New Years are on a Thursday. As broad generalization, many people are taking this week off, but there are also a sizeable percentage taking the following week off as well. Unfortunately for lenders and investors, these next two weeks are the last weeks of the month and of the year, and balancing customer service versus vacations can be problematic.

Let’s take PennyMac’s correspondent division’s schedule as a proxy for the industry. On Christmas Eve, Wednesday, December 24th, mandatory flow, bulk and DT groups are closing in the middle of the day whereas best efforts and AOT are closing nearer the normal time. (Who wants to work Christmas Eve?) On Thursday the company is closed, but Friday offers normal hours.

The following week the same pattern is followed with an early close Wednesday, December 31th for mandatory flow, bulk and DT groups while best efforts and AOT closes later in the day. Thursday everything is closed, but Friday things return to “business as usual.”

From a loan officer’s perspective, especially those with kids, the year is pretty much over. Their borrower clients – especially those with kids – are often out of town. Locks will drop off dramatically, lock desks will be lightly staffed, and those still working will tend to have a different outlook on work. Investors will be protecting their returns heading into year end. Therefore the appetite for new securities may be muted. Don’t look for a lot of non-agency deals to be issued.

But investors are particularly interested in what is coming down the pipeline at them. Applications turn into locks, locks turn into funded loans, and funded loans turn into assets. Borrowers may decide to apply or lock during the holidays, or wait until January. A loan lock establishes the interest rate that a borrower will pay as long as the loan closes before the end of the lock period. Lock periods typically last from 30 to 60 days, though in markets where the loan approval process is slow, the lock period can last as long as 90 days. And the problem with locking now is that the borrower may feel that a couple weeks are lost with short staffing.

Borrowers like lock periods because they take away the uncertainty associated with constantly fluctuating mortgage rates. Particularly with expensive homes, a small increase in interest rates can mean a big change in monthly payment and plenty of people are talking about locks increasing.

Borrowers must also think about the time value of money. They must pay extra for an extended loan lock given the time value of money and the volatility of the market. It’s not free. The interest rate will be a bit higher or the points will reflect the loan lock fee. That’s because the lender is taking on the risk that rates could go up while the transaction is processed, so the lender could end up losing money if the loan is funded at a lower-than-market interest rate. But locking the loan gives the borrower peace of mind. Most real estate experts recommend that borrowers lock.

All of that being said, most of Optimal Blue’s clients see a drop off in locks during the holidays. Many LOs coast into January, not wanting additional fundings and tax burdens, companies are short-staffed, as are investors. So things quiet down.

On Friday the 5th the unemployment data showed that the United States is seeing continued job growth – often beyond expectations. But then we spent last week watching rates go down. What gives? Harry S. Truman said, “Give me a one-handed economist! All my economics say, ‘On the one hand… On the other hand…’”’ But we are definitely seeing cases being made for both increases in interest rates and decreases in interest rates, often from the same piece of economic information. What’s a mother to do?

Bond prices are certainly higher, and thus rates lower, than this time a year ago. The rally of 2014 has stampeded through virtually every counter-argument including that the economy is strengthening, a solid stock market, the end of QE balance sheet expansion, and rumblings from the Fed about the Fed Funds rate. The yield on the risk-free 10-yr T-note is roughly 1% lower than where it was a year ago! So what is furthering arguments for the bond market moving in any one direction?

Traders have been talking about oil weakness, and thus strength in the U.S. dollar. Those who are inclined to think bonds are going to rally (and rates drop) point to oil price declines being an indication of disinflation or deflation. But others say that the benefits to U.S. consumer will outweigh hits to the oil industry. The price of oil certainly impacts inflation in this country, and there are those that say we’re headed to 0-1%, with deflation a distinct possibility. But others say that the core effects limited and will eventually be overcome by strengthening wages.

Changes in wages can be impact by the labor market. Bullish traders say that the labor market numbers of late have been backward looking, and that there are many who are still badly underemployed with little or no wage growth. But bearish traders say that 2014 represents the most jobs since 1999 and that there are signs of strengthening in hiring and mobility to the point of traction in wages. More people working and making more money lead to increases in consumer spending. Some say that caution from the recession will linger for many years. But others believe that consumer spending is gaining momentum and that our confidence is at its highest levels in a decade.

Bullish investors and traders say that we’re going to undershoot of inflation target and that the Fed will keep the Funds rate at zero at least through 2015. But other believe that the Fed sees an increase in Funds rate as normalization and that it will start raising short term rates in 2015 as long as growth is on track. And of course there are two opinions about real rates, one thinking that real rates are going to zero (or negative) versus those who think that current low real yields are an artifact of zero funds rate and they will normalize as the Fed tightens.

And what about the stock market? Last week equities “took it on the chin.” Some say that we are still significantly overvalued and that a correction will trigger a return of “Risk Off” bond rally. Of course this thinking is countered by those who point out that the S&P is still “only” +9% year to date and that price/earnings ratios remain reasonable.

All of the conflicting views will receive more information this week with the Federal Reserve’s Open Market Committee meeting occurs. This meeting, a two-day affair, will likely foster a lively argument between those bullish and bearish about bonds. Stay tuned!

Residential production at most lenders continues to be either conventional conforming or high balance (usually underwritten to Fannie & Freddie guidelines) or FHA & VA. In fact the vast majority of loans involve these “government” programs, and they have been for quite some time. Recently the Federal Housing Finance Agency (FHFA), which oversees Freddie and Fannie, announced that it will clear up certain guidelines, thus giving lenders more transparency (and less confusing liability for potential buybacks in future years). Will it really matter? And what impact will it have on the price difference between conforming loans and those guaranteed by the FHA or VA?

The new mortgage guidelines may make it easier for consumers to qualify for loans – which should help a stagnant housing market and also give lenders a clearer path in assessing their risk. The changes may be felt the most in loans of greater than 80% loan-to-value. The clearer rules should speed up the loan process and reassure lenders that the loans they are offering meet guidelines. They also provide some flexibility when it comes to down payments which had disappeared in the wake of the housing crisis as lenders tightened requirements – demanding larger down payments and higher credit scores from applicants.

One reason buyers had to come up with more money for a down payment was the lack of private mortgage insurance (PMI). When a borrower who is obtaining a Fannie or Freddie loan makes less than a 20% down payment they are required to take out PMI to cover the loan in case of default. FHA loans quickly became the low-down-payment option for consumers, and FHA loan volume surged 355% from 2007 to 2009. So did their fees.

But the Federal Housing Administration saw its capital levels sink. And the FHA raised its mortgage insurance premiums much to the dismay of borrowers and lenders that specialized in FHA loans.

Now that new mortgage rules are in place, consumers have relatively attractive options. Some conventional loans are requiring as little as 3% down, but also requiring the borrower to take out PMI. The premium is paid monthly, as part of the mortgage payment.

Surveys of the cost of obtaining an average conventional versus FHA/VA loan can see significant savings on mortgage insurance by choosing a conventional loan over an FHA loan. As noted in the paragraph above, FHA mortgage insurance premiums have nearly doubled since 2008. Someone who buys a median-priced home now has to pay $17,398 in premiums during the first 5 years, compared to just $9,210 in 2008. Borrowers obtaining a conventional (Freddie or Fannie) loan consumers putting less than 20% down can save between $2,251 and $12,026 in just 5 years. Of course if the borrower puts more money down (a higher down payment), the lower the premiums.

On top of that an FHA loan, which is guaranteed by the U.S. government, requires a mortgage insurance payment for the life of the loan. But with a low down payment conventional loan, the homeowner may be able to stop PMI payments once the LTV goes below 80% and in to the 70% range: an increase in equity in the property. That can reduce monthly mortgage payments by more than $100.

Once again it pays for the borrower to consult with a well-trained loan originator about the options, especially if they want to purchase a home and have less than 20% down. Anyone looking at the programs should be sure to include FHA’s up-front mortgage insurance cost that is typically financed into the loan amount. And LOs tell borrowers to make sure they are aware of all costs of any loan. When you compare FHA and private mortgage insurance costs, include FHA’s up-front mortgage insurance cost that is almost always financed into the loan amount.

One of the common questions LOs ask is, “What happens to a mortgage after I originate it? Who ‘owns’ it?” It is a reasonable question, as some loans are held in bank portfolios while others are securitized. And banks can also buy mortgage-backed securities. Let’s take a look at the latter as it is a major component of mortgage demand, and therefore rate sheet pricing.

The domestic bank holdings of agency MBS have increased by $65 billion so far this year. After starting the year on a strong note, bank demand for agency MBS slowed somewhat from March to August but picked up steam again over the past 2-3 months. While the YTD growth in MBS holdings of domestic banks is neither too high nor too low, their ownership of Treasuries has increased by as much as $129 billion. Overall, bank demand for liquid securities was fairly strong in 2014, although a major portion of this demand was focused on Treasuries instead of agency MBS. This is all the more impressive considering that the growth of loans and leases on bank balance sheets has been very strong and had absorbed almost all the growth in their deposit base YTD 2014.

Domestic banks own close to 27% of all outstanding balance of agency MBS – so domestic bank activity in the MBS market is going to have a decisive influence on the direction of MBS spreads in 2015. Apart from Fed’s activity and net supply of agency MBS, domestic bank demand is likely to be the most significant determinant of both the direction and volatility of MBS spreads in 2015.

As mentioned, domestic bank holdings of agency MBS have increased by about $65b billion and Treasury (plus agency debt) holdings have increased by about $129 billion so far this year. Considering that total agency MBS and Treasury holdings of domestic banks at the beginning of 2014 were about $1.3 trillion and $408 billion respectively, the percentage growth of Treasury holdings is a lot higher than that of agency MBS. It is likely that banks are more aggressively growing their Treasury holdings instead of MBS holdings considering the very tight spreads offered by agency MBS in general. In fact the percentage of Treasury and agency debt securities in total securities portfolios of large domestic banks is at its highest level since 2000 per the Fed’s H.8 Report.

But all banks are not acting in concert. There is a meaningful difference between the behavior of large and small banks: large banks have increased their Treasury and agency bond holdings by as much as $190 billion, the increase in the Treasury and agency bond holdings of small banks was very small. In addition, small banks have increased their real estate loan holdings (both commercial and residential) by $101 billion, but large bank holdings of the same have declined by $12 billion.

And some banks are moving more of their securities holdings into held-to-maturity accounts from available-for-sale accounts because of a new regulation related to the treatment of unrealized gains/losses in bank capital calculations. In terms of allocation within the government (liquid) securities portfolio, banks appear to be favoring a combination of treasuries and agency CMBS versus agency MBS and debt.

One of the important long-term drivers of domestic bank demand for agency MBS is the difference between the growth in deposits and the growth in loans (“excess deposits”). The deposit base of domestic banks had increased by $312bn in the first 10 months of 2014 versus about $372bn in 2013.

What does all this mean for the guy on the street? To sum things up, banks have a number of possible ways to put depositor’s money to work, one of which is to buy MBS. If deposits drop look for banks to lighten up on MBS holdings, pushing prices down and rates higher. And the opposite may occur as well if banks continue to add deposits. Either way, understanding the link is important.

A new hire into a Capital Markets group will often ask about the link between Treasury securities and mortgage prices. One subject is the pros and cons of using Treasury securities to hedge locked mortgage pipelines, for example. The fact that U.S. Treasury securities are viewed as “risk free” by money managers and investors around the world is very important in this discussion, as every other security (mortgage debt, corporate debt, and so on) trades as a spread off of Treasury securities.

The spread for securities backed by mortgages varies from one day to the next, depending on various factors. In general these factors are based on the market’s perceived riskiness of those mortgages backing the securities, and possible of the securities themselves. In turn, the home loans that are used to create the securities have varying degrees of risk.

So it was with great interest that the market took note of the most recent delinquency figures released by the Mortgage Bankers Association last week. The delinquency rate for mortgage loans on one-to-four-unit residential properties decreased to a seasonally adjusted rate of 5.85 percent of all loans outstanding at the end of the third quarter of 2014.  The delinquency rate decreased for the sixth consecutive quarter and reached the lowest level since the fourth quarter of 2007.  The delinquency rate decreased 19 basis points from the previous quarter, and 56 basis points from one year ago.

This is good news indeed. The fewer delinquencies, the more investor comfort with securities backed back mortgages, the greater the demand, the higher the price, the lower the rates, the tighter the spread! Winner winner chicken dinner!

Delinquencies don’t include foreclosures, but we had more good news there. The percentage of loans in the foreclosure process at the end of the third quarter was 2.39 percent, down 10 basis points from the second quarter and 69 basis points lower than one year ago.  This was the lowest foreclosure inventory rate seen since the fourth quarter of 2007.

And so we are now back to pre-crisis levels for most measures. But there is plenty of leftover pain. The largest increases in foreclosure starts rates were for subprime loans.  Even though few to no subprime loans have been made post crisis, they still accounted for 33 percent of the new foreclosures started in the third quarter. The MBA reported that the foreclosure starts rate for FHA loans increased by 12 basis points in the quarter.  FHA loans were 17 percent of all loans serviced and accounted for 27 percent of new foreclosures.  Of all FHA loans, those originated in 2010 and prior accounted for 87 percent of serious delinquencies.  More recent vintages accounted for the remaining 13 percent. The MBA’s chief economist reported that on an aggregated basis, both judicial and non-judicial states saw decreases in loans in foreclosure, although the judicial states continue to have a combined foreclosure inventory rate that is around three times that of non-judicial states.

So what does all that mean? It means either that the market is improving, or everyone that was going to go delinquent has done so and we’re back to “normal.” (Except for New Jersey which continues to lead the nation in loans in foreclosure, although it saw another decrease from the previous quarter.) Even Florida, once with the highest percentage of loans in foreclosure, experienced a significant decrease in the third quarter. The foreclosure inventory in Florida has declined steadily for over two years now, and the percentage of loans in foreclosure is currently less than half of its peak in 2011. It is indeed good news!

Last week, following the conclusion of the October FOMC meeting, the Fed had announced an end to the QE 3 asset purchase program it started in September 2012. Now what? Should we care? Will traders and analysts have anything to talk about?

It is obvious that Fed’s purchases have dominated the overall activity in the agency MBS market over the past two years as it bought about $1.42 trillion agency MBS and increased its MBS holdings by about $870bn (after accounting for pay-downs) since announcing the QE 3 program. To put these numbers in perspective, the total gross issuance of agency MBS from September 2012 to October 2014 was $2.91 trillion while the total net issuance over this period was $328 billion. Thus, the Fed had absorbed about 49% of all the gross issuance of agency MBS and also provided net demand for 2.6 times the organic growth in the agency MBS market since September 2012.

Estimates indicate that the Fed owns about $1.76 trillion agency MBS out of the total agency MBS market size of $5.46 trillion – has it shifted the MBS market relative to the Treasury market? The nominal spread offered by production coupon MBS over 5-year and 10-year Treasuries now is about 48bp tighter than the average over the two-year period prior to the announcement of the QE 3 program on September 13, 2012. The Fed has gradually wound down its purchases, and nominal spreads offered by agency MBS versus Treasuries have changed very little in 2014 – in fact, nominal spreads offered by production coupon MBS versus the Treasury curve have remained nearly unchanged from the beginning of the year.

Sure enough: most market participants had expected the end of the QE 3 program to have a more significant impact than what was seen in MBS spread movements over the past several months. In other words, the end of QE was greeted with a yawn. Remember, however, that the Fed will continue to investor paydowns which lends some support to the demand side of the curve – or at least balances out that part of the supply.

MBS spreads have held up very well this year largely because of two factors. First, production of agency paper is down, and agency MBS volume had declined substantially from 2013 to 2014. Many thought that the market’s estimate for organic growth in the MBS market at the beginning of 2014 was at around $200-210bn but the actual growth is likely to be only around 75 billion. Second, interest rate volatility has been fairly low (except a few weeks ago) and implied volatilities in interest rate options market have declined substantially, which had helped negatively convexed products like agency MBS.

So now what? If economic conditions warrant it the Fed could crank things up with QE4. It could continue to invest principal paydowns. Or it could actually start raising short term rates next year (certainly not this year). When will the Fed increase the funds rate and when will it start tapering of reinvestment of MBS pay-downs? The smartest guys in the room are saying this should happen in about a year.

But a move in overnight Fed Funds does not directly move mortgage rates. Granted, the same factors influence both, but if rates go up due to economic growth, for lenders that means more potential borrowers and home buyers… not such a bad thing. In the meantime, investors are watching things closely. A sustained widening of MBS spreads look unlikely over the next few months unless the net issuance of agency MBS picks up substantially – highly unlikely.

We are pretty much done with 2014 and with Quantitative Easing here in the United States. By most accounts it was a success, although many people continue to second guess its impact, usefulness, and possibility of it being used again by the Federal Reserve. Certainly lenders have benefitted from the lower rates as have countless homeowners.

But the United States does not operate in a vacuum and now Europe’s economy could arguably use a shot in the arm. The prospect of QE has driven risk-free rates lower in Europe, which has lured companies based in the United States to issue Euro bonds. This impacts Optimal Blue customers both directly and indirectly for a number of reasons. Smaller lenders do not have access to the global markets, but the global markets impact them.

The spread between investment grade Euro notes and investment grade dollar notes is currently 211 basis points, an all-time high. Companies like Apple or Verizon are issuing billion in euro bonds yielding something like 1.65%. If you wonder why the stocks of big S&P 500 companies seem to be doing great in spite of our economy merely doing “well”, this is why. International exposure matters. U.S. companies are forecast to access the European debt markets to raise funds in euros at the fastest pace in at least eight years in 2015 as borrowing costs in Europe fall below dollar rates by the most in a decade.

Independent mortgage banks cannot borrow at 1.65%. They pretty much borrow from warehouse lenders at 3 or 4%, or they can access the debt markets at 9-11%. But multinational companies like Apple can borrow at 1.65% overseas. And certainly the big banks that have residential lending operations have low cost of funds.

We have all see the announcements and minutes from the Federal Reserve Open Market Committee meetings. They have pretty much set the stage for higher U.S. borrowing costs next year (at least short term rates) while European interest rates are predicted by economists to remain at record lows. As inflation in the region is poised to turn negative, momentum is building for the European Central Bank to start a quantitative easing program of government bond purchases to boost growth.

That is an interesting situation: rates heading higher in the United States while remaining at rock bottom overseas. Most experts think the yield gap to widen in the first half of the year on expectations that the ECB will continue to pump cash into the system through the purchase of bonds and that the Fed will raise interest rates.

As noted, most lenders don’t access the European markets. And interestingly enough, the big banks which are currently enjoying a very low cost of funds will see their margins squeezed as rates head higher. And when rates head higher we can expect warehouse banks to also raise their rates, especially as many warehouse lenders’ terms are pegged off an index.

Lenders are already making plans for 2015, trying to hone their business models to accommodate various rate environments, overhead escalations, expansion plans, and so forth. And we all remember how “the smartest guys in the room” predicted higher rates in 2014. They didn’t happen, and lenders were reminded that business plans should not be based solely on interest rate projections but instead on expansion/contraction plans, margins, and revenue.

Last week we learned that New York’s Department of Financial Services believes that Ocwen denied struggling borrowers the chance to fix loan problems and avoid foreclosures. The regular alleges that Ocwen inappropriately backdated foreclosure warnings and letters that rejected mortgage loan modifications, making it nearly impossible for borrowers to appeal decisions. Many borrowers who had fallen behind on loan payments also received warning letters months after the deadline for avoiding foreclosure had passed, department investigators found. Ocwen blamed software errors in the company’s correspondence systems for generating improperly dated letters.

Ocwen is not insignificant. With a portfolio of well over $100 billion it is the fourth-largest mortgage servicer in the country and the largest non-bank servicer. It specializes in servicing high-risk mortgages. One would think that someone would have checked to make sure that it wasn’t mailing out modification denial letters that were dated more than 30 days prior to the day that Ocwen actually mailed them. (These borrowers were given 30 days from the date of denial letter to appeal, but those 30 days had already elapsed before they received the letters.) Or that Ocwen would have checked to make sure it wasn’t mailing out backdated letters to borrowers facing foreclosure with a date by which they could cure their default to avoid foreclosure, but that had also already elapsed.

The implications for the industry are apparent. First, no company is immune from further lawsuits and liabilities. The latest claims of wrongdoing against Ocwen come less than a year after the company agreed to reduce struggling borrowers’ loan balances by $2 billion as part of a settlement with federal regulators and 49 states over foreclosure abuses. Regulators and the public believe that this is the most recent evidence that many of the same kinds of abuses that helped create the housing crisis and contributed to the Great Recession are still happening.

After the news broke Ocwen’s stock and bonds sold off as investors became concerned about its potential legal liability and the disruption that may be caused to its servicing operations. Investors are also wary of other non-agency pools of loans, and of every large servicer’s policies and procedures. This news could lead to additional costs imposed on non-agency residential mortgage-backed security (RMBS) servicers or investors.

The best case for RMBS investors would be that this issue is fairly contained, it leads to only a small fine on Ocwen, and the issues with the servicing practices are resolved fairly quickly. But RMBS investors should know the implications of a worst-case scenario. If the alleged practices are widespread, other state/federal regulatory agencies could also get involved and take strong action against Ocwen. A much larger fine could be levied on Ocwen and there could even be pressure on FHFA to move GSE servicing away from Ocwen. Such measures could potentially threaten its operational stability, potentially increase the likelihood of insolvency and seriously affect its ability to service its loans. Other possible outcomes include a settlement from regulators, which could impose forgiveness-related costs directly onto non-agency investors.

The vast majority of servicers do no specialize in troubled loans or borrowers. But whether or not a company is servicing these loans is of little consequence. What is important is that servicers, large and small, need to spend additional resources to make sure that regulations are being followed to the letter. The decision to retain servicing is not one to be taken lightly as the consequences of a mistake can be dire with the possibility of changing the financial wellbeing of a company for its shareholders.

I wanted to wait until the dust settled at the conference in Las Vegas before writing the commentary. What were the jungle drums saying? And is it of any use to LOs?

The big news was that the FHFA had requested Freddie and Fannie increase their maximum LTVs to 97%. But these lofty LTV levels are well known by FHA and VA and other programs. They have also been actively offered by banks to be placed into their portfolios. And mortgage insurance companies have insured this LTV for quite some time.

Banks and mortgage lenders are unlikely to loosen credit on home loans any time soon until Fannie Mae and Freddie Mac release more details on the latest efforts to jump-start the housing market. Let’s face it: banks and non-depository mortgage banks have been grappling with buybacks (putbacks) for several years from the Agencies, and they are in no rush to engage of a repeat of 10 years ago, and going through the buyback nightmare that they have suffered since.

Most mortgage lenders with whom I spoke to in Las Vegas remain gun-shy about loosening credit after being forced by Fannie and Freddie to repurchase billions of dollars in soured loans since 2008. They’ve seen regulatory enforcement actions and large fines from the Consumer Financial Protection Bureau and the Justice Department. And no lender with a balance sheet to protect wants to go through that. To encourage lenders to make more loans to borrowers with lower credit scores, the FHFA for Fannie and Freddie promised far more clarity on mortgage-buyback requests. We will see if reputable lenders follow along.

Fannie and Freddie also will lower down-payment requirements to as little as 3% to 5% for borrowers that have “compensating factors,” such as higher credit scores or incomes. We won’t know for weeks the specific details.

The other worthwhile news is that the OCC, Fed, FDIC, SEC, and HUD released a final rule on risk-retention requirements for various types of securitizations, as well as exemptions to these requirements (through qualifying criteria). The rules will become effective one year after publication in the Federal Register for securitizations backed by residential mortgages and two years after publication for all other securitized asset classes.

The industry has been waiting to see if QRM was going to equal QM, rolled out in January. The implications for residential mortgage-backed securities seem relatively benign with qualified residential mortgage (QRM) equated to the qualified mortgage (QM) rules. For non-QRM loans when they are securitized, the REIT securitization option seems to be the obvious choice at least for now.

The rule was consistent with the draft proposal that had been circulated, so there were no surprises. Dodd-Frank had a 5% risk retention requirement for securitizers of mortgages that are not qualified residential mortgages (QRM), but left the definition of QRM to regulators. The adopted rule states that the definition of QRM will be no broader than the definition of Qualified Mortgage (QM). The QM definition, which was set by the Consumer Finance Protection Bureau (CFPB), has some restrictive criteria and the most meaningful one is probably the 43% DTI requirement. But remember that the GSEs are exempt from QM until they are out of conservatorship (or January 10, 2021, whichever is sooner), and the FHA is also exempt from QM. This suggests that the near-term impact of QRM (and QM) is likely to be very limited. Most non-agency production that is currently being securitized, primarily high quality jumbo loans, are QM loans so they will also be QRM loans and there will be no risk retention requirement. The one exception is interest only (IO) loans. Given the strong demand for high quality jumbo loans from depositories, these loans should easily be funded by banks to the extent that investors are less willing to invest in these loans because they are not QM. Analysts believe that the bigger problem for investors in these loans is that they are not QM, and not the risk retention requirement because they are not QRM.

As prepayment news comes out, analysts have noticed a trend: VA loans are paying off more quickly than FHA loans. The unexpected increased buyout activity in GNMA over the past few months has led to a significant clean-up and a sharp reduction in aggregate delinquencies, especially for non-bank servicers. In fact, newer production GNMA speeds have been coming in much faster than expectations, driven largely by VA loans, due to their higher loan size, the third party origination (brokers) effect, and a lower refinancing rate, compared with FHA borrowers. Of course GNMA pools are made up of other loan types, but FHA & VA loans make up the lion’s share, and the trend is worth a look.

VA loans form an increasing share of recent GNMA securitizations. The faster speeds on VA loans appear to be driven by their higher loan size, the TPO effect, and a lower refinancing rate, compared with FHA borrowers. VA loans generally have worse convexity than FHA since the VA borrower tends to have better credit, and LOs and underwriters know that VA borrowers have access to an unencumbered streamline refinance program and are subject to relatively lenient fees. So VA speeds tend to rise even when refinancing incentives are very low.

But it is becoming more noticeable as the share of VA loans in GNMA issuance has been rising steadily (currently 35%). Generally, VA speeds are dramatically fast for newer originations and then start declining as time passes coming closer to FHA speeds over time. A significantly higher loan size at origination is likely boosting the speed of early pay-offs. In recent years, the difference in loan size between FHA and VA loans has increased significantly. For loans originated at the beginning of 2011, the difference in average size of FHA and VA loans was only $15-20k. Since then, the average size of FHA origination has remained around $170K, while that of VA originations has gone up to $225k. The higher size of VA loans makes them much more sensitive to any refinancing incentive than FHA loans since it results in higher savings relative to fixed costs of refinancing. So VA loans tend to pay faster in a rally just by virtue of their higher loan sizes.

What about broker business? Do broker-originated loans pay off more quickly since the broker tends to mine their database more actively? More than half of VA loans are originated through TPO (brokers and correspondents), and indeed TPO loans prepay faster than retail originated loans due to the active solicitation by brokers – especially after the 3-6 month early pay-off penalty goes away. And since brokers are compensated based on volumes, the effect is most pronounced for larger sized and good-credit loans.

Lastly, generally speaking VA borrowers have better credit. This may or may not impact prepayments directly, but it may help their rates and cost to refinance. There are a couple reasons VA borrowers may be obtaining lower refinancing rates. Banks are concerned about FHA putback risk and lenders are increasingly becoming reluctant to finance FHA mortgages, given the uncertain put-back risks they face. As a result, they may be offering higher rates for FHA refinance. The share of FHA loans originated by big banks has dropped from 70% in 2011 to less than 33% now.

FHA borrowers cannot roll in the closing costs for streamline refinancing into the balance of the loan, but the lender can offer them premium pricing and convert the upfront cost in points to a higher mortgage rate. VA loans allow up to 2 points of discount to be rolled into the balance of the loan for refinancing. A borrower can take those 2 points and pay them to the originator to lower the rate on his mortgage. This should result in a lower refi rate than a purchase rate.

All of these factors add up. Whether or not they continue remains to be seen, but if rates continue lower we can expect the difference to weigh on rate sheet pricing.

The lending industry has been dealing with the “QM versus non-QM” discussion and decision for nine months now. Qualified Mortgages have become part of the vernacular, and every day companies are weighing the risks of offering the product through retail, wholesale, and correspondent channels. QM, of course, refers to the federal Qualified Mortgage rules that are designed to foster “safe” lending. They ban certain loan features such as negative amortization and interest-only payments; set a 43% ceiling for debt-to-income ratios; and impose a 3% limit on total loan fees, among other requirements.

Of course, doing a QM loan does not shield a lender from a lawsuit in the future. It is also important to remember that non-QM loans do not equate to subprime loans. Lenders jumping into the non-QM space emphasize that they have no interest in funding subprime applicants who lack the ability to repay their mortgages. Many lenders, for example, offer products that allow debt ratios of 50% and depart from other QM standards for applicants who have strong compensating factors such as substantial down payment and reserves.

Impac Mortgage already has begun making loans nationwide on what it calls “Alternative QM” mortgages to several categories of creditworthy borrowers with special needs. Other lenders are following suit. They are targeting near-miss borrowers who almost qualify under standard rules, but not quite. Say they have solid credit scores and good jobs, but have a debt-to-income ratio of 49%. They’re likely to have difficulty making it through Fannie Mae’s or Freddie Mac’s underwriting systems, but Impac may fund them after taking a hard look at their bank reserves and assets.

Lenders are also addressing self-employed borrowers who have been left behind by QM rules and large lender underwriting guidelines. Business owners, for example, generally can’t show IRS W-2 forms and may have irregular income flows, complex tax situations and periodically high debt levels. Impac, New Penn, and others allow them to document their income using 12 months of recent bank statements and to have debt-to-income ratios as high as 50%. Also included in the product lineups are programs helping investors with multiple properties. They face significant hurdles when they apply for mortgages. Investors who own 10 or more rental homes or commercial properties and seek to refinance and pull money out are frequently turned down by conventional lenders. So some lenders evaluate borrowers’ incomes based on the properties’ cash flows and has no limit on total properties owned.

But all isn’t unicorns and rainbows. There is still the initial concern about future liabilities, and about investor acceptance. Although this may change, non-QM lenders are looking for borrowers with high FICO scores and ample money to put down on the home, earning a low loan-to-value ratio. Ability to Repay, or ATR, is critical, and non-QM loans can be a good credit risk if the borrower demonstrates an ability to repay.

Investors are showing interest in the product. The government, indirectly, wants the industry to increase “private lending” and therefore do non-QM although the agencies have a waiver until they come out of conservatorship to go above the DTI limit. Despite their issuing a tough QM rule, financial regulators really want lenders to do more non-QM to decrease Freddie’s and Fannie’s share of the total mortgage market.

Redwood Trust and other securitizing companies have added non-QM loans to their mixes. Given the higher yields of non-QM loans (usually 1-3%), the addition increases the overall yield of a large pool. And with money managers and hedge funds searching for yield, it has helped the demand for these pools – a trend only expected to continue and grow.

Here’s your lesson for the week: what happens when you combine REITs with dollar rolls? And what it might mean for lenders since utilizing dollar rolls doesn’t fit with all mREIT portfolio strategies. But for those with which it does, it’s nice supplementary income with real value. It may not last forever so companies that are “making hay while the sun shines” is something that many lenders can learn from as analysts appreciate mREITs capitalizing on it while it does.

As a refresher, a dollar roll is “similar to a reverse repurchase agreement and provides a form of collateralized short-term financing with mortgage-backed securities comprising the collateral. The investor sells a mortgage-backed security for settlement on one date and buys it back for settlement at a later date.” And a REIT is an acronym for a real estate investment trust, which is “a closed-end investment company that owns assets related to real estate such as buildings, land and real estate securities. REITs sell on the major stock market exchanges just like common stock.”

mREITs make most of their money with traditional net interest spread income. They buy mortgage bonds, leverage positions using debt, and net income is mostly interest income minus interest expense (including hedge expense) less operating costs. A number of mREITs (mortgage REIT) substantially beat estimates in the second quarter due to strong dollar roll income. The unusually high profitability of dollar roll positions declined somewhat in this quarter, but remained strong overall.

Dollar roll income is similar in many ways, but quite different in others. Most new issue agency MBS is purchased for future delivery (e.g., sign the contract today, take delivery of the bond in October). Dollar roll income is when you accept a payment to push your delivery date forward by a month (e.g., accept a 35bp payment to push your October delivery to November).

Why roll? There are two (intertwined) reasons mREITs are using the dollar rolls today. First, you don’t pay for repo borrowings to fund MBS positions until the bonds actually settle, so there are essentially no funding costs when rolling. Second, sometimes payment for rolling your settlement date forward by a month materially exceeds the interest you’d collect on the same bond. This can lead to dollar rolls having an “effective yield” or effective net spread well in excess of holding the bonds.

At this point the advantages outweigh the minor disadvantages (the mREIT has to be comfortable owning & hedging the rate risk on new issue fixed rate MBS, and dollar roll income is considered derivative income for REIT purposes meaning it’s not “good” income for the REIT 75% income test). Dollar roll profitability can be volatile. The “effective yield” on dollar roll positions tends to be much less predictable than cash bond yields, so a sudden decline can negatively impact quarterly EPS.

Market misunderstanding can create investment opportunity, and analysts anticipate dollar roll income remaining a sizable part of total earnings per share for several mREITs for at least another few quarters (possibly much longer).

The first focus for mREIT investors when judging a quarter should be on dividend paid + change in book value, also known as “economic return”. That’s a very difficult measure for an mREIT to fake or manipulate, and equally difficult for an investor to misinterpret. Dollar roll income, all else equal, tends to be accretive to economic return. As every lender and mortgage-related company seeks to scrape up every basis point they are turning to financing arrangements such as this for income. It could very well mean the difference between success and mediocrity.

Last week the Federal Reserve continued on its path of scaling back (tapering) its asset purchases. When the purchases finally end next month, rates may not do much – but volatility is expected to escalate. And with it, capital markets crews will be called upon to dust off their extension and renegotiation policies. So what do LOs think of these policies, and why do they seem to be a one-way street in terms of the borrower benefitting and the lender suffering?

Most lenders have a policy that if interest rates drop after a borrower has locked in their mortgage rate and cost that the borrower may under certain conditions be able to relock their mortgage at a lower rate and/or cost, this is known as a “float-down”. Borrowers are told that when they lock in their rate the lender will honor the rate and terms as long as the loan is approved and is able to fund the mortgage on or before the lock expiration date, regardless of how high the mortgage rates may have climbed in the open market.

Lenders, and especially capital markets personnel, know that when a loan is locked they loan is either hedged or is sold to an investor, in effect “pre-selling” the mortgage in the market, making a delivery commitment to investors. What borrowers are often not told is that if those commitments are broken the lender is penalized and usually there is a trickle-down effect to the originating entity that broke the lock. So if the commitment is made and then rates drop lenders recognize they need to have a mechanism in place to present a lower rate to the locked in client or risk having borrowers go to other lenders for lower rates and therefore burning their commitments.

As a result most lenders have a float-down policy that does not transfer the entire drop in interest rates to their clients in a down rate environment but usually splits the difference between the current market and the lock in rate and terms. Typically the conditions for a float down are that the loan must be approved and ready to close within 14-15 days (the loan is ready for loan documents with no outstanding conditions), the market rate must have dropped 0.25% or more for float down to occur of 0.125% or possibly more, the borrower must float down, if eligible, before the original rate lock date expires, and float downs can only occur one-time.

Rate lock extensions come into play when rates increase and the loan has not closed. If a borrower’s rate lock expires and they try to re-lock the loan, most lenders will offer the borrower whichever is higher: the same rate or the new market rate. The lender protected the borrower against higher rates by locking in the rate several weeks ago. Most have a policy to split lower rates with the borrower if rates drop, but they are not going to let the rate lock commitment expire then give the borrower a lower rate.

But borrowers are often encouraged to extend the lock if they know they are not going to close their loan by the time the rate lock expires. Just as at the beginning of the loan, when borrowers can buy a longer period, when the rate lock is about to expire most lenders will offer a rate lock extension for a fee. The fee will differ from lender to lender, as a rule the extension fee will be the same cost or more expensive than the original cost to lock for fifteen extra days at the beginning of the transaction.

Due to competitive pressures in the market, lenders will protect a borrower against increases in rates if there is a rate lock, and may allow borrowers to lower their rate if they drop. But the protection only lasts so long. LOs often tell borrowers as long as their rate is locked they are in good shape, and if rates drop “they will go to bat for them.” And if rates go up they will extend. Most successful lenders strive to educate their LOs and brokers about borrower education, and reminding them there are advantages and disadvantages of rate locks. And having an established renegotiation and extension policy is critical.

What’s happening this week? Among other things, the market is watching U.S. Federal Reserve’s Open Market Committee as its faces its most pivotal meeting of the year. (Although I seem to remember that line being used before.) The Fed will debate a potential overhaul of its guidance on interest rates and solidify its exit strategy for its extraordinarily easy monetary policy. The details of the central bank’s exit plan from Quantitative Easing (QE) are almost complete despite the intense debate internally over its pledge to keep interest rates near zero for a “considerable time”.

The recent strong run of economic data continues to add pressure to Fed Chair Janet Yellen and other top officials as they acknowledge the possibility of raising rates sooner than expected. The Fed’s meeting this week will most likely end with no change in policy beyond the well-telegraphed reduction in asset purchases. However the main focus will be on the Fed’s release of economic and interest rate projections and growth forecast through 2017. Analysts will analyze the post-meeting statement to see if there are any clues to reshape market expectations and timing of the first U.S. rate hike in more than eight years.

Last week Fed policymakers receive a confidential set of briefing materials. Together they are officially called the “Report to the FOMC on Economic Conditions and Monetary Policy”. That is a mouthful, so it is now known as the “Teal Book.” The Teal Book came about in the 1960’s when they combined the Green Book and the Blue Book. In 2010, the Fed officially merged these into one: The Teal Book. It contains analysis prepared by Fed staff ahead of the FOMC
Meeting, which covers developments in the US and international economy, provides updates on the forecast and outlook, and reviews a range of policy choices within this context, covering alternative strategies that are summarized in a menu of potential changes to consider while drafting the post-meeting FOMC statement.

(But we can’t forget the Beige Book. It summarizes regional economic developments and is released publicly two weeks before the FOMC meeting, while the Teal Book, like past Green Books and Blue Books, will only be released publicly with a five year lag. Who knew?!)

As usual, analysts will slice and dice the verbiage of the announcement, looking for subtle nuances in language: a change of a “can” to a “might”, unfortunately, and move markets. Officials want to remove “considerable time” from their language and also ditch the calendar-related guidance. The timing of the rate hike could accelerate if economic data continues to come in stronger than expected – is that shocking news to anyone? The Fed’s largest challenge with its exit strategy involves moving rates higher while keeping inflation stable given the immense liquidity in the financial system from their asset purchases. The Fed is considering using a reverse repurchase facility to sop up excess liquidity once monetary policies tighten. Look for a possible initial public release of an exit strategy blueprint at the FOMC announcement.

The Fed has a lot to think about. August nonfarm payrolls’ gave us a downside surprise. But for much of the summer interest rates have been pushed by geopolitical and international economic concerns – both totally out of the control of the Fed. Notably, rising concerns about Russia-Ukraine developments and weak economic data in Europe drove Treasury yields lower on August 7 and August 15, with the intermeeting low on 10-year yields occurring on August 15.

We can spend our wondering what the Fed will do, or what will happen overseas. But lenders continue to focus on what they can control, how they can improve efficiencies, improve revenue one basis point at a time, and doing their jobs.

Every person involved in capital markets knows that prices are set by supply and demand. On the supply side of the equation, there will always be people (or companies) that want money, and are willing to borrow at a certain rate. On the demand side of things, banks want assets to put into their portfolio, but investors also want to own bonds – and liquidity is very important. So anything that impacts the demand for MBS tends to cause a great amount of interest, since the demand for securities directly impacts the rates paid by borrowers.

With this in mind, the industry is keenly aware of, and following the developments in, the Federal Housing Finance Agency’s proposal for a framework for how Fannie Mae and Freddie Mac might issue and back a single-type of mortgage-backed security. The framework is a key step on the way to development of a single security, which FHFA officials said will reduce borrowing costs for potential homeowners. It would also potentially reduce costs for Freddie Mac, the smaller of the two mortgage companies, since Freddie pools trade “behind” Fannie pools.

Liquidity is important! For years, securities backed by loans guaranteed by Freddie Mac have traded at slight discounts to those backed by Fannie, which some investors attribute to Fannie’s securities being more liquid. The discount has varied significantly in the past, and Freddie Mac typically must compensate lenders for the disparity. Analysts in the past have pegged Freddie’s cost of the adjustment at hundreds of millions of dollars annually.

But the devil is in the details, and some investors are wary of the move. The FHFA said the new security would combine some aspects of the current Fannie mortgage-backed security with the disclosure framework of Freddie’s securities. The new security would have underlying loans that were purchased either by Fannie or Freddie, rather than combine the loans. The FHFA has requested input from the public on the proposed security’s structure.

The initiative to create a single security has been a priority for FHFA Director Mel Watt, who took over the agency in January. As has become apparent, waiting for Congress to do anything with the GSEs is practically futile, and FHFA officials have said that a change wouldn’t require legislation. But investors would need to embrace the new security for it to be a success. The combination of the securities will be a “multiyear process,” but it important for the industry to have input now.

Although the proposal combines many of Fannie’s and Freddie’s features, under the current proposal, investors might still end up treating the Fannie and Freddie-backed securities differently. If the economics for securitizing through one agency or the other continue to be different, then the problem that Freddie is dealing with today is going to persist. The new single securities backed by Fannie or Freddie loans along with Fannie’s and Freddie’s legacy securities would be interchangeable if they were resecuritized.

We all need to keep the goal in mind: combining Fannie and Freddie’s securities would increase liquidity in the market and ultimately reduce costs for borrowers. If that can be accomplished with a minimum amount of interim disruption, the industry would have done something very valuable without interference from the government – and that might be an even better goal.

I don’t know what happened to August, but it is gone. And with it went some very good funding months for many lenders. September is anyone’s guess, but preliminary word has pipelines at decent sizes for many lenders. But some of the things that happened in August may set the tone to the mortgage industry for quite some time, and it is important for capital markets, as well as originators, to keep some of those events in mind going forward.

First, rates are great. Treasury rates are, and have been for several months, lower than where we began the year. Few LOs can yelp about rates being too high for doing business. But balancing out that environment is the implementation of the qualified mortgage rule has, arguably, caused borrowers to shy away from the market while lenders tighten credit standards. And even if lenders embrace QM and non-QM lending, the compliance environment has led to lenders, fearing lawsuits over possibly innocent mistakes, to add on paperwork and hurdles for borrowers.

This has caused the fragile mortgage market to contract further than expected and pushed most to reset expectations for the housing recovery. The recent mixed picture in housing is a precursor to a more concerted effort to increase lending while the housing market remains fragile. On a positive note, origination margins are markedly better this quarter as a drop in secondary market yields combined with sticky mortgage rates has pushed gain on sale margins higher. This should make third quarter mortgage banking income as good, if not better than what we saw in the second quarter despite additional MSR (mortgage servicing rights) markdowns from lower rates and slightly lower volumes due to slowing purchase applications.

But this was all going on prior to August. On the policy front, August was a busy month as the Department of Justice announced a $16.65B settlement with Bank of America, the GSEs released Q2 earnings which show that the U.S. government has recovered $219 billion (yes – over $200 billion) on its $189 billion, Pershing Square jumped into the ongoing GSE shareholder court battle, Fair Isaac announced technical changes to its FICO credit scoring methodology that could benefit borrowers (in the long run – not immediately), Mark Zandi and Jim Parrott released a paper on the private mortgage insurance eligibility requirements (PMIERs) that will likely impact the debate, and MBA President Stevens discussed his thoughts about lender overlays in the mortgage market. How are we supposed to keep track of all that?

But wait – there’s more! FHA Commissioner Carol Galante is departing. The FHFA, who oversees Freddie Mac and Fannie Mae, released a request for input on the “Single GSE Security” proposal. The CFPB continued to fine companies, including Amerisave, and apparently has Flagstar in its crosshairs according to a recent Flagstar financial report. Fannie cut its 2014 housing forecast, but the MBA tallied up its 2nd quarter results showing that private lenders did well in earnings per loan. Barclays settled with Thornburg, Affiliated left the correspondent channel, Ellie Mae bought AllRegs, and lenders and banks continued to merge.

Credit loosening finally here? Credit standards have widely considered to be very tight since the financial crisis began. According to the Federal Reserve’s Senior Loan Officer Survey, we have not seen a single quarter in the last eight years where credit standards meaningfully loosened until this quarter. We believe this is due to a modification of rep/warrants rules by the FHFA combined with the mortgage market finally absorbing the Qualified Mortgage rule implemented in January. See page 19 for more details.

How are we supposed to keep track of all of that? Darned if I know. An in-depth knowledge of all of that is nearly impossible, but it behooves lenders to at least stay abreast of all this, and the potential impact on their business.

I would venture a guess that every residential lender in the United States has an attorney on its payroll, has one on retainer, or has consulted with one. Just think of all the potential lawsuits that could come from 50 states and various federal agencies, suing all the lenders, investment banks, and rating agencies that were doing business ten years ago. And just think of all the potential pitfalls that could befall every lender, securitizer, and so on in the upcoming decades.

So it was with great interest last week that the news broke of an actual settlement between Bank of America and the Department of Justice when they announced a $16.65 billion settlement stemming from violations. The headline settlement amount is not a lump sum. It is comprised of a $9.65B cash component and $7 billion in consumer relief. The DOJ has now been at the heart of almost $37B in headline penalties under FIRREA from JP Morgan Chase, Citigroup and now Bank of America.

Unfortunately, the fix does little to repair much of anything, and certainly doesn’t make investing in these securities any more safe than in the past. The $9.65 billion goes to the Justice Dept., six states, and other government agencies, including the SEC, and $7 billion goes to ‘struggling consumers.’ There is nothing going to any investors in the securities – and wasn’t that the crux of the lawsuit? Citi’s $7 billion settlement in July was comprised of $4.5 billion for the Justice Department and various government entities and five states, and $2.5 billion for consumer relief.

Unfortunately for those that purchased these bonds, there is no visible relief, nor the impression that they are anxious to buy more. Arguably investors were taken advantage of when they bought the securities, they received nothing for a remedy, and they are still concerned to about various communities using eminent domain to seize the collateral that backs their investment in the Private Label Securities market.

The Treasury and others can focus lots of energy on trying to fix PLS reps and warranties, structures, alignment of interests, and reducing conflicts, but when investors (who did nothing to contribute to the PLS debacle) continually get the short end or really no stick at all, there should be no surprise that the biggest triple-A investors have not participated in the fledgling PLS 2.0 market and they are not likely to participate in the future. Without their return, it will be very difficult for the government to reduce its participation in the mortgage market and we will be stuck with a very high level of government involvement for a long time.

Things don’t end there. The Bank of America settlement brings up other concerns, some of which are specific to this case and others that are more general. Bank of America’s $1.3 billion High Speed Swim Lane case is not covered by the terms of this agreement. The Mortgage Debt Forgiveness Act’s expiration is restricting the impact of these settlements. And FIRREA is here to stay for financial firms but the scrutiny of these settlements is growing.

The BAC deal includes $490 million that is intended to soften the tax impact of principal reductions and short sales initiated under the deal given the that the Mortgage Forgiveness Debt Act has yet to be reauthorized. Attorney General Holder stated: “Until Congress acts, the hundreds of thousands of consumers we have sought to help through our settlements with
JP Morgan Chase, Citigroup, and now Bank of America may see a significant tax bill just as they are beginning to see the light at the end of a dark financial tunnel.”

Critics suggest that this is merely a transfer of wealth from the private sector to the government. And it is not hard to see that.

This quick note from a trader last week caught my eye. “Into the violent move in rates mortgages are finally starting to give up ground here as we’ve seen pretty material real money selling both outright and as basis across the entire stack…Also supply is starting to accelerate a bit at $1 billion of new bonds, clearly this makes sense but the likely flush of supply will occur when the market settles back and down, and new loans lock at lower rates.”

But are we really going to see a “flush of supply”? Certainly we will see some, but perhaps not as much as in the past. Late last week risk-free Treasury securities rallied. The 10-yr T-note hit 2.30%, finally closing Friday at 2.35% – its lowest level since June of 2013. Investors and traders are voicing concerns over an increase in mortgage supply with the drop in rates, and are anxiously waiting to see when originators will drop their rates and by how much. Others, however, are reminding the market of the relationship between rates and the primary/secondary spread.

The correlation between 10-yr T-note yields and the primary/secondary spread is roughly -80%. If originators were perfectly efficient, this correlation would be closer to 0 as drops in interest rates would spur simultaneous decreases in the mortgage rate and the primary/secondary spread wouldn’t move (and vice versa when rates go up). Given current pricing attributes, analysts are starting to think that this correlation will inch closer to -100%. What does that mean for lenders?

Originators, and thus investors, may be surprised to see that the expected pickup in loan volume due to a declining rate may be undermined by a primary/secondary spread which is reverting back to its longer term trend of 110-115. Rate volatility is creeping back into the market causing originators to demand more of a rate cushion. So while we will see an uptick in origination as borrowers take advantage of the free option and lock rates, we will see nowhere near the volumes from a year ago.

The overall larger, refi window will be relatively muted as originators protect themselves from getting chopped up in more volatile markets. As we move into autumn, purchase applications historically drop, and there is little here in 2014 to suggest that this won’t happen. Higher G-fees (relative to the last time we were at these rate levels) from Fannie & Freddie, and more HARP burnout, will keep volumes systematically lower. Originating a loan has never cost lenders, and therefore borrowers, so much. In the 1st quarter the MBA reported that total loan production expenses – commissions, compensation, occupancy, equipment, and other production expenses and corporate allocations – increased to $8,025 per loan in the first quarter, up from $6,959 in the fourth quarter of 2013.

Investors thinking we are going to see a huge boom in MBS issuance should remember that not only are there millions of borrowers with rates less than where they are now, but the impact of any move in rates is dampened by the cost of actually closing a loan. Secondary personnel and models that set rate sheet pricing aren’t keen about lowering rates when they have hedges in place on an existing pipeline that has huge mark-to-market gains in it.

Bucking this pattern are sellers of homes and lenders pushing for volume, and old programs are making a resurgence. For example, owners of homes are offering to lower their buyer’s mortgage rate by buying down the rate. Mortgage assistance may help offset rising prices and the much-predicted looming rise in mortgage rates. “Seller-assisted, below-market-rate financing” on for-sale signs outside of listed homes may help, as well as interest rate buydowns, but it won’t set things on fire.

Two weeks ago this column highlighted the move toward a single security platform. The conservator of Freddie & Fannie – the FHFA is expected to announce information on its drive toward a single security for the two loan products. A single security is a multi-year effort, and will no doubt be rolled out over several years. The viability of using the single security process and applying it to jumbo and FHA/VA loans is open for discussion. After all, why not use the same mechanism for pooling, rating, distributing, and owning all the different types of mortgage-backed securities that are out there? It would certainly lead to simplification in the secondary markets.

Last week SIFMA (Securities Industry and Financial Markets Association) released its thoughts on the mortgage-backed security business. Namely, how can, or should, the industry revitalize it? The emphasis of the SIFMA report was on private-label securitization (PLS). The Treasury Department had requested comments on the obstacles to PLS market growth and how these challenges can be addressed. SIFMA’s letter represents the comprehensive views of both buy and sell side members.

SIFMA believes that the continued dormancy of the PLS market is due in part to the lingering effects of poor origination practices during the housing boom and the resulting reluctance of sophisticated investors to buy senior debt. This should come as no surprise to anyone who has been anywhere in or near the business during the last decade. SIFMA goes on to say, however, that the PLS market is also constrained by other factors including market dynamics, regulatory uncertainty, disagreement over roles and responsibilities of transaction participants, and the comparative advantage provided to GSE and FHA mortgage-backed securities due to government guarantees and preferential regulatory treatment.

It is hard to have a market, however, without investors. SIFMA members believe there is a need for investors to have greater confidence to invest in mortgage credit risk in the PLS market, which would make PLS pricing more favorable and increase liquidity. Efforts to improve PLS markets should focus on reducing current roadblocks, leveling the playing field, and increasing the competitiveness of PLS so that issuance can rebound over time. No investor wants to buy “a pig in a poke.” Investors want accurate data and transparency of cash flows, documentation that has integrity, appropriate reps and warrants and the ability to enforce them, and a level of overall comfort that they apparently didn’t have ten years ago.

All of this comes with a cost, of course. And who will pay that? There is a move away from having the issuer pay the rating agency, for example, due to the perceived conflict of interest. Issuers of Private Label Securities need to be able to estimate future costs of doing business in order to be willing to commit capital. The current level of uncertainty in the regulatory, legal and policy environment makes this very difficult. Along with economic factors discussed above, this uncertainty undermines issuer and sponsor incentives to increase their PLS issuance.

Throughout the process, everyone agrees that something must be done. With an eye on not cutting off the origination process, policymakers need to take steps to build the confidence of mortgage investors that policy will not unexpectedly shift in the future, at a cost to investors. In particular, policymakers should ensure that eminent domain is not used to seize performing mortgages from PLS trusts. It will take years, and almost becomes an engineering exercise for the industry to create set of programs, policies, and procedures that appeal to investors, lenders, and borrowers.

Unfortunately for the industry, buybacks, settlements, and indemnifications have become part of the fabric for lenders. There are scores of reasons why they occur, and any large lender can provide plenty of tales of issues that are either quietly taken care of or are escalated into legal action. All of this, of course, creates a cost to the lender which in turn is passed on to new borrowers.

Anyone in capital markets is very familiar with the “buyback dance.” Usually a letter or an e-mail is received regarding the Jones loan citing some deficiency or other problem. Depending on the size of the lender (Well Fargo, Frank & Bill’s Mortgage Co.) the person running capital markets takes on the assignment, it is passed on to quality control, or some staff member that has a solid knowledge of underwriting or policy issues. Research is done, the days and weeks grind on, the issues are uncovered, and argument is presented, back & forth ensues, a conclusion is reached. It is happening hundreds of times a week, at nearly every lender, in every state.

I bring this up because this is a very simple case. The complexity only increases, especially when various counterparties are included. For example, the industry recently learned that mortgage-bond trustees rejected a part of JPMorgan Chase & Co.’s $4.5 billion settlement offer over investor claims of faulty mortgages while accepting the deal for most of the transactions. This deal was first proposed in November, and yet it drags on.

This is not one loan, but 330 mortgage-bond deals. The accord is being declined by trustees for five of the 330 mortgage-bond deals and part of another. The trustees include Bank of New York Mellon Corp., Wells Fargo & Co. and Deutsche Bank AG. And news reports indicate that a decision was delayed until Oct. 1 for part or all of 27 other transactions.

Certainly it is progress. “We believe the acceptance by the trustees of the overwhelming majority of the 330 trusts is a significant step toward finalizing the settlement,” JPMorgan said in a statement. And you can rest assured that the company has put aside reserves accordingly. But this will not be the last we hear of it. The lack of a more sweeping approval may leave the bank exposed to a larger payout. JPMorgan negotiated the proposed agreement with 21 institutional investors including BlackRock Inc. and Pacific Investment Management Co. in a bid to move past legal troubles, and expenses. The accord was announced the week before Chase agreed to a record $13 billion settlement with government agencies over faulty mortgage securities.

One can only imagine the legal fees incurred, not only by Chase but by Bank of America, Citi, Wells, SunTrust, etc. Hundreds of smaller lenders, and capital markets staffs, do not have the same resources that Chase does. Can a person running capital markets for a company doing $40 million a month, striving to earn every basis point, spare the time and energy vigorously defending their company against claims, many of which are groundless? Unfortunately, of course, one doesn’t know if they’re groundless or not, or material or not, until the time is spent and the manpower used.

And while this is taking place, hundreds of capital markets employees are fortunate to be able to spare the time and effort since a portion of their daily tasks are being aided by automation, including the pricing work done by Optimal Blue.

Even though GSE reform (basically Fannie Mae and Freddie Mac, for the purposes of this article) is pretty much dead until at least 2015 in Congress, that has not stopped those in the business from moving ahead with changes. The FHFA, MBA, NAR, home builders, and banks are all pushing agendas with regard to changes that could and should be made. The message to Congress: lead, follow, or get out of the way.

One area of reform that is receiving a lot of publicity lately focuses on the secondary markets. Namely, why do we need two different securities? Historically, there are differences between a loan underwritten to Fannie’s guidelines (through DU) and Freddie’s (LP). Each has programs that the other does not have. And there are certain guideline nuances exist, typically known to LOs and underwriters. But these have been gradually disappearing as the FHFA has overseen both agencies, and tend to issue bulletins where both Fannie & Freddie announce changes to policies and procedures.

So historically Fannie MBS are composed of Fannie loans and Freddie PCs are composed of Freddie loans. Having each entity sell separate securities divides trading, reducing liquidity. But the FHFA may soon ask for public comments on a plan to have the loans of both companies going into one security: a common security platform. As one can imagine, a tremendous amount of cranial capacity is going into this, not only for future originations, but also existing securities.

Moving to a market in which both companies issue a common security will have implications for everyone from home buyers and lenders to investors and taxpayers. Risks of combining the securities include reduced demand because some investors want to avoid Freddie Mac debt, and limits on investor holdings from single issuers may also hurt values.

But nothing happens overnight. A single security is a multi-year effort, and will no doubt be rolled out over several years – although Wall Street will react immediately even though something may not happen until 2016 or farther. One issue that can’t be ignored is the relative size of the two. A daily average of $121.6 billion of Fannie Mae securities traded in the main part of the mortgage-bond market during the first quarter, compared with $14.3 billion for Freddie Mac backed debt, per the Financial Industry Regulatory Authority. Liquidity is an issue, as slower trading in Freddie Mac notes has at times led the debt to trade at lower prices than securities issued by Fannie Mae. That’s led Freddie Mac to rebate some of the fees it charges for guaranteeing the debt to lenders that package mortgages into its bonds in order to support its market share, reducing the profits it turns over to taxpayers.

Another question that should be addressed is the viability of using the process and applying it to jumbo and FHA/VA loans. After all, why not use the same mechanism for pooling, rating, distributing, and owning all the different types of mortgage-backed securities that are out there? It would certainly lead to simplification in the secondary markets.

But the question will remain: what to do with the trillions of dollars of existing Freddie and Fannie securities? Will those continue to trade using old methodologies? Old remittance cycles? Old reps and warrants? These questions, and a myriad of others, are being answered by the FHFA in expectations of a proposal that will be great interest to the marketplace.

I have been sensing production issues for quite some time. Companies had a poor winter, but saw rebounds in March, April, and May. June continued the trend, but for many lenders July is evidence of the “summer doldrums.” There have been sporadic layoffs, although with vacation schedules this is not widespread. But do the numbers and evidence support a slowdown in residential lending?

The gross and net issuances of agency MBS in the first half of 2014 were $396 billion and $8 billion, respectively, and these numbers were a lot lower than the market’s expectations at the beginning of the year. The difference, of course, is refi volumes whereby existing debt is being retired but new debt assumed. The sharply lower gross/net issuance (and hence lower originator selling) has been one of the major technical factors supporting the tight valuations of agency MBS basis over the past few months. Investors are well aware that if the net supply of MBS continues to remain low, it may take a long time for MBS spreads to return to their historical averages even after the Fed ends the QE 3 program.

So where did the projections originate? Analysts assumed that existing and new home sales volumes and home prices in 2014 would be significantly higher year over year. Existing homes’ sales volumes, however, in the first half of the year has turned out to be about 6–7% lower than in 2013. Using the actual data, of course, results in previous net supply projections would have been about $60 billion lower than original projections primarily because of lower existing and new home sales. Realtors everywhere cite a lack of inventory. People are happy where they are, don’t have viable alternative places to live, are still underwater and can’t sell, or investors are holding on to rentals due to good returns on capital.

Of course, if the purchase market drifts down heading into the autumn, securitization volumes will also diminish. In looking at that trend, it is important to remember that banks are continuing to hold on to loans. If banks keep a higher percentage of conforming loans they originate on their books, the net issuance of MBS could be sharply lower. At the beginning of the year analysts did not expect a material decline from the high securitization rate seen in 2013 because of the current focus of banks on liquidity coverage ratios. But investors have watched as the securitization rate of conforming mortgage rates has likely declined substantially in 2014 while the volume of residential loans on the books of banks have been increasing gradually in
2014.

But these are mostly jumbo loans. While nonconforming loans on the books of banks may have increased, it is unlikely that this alone could cause anywhere close to the $100–110 billion difference in MBS issuance from 2013 to 2014. As it turns out, analysts are seeing signs that banks may have been keeping high quality conforming mortgages, and jumbo conforming loans, on their books instead of securitizing them.

So are we back to the future in terms of securitization numbers? Possibly: the securitization rate in the first half of 2014 has dropped at least to the 2011–12 levels (if not further lower than the 2011–12 level). If the recent trends with securitization rates were to continue, for the full-year 2014, one would expect the net supply of agency MBS to be $55–60 billion (or $45–50 billion in the second half of 2014). And that would indeed help mortgage rates relative to Treasury rates.

No one owns a crystal ball that can predict the future with consistent certainty. But people try, and certainly we can make some educated guesses about mortgage-backed security events during the remaining months of the year. Certainly current coupon agency MBS passthroughs had a great run in the second quarter of 2014 and outperformed their Treasury hedges, and made up for the opposite happening in the first quarter. But what about the next five months?

As most of us are seeing, the gross and net issuances of agency MBS have turned out to be a lot lower than expected. This has helped performance. And interest rates (especially mortgage rates) have remained in a very narrow range, implied volatilities have declined materially, prepayment trends were favorable and dollar rolls have traded special, all of which made the carry offered by agency MBS very attractive.

On the demand side, unless something totally unexpected happens in the economy, the Fed will to taper its MBS purchases by $5 billion a month and end its MBS purchases program altogether by Halloween. It is expected that the Fed is likely to be a net buyer of about only $45 billion MBS in the second half of 2014 versus much more in the first half. More importantly, Fed’s daily purchases of MBS are going to decline to only 30% of total issuance by August and to 25% by October from about 62% in the first half.

Domestic banks have been more active in the MBS market in the first half of the year than in 2013 and their agency MBS holdings have increased by roughly $30 billion. It is interesting, however, that banks have grown their Treasury holdings by about $60 billion, which seems to indicate that banks are likely paying attention to the rich valuations of MBS and buying Treasuries instead of MBS. Considering that agency MBS spreads are a lot tighter now than the average spread level in 1H’14 and the Fed’s QE 3 program is nearing its end, banks will probably be less active in growing their MBS holdings in 2H’14 than in 1H’14. Mortgage REIT holdings of agency MBS appear to have modestly increased in the first half after declining by almost $100 billion in 2013. Few expect this to change.

But the first half of 2014 saw much lower supply than expected of agency MBS. Some analysts say it was as low as (gross and net) $395 billion and $10 billion, respectively. Obviously, the likely magnitude of the net supply of agency MBS in the second half will be an important driver of MBS spreads over the next few months. Considering the recent trends in new and existing home sales and refi activity, “the smartest guys in the room” estimate the monthly gross and issuances of agency MBS to average $82-$84 billion and $8-$10 billion respectively in 3Q’14 and decline slightly from these levels in 4Q’14.

To the benefit of capital markets staffs everywhere, the range-bound nature of interest rates (especially mortgage rates) had minimized convexity hedging costs during the first half of the year and served as a tailwind for the MBS basis. But the vacation will end at some point, and it appears likely that the interest rate and volatility environment will become a lot less favorable to the MBS market. If things are quiet overseas, and our economy picks up some steam, expect rates to travel higher. And as we approach the Fed’s first rate hike we can expect the yield curve to steepen.

Recent FOMC forecasts contained an upward shift in interest rate forecasts for end-2015 and 2016 compared to their prior forecasts. However, Fed Chair Yellen does not appear to be in a rush to hike rates. In fact, during the post-FOMC press conference, Yellen referred to the recent strong prints in CPI as “noise”. Policy decision making is likely to be more data dependent, as both the level of underemployment rate and wage-growth indicate signs of potential weakness in the economy.

It seems as if the bond market lives in mortal fear of inflation. In fact, there is always someone in the press predicting that inflation will be an issue. At some point, they will be right, and thump their chest accordingly. But they have not been right for many years. Is there any new reason that Capital Markets personnel should start wringing their hands now? Over the past two years, inflation has remained persistently low as measured by the core personal consumption expenditures price index (core PCEPI), which excludes volatile energy and food prices.

Before we go through the current economic picture, let’s do some basic math as a reminder about the impact of inflation. If someone (an investor, a retired person, whoever) buys a vanilla-type bond that pays 3%, in general that bond will pay them a 3% return regardless of what happens during the duration of the bond. In a 0% inflation world, that is fine. But if inflation is at 3% a year, suddenly their return is eaten up: it costs 3% more to buy the same things now as it did last year. If it happens again, the buyer is in the hole. And thus potential buyers will want a higher yield, which can be accomplished by paying a lower price for bonds, and which in turns drives the price of bonds lower.

Economists are good at using inflation using model-based forecasts, often using the well-known Phillips curve model. The model, which suggests that inflation depends on past inflation and a measure of slack in the overall economy, is certainly better than a coin toss! Economists are good at adding variables onto the basic Phillips model. There are two that are popular right now. The first “extension” incorporates anchored inflation expectations with the constraint that long-run inflation eventually returns to the Fed’s inflation target of 2%. The second extension uses an alternative measure of economic slack that excludes the long-term unemployed and focuses on the short-term unemployed.

The basic model tells us that inflation is expected to remain very low for the next few years. With the two additions noted above, most predict a path for inflation that is still low but is higher than implied by the basic model. Remember that the Phillips curve framework is based on the premise that, during times of economic prosperity when overall demand rises higher than overall supply in the economy, there will be increasing pressure to push prices up. By contrast, during times of economic distress when demand falls relative to supply, there is a downward pressure on prices. The model therefore suggests that inflation depends on some indicator of unused productive capacity in the economy, or “slack.”

What about unemployment? While there are numerous measures of slack, a popular choice among economists is a measure referred to as the unemployment gap. This gap is defined as the difference between the level of the current unemployment rate and what the unemployment rate should be if the economy were operating at its full capacity. Last week we saw the unemployment rate drop to 6.1%, and the smartest guys in the room think we’re heading for something with a 5 handle.

But even as unemployment slides lower, models indicate that inflation is still not a huge threat.
Inflation, as measured by the core PCEPI, currently stands below the Fed’s 2% target. A simple empirical Phillips curve implies that inflation will remain relatively low in the near future, and even tacking on some additional variables, inflation is thought to pick up a little steam – but not much. Of course, models can be changed based on real life; real life does not change based on models. But for now, the inflation hawks don’t have much upon which to hang their hat.

Who is Starwood Waypoint? To be honest, I’d never heard of them, although I imagine hundreds of people, if not more, are gainfully employed there. Five years ago, if you had asked the average person, or for that matter many in the mortgage business, who Walter Investment, Ocwen, Nationstar, Lone Star, Two Harbor, or PennyMac was, you might have received a shrug. But once again we are all learning a new set of companies, and it is Starwood’s time in the spotlight.

Last week Starwood Waypoint announced the acquisition of a pool of 1,441 nonperforming loans. Lenders who are thinking about peddling a pool of scratched & dented loans always wonder about the purchase price of these assets. In this case, the purchase price of $117 million equates to 68% of BPO value and 62% of UPB. So lenders can figure on a 30-40 point hit for bad loans that are nonperforming.

This follows HUD’s recent announcement of Lone Star’s winning bid for a pool of NPLs with a purchase price of 77.6% of BPO value. While competition in the nonperforming loan (NPL) sector has increased – there is plenty of capital chasing fewer deals – most believe Starwood’s pricing makes Lone Star’s pricing suspect. But HUD described this June 11 auction as it’s “most competitive” to date with 27 bidding investors. (HUD’s second auction totaling approximately $1 billion in UPB took place on June 25th and winning bids have not yet been announced.) But the June 11th HUD auction may suggest different underwriting assumptions including higher leverage through securitization.

Lone Star…Starwood…Ocwen… these company and many others are attempting to make money buying distressed assets, working the loans and pools, foreclosing, and so on, and then repackaging and selling the loans or properties. I’ve heard one analyst describe them as “house flippers on steroids”. But it can be a sound business model, at least for those doing it. It takes expertise, time, energy, and labor to do what these companies are doing. And the market should appreciate their efforts.

Capital Markets staffs, and owners of lenders, are especially interested in their efforts. Determining a price of a bad loan is always a shot in the dark, and the canned answer is that it is “probably worth 70 or 80 cents on the dollar” depending on what ails the loan or the property. Ten to twenty years ago the subprime industry based its LTV standards on what could be gained in the event of a foreclosure, and this is still used in helping to determine the price of a given loan.

As lenders know, when homeowners default on their mortgages and enter foreclosure, costs related to this situation begin to add up quickly. With several missed mortgage payments in a row, a lender’s foreclosure efforts normally lead to additional fees and expenses. In the days leading up to a foreclosure sale, homeowners who want to reinstate their mortgages usually face an enormous bill. The costs incurred by the lender to foreclose defaulting borrowers typically add up to tens of thousands of dollars.

Certainly lenders that are about to begin foreclosure proceedings will incur numerous costs, so they will add various fees to the loans as the foreclosure process moves forward. The credit rating agency Standard & Poor’s states that typical lender foreclosure costs equal about 26 percent of mortgage loan amounts.

So there is a difference between incurring 26 points in foreclosing or selling it at a loss of 30-40. The difference can be explained, of course, because lenders are in the business of lending, and prefer to spend their resources doing exactly that. But it is good for Capital Markets staff to know the numbers!

It’s all about supply and demand, right? Last week the MBA reported that the prior week’s mortgage applications (per the MBA, representing 75% of retail originations) were down significantly. This was no surprise to lock desks, but was of great concern to both regulators, who occasionally wonder if their policies are cramping home buying, and investors who want to buy mortgage-backed securities. And if the supply is down, and demand is strong, that will lead to higher prices and lower rates, right?

And so traders reported that during the past week, 30-year production coupon MBS passthroughs outperformed their Treasury hedges by 8-10 ticks. The 30-year 4.5s and 15-year 3.5s were the best performers across their respective coupon stacks as REIT and money manager interest in these coupons continues. And the Fed continues to buy current coupons of agency production.

The biggest story in the agency MBS market continues to be related to lower-than-expected gross and net supply of agency MBS in 2014. Based on the latest trends in factors that typically drive net issuance of agency MBS, analysts now estimate that the net supply in all of 2014 is likely to be only about $65–70bn (or about $50–55bn in 2H’14).

So MBS investors were very attuned to the Fed’s meeting last week, especially given the lack of other market-moving news. While the Fed reduced its monthly net agency MBS purchases by $5bn to $15bn per month starting July, which was along the expected lines, the FOMC statement and the Fed chair’s comments were viewed as somewhat dovish and agency MBS have put in a very strong performance since. Economists expect the Fed to continue to taper its MBS purchases in each one of the next three meetings and that Fed’s net purchases of agency MBS will approach $0bn by November.

What does that mean for Optimal Blue clients? It means that their production will have less demand by investors. But if their production is down in a similar fashion, will it impact prices? Perhaps. Perhaps not. No lender thinks their production is going to drop, and there will still be investor demand.

Looking at actual numbers, analysts reduced projections for net supply of agency MBS in all of 2014 to $95–100 billion. This might even be too high, and some are thinking it might be as low as $65-$70 billion. At those levels, domestic money managers may not be able to add any agency MBS between now and the end of the year. So MBS spreads could remain fairly tight until the Fed’s purchase program actually nears its end. The only investor group that seems to have the capability to break the currently strong supply-demand technicals in the MBS market appears to be domestic banks.

In theory, lenders and borrowers stand to benefit, at least on a relative basis. Home loan rates may not go up as much as Treasury rates, but if all the rates go up, then what will supply do? Supply will continue to drop: there is little reason for a homeowner with a 3.50% loan to refinance into a 4.50% 30-yr loan, and rates aside, loan level price adjustments and gfees are higher than in the past, making it less cost-effective to refinance.

What about the government? Will it step in and institute some wiz-bang refi program? Don’t count on it. With the economy doing “okay” and many markets appreciating, there is little need at this point to institute more interference. And thus lenders are focused on adding production units, hoping rates don’t get carried away to the upside, and increasing their back office efficiencies. In other words, doing their jobs.

There has been a noticeable lack of non-agency (typically jumbo loan) securities issues so far in 2014. Issuance has dropped to $1.6 billion this year from more than $6 billion in the first five months of 2013, which is about 1% of the $1.2 trillion that was sold annually during the U.S. housing boom of the 2000s. Granted, a certain percentage of that $1.2 trillion arguably should not have been originated or securitized, but you get the picture. So the market taken notice of deals done in the last few weeks, and it is important for anyone in capital markets to take notice as well.

Aside from an Everbank intermediate ARM deal, reportedly pulled back to slice up in a different way to make it more palatable for investors, WinWater’s deal caused some excitement. WinWater Home Mortgage’s $250 million residential jumbo deal was rated by Kroll Bond Rating Agency (WIN 2014-1). According to one report, WinWater is “a residential mortgage conduit aggregator focused on opportunities in the non-agency jumbo sector.” The pool is 306 loans with an average balance is $815,247, average FICO score of 753, and an average LTV of 71%. 65% of the loans are on California properties (about 19% each from LA and SF areas), 8% from Washington, and 3% from Texas.

Not surprisingly Kroll notes that the concentration of loans in California is a concern of the deal. But as security issuers have found out, it is hard to put together a jumbo deal without California loans, and most of the loans come from California-based lenders: JMAC Lending: 14%, RPM Mortgage: 13%, and Opes Advisors: 10%, followed by Guaranteed Rate, Paramount, and Texas’ PrimeLending. Cenlar services nearly all of the loans, and the master servicer and custodian is Wells Fargo.

And now we have reports that Citi will also be issuing a non-agency security backed by 285 loans with total principal balance of $217.9 million. It will be titled Citigroup Mortgage Loan Trust 2014-J1, and filled with mortgages acquired by Citigroup Global Markets Realty. The top three lenders who originated the loans are Stearns Lending (34%), Nationstar (30%), and Freedom Mortgage (11%) – everyone else clocked in at less than 5% of the total pool. And it supposedly will be rated AAA to reflect a 6.35% of credit enhancement provided by subordination. The loans will be serviced by Nationstar (71.1%), Fay (23.0%), Fifth Third (3.2%), and PennyMac (2.8%). But perhaps the most comfort provided is that the originators will provide traditional life-time reps and warrants.

The heart of the lack of issuance is that banks are perfectly happy to put these loans into their portfolios rather than securitize them. The credit risk is often better than agency products, intermediate ARMs fit bank’s liabilities better, and banks have had trouble lending money out on commercial or industrial projects. So why let others share in the return?

We also have a Colony Capital LLC deal: Colony American Homes Inc. is planning to sell $558.5 million of bonds backed by 3,700 rental homes it manages in seven states, the fifth deal in the new securitization market since November per Bloomberg. $291 million of bonds are set to receive AAA grades from Morningstar Inc., according to a presale report from the firm’s credit- rating unit. Blackstone Group LP last year became the first among the hedge funds, private-equity firms and real-estate investment trusts that expanded in the rental business amid the U.S. foreclosure crisis to tap the securitization market. Its second sale last month was the fourth for such debt and brought total issuance to about $2.5 billion.

So perhaps the securitization biz is starting to shake loose somewhat…

Back “in the day”, Capital Markets managers would see each other at conferences and start chatting about what each one was up to, who was the hot investor, what their product mix was doing, and so on. The talk would inevitably turn to guarantee fees (Fannie) or guarantor fees (Freddie), and what each other was paying. Back then, gfees (to simplify terminology) were based on the credit-worthiness of the lender, the perceived risk of the loans it was originating, the size and financial strength of the lender, and a few other items thrown in for good measure.

Countrywide always had a great (low) gfee, followed by the Wells and Chases of the world. At one point it was rumored that Countrywide’s was less than 10 basis points, while smaller lenders might see something closer to 20 or 25 basis points. And it mattered: at a 4:1 buydown ratio, spending a full point (4x.25) to buy down a given rate on a mortgage to 0 was not as competitive as .5 in price. And it matters even more now. Gfees, which in 2009 were in the low 20 basis point range, are now in the mid-50s, and buydowns are closer to 8:1. So the cost to the borrower is nearer to 4 points, so when coupled to loan level price adjustments the cost is huge.

So it was with great interest last week when the industry and consumer advocates, heard that the FHFA announced that it is seeking input on the guarantee fees (g-fees) charged by Fannie Mae and Freddie Mac. Most remember that in December the FHFA, under Ed DeMarco, had announced a 10 basis point across-the-board increase in guarantee fees and an increase in upfront fees charged to higher risk borrowers. These increases were put on hold by Mel Watt after he became director of FHFA at the beginning of the year. The announcement and commentary from FHFA further reinforced views that Mel Watt will take a broader view of FHFA’s role as conservator of the GSEs, which in turn should be a positive for the housing market.

After his swearing in as Director of FHFA, Mel Watt announced on January 8, 2014 that he was putting the increases on hold pending further review. LLPAs currently can be up to 3.25% up front, which can equate to a 50-75 basis point increase in the mortgage rate (on top of private mortgage insurance).

But before everyone sends in a request to “lower your fees now!” it is important to remember that the announcement from the FHFA asks for industry input on a number of key issues. The first is the appropriate return on capital that should be driving gfees. The second is whether or not there is a level of gfees that will drive private capital back into the market. As we all know, the fabled “private capital” has been slow to invest.

The third issue is the impact of rising gfees on overall mortgage volume. The best entities to answer that one are the big banks – what small or mid-size lender has a research staff to accomplish that study? And the fourth issue is whether the GSEs should charge higher LLPAs if it means that these loans move to Federal Housing Administration (FHA) programs?

Unfortunately for lenders, most of their products are still government –related (Fannie, Freddie, FHA, VA, or USDA). And yes, every time the gfee increases, or loan-level price adjustments increase, the change in conventional loans shifts some borrowers to FHA products. Unfortunately the FHA has raised its insurance fees as well. And who pays for all of this? The borrower – of course.

Last week was relatively quiet in residential lending, given the Memorial Day Holiday. But that did not stop the industry from taking a look at itself, and I took the liberty of using a healthy number of comments from various lenders to try to obtain a sense of what is happening out there.

After a relatively poor November and December, January and February results were even worse for many lenders. In fact, many were thinking that things had better improve in March and April… or else. Sure enough, things have markedly improved for most small and mid-sized lenders, and in fact many are now seeing higher closings and pipeline size than they did a year ago!

However, industry analysts believe that the tone on the outlook for the residential mortgage market in 2014 is fairly cautious. (Sentiment was more positive on the commercial mortgage sector.) The larger banks, especially, have sounded a cautious note on production, stating that they are concerned about the current market as production has been lower in general than what was originally projected for the market at large. On purchase volumes, the big banks have seen some pick-up from 1Q, but still remain concerned, especially regarding affordability concerns with prices appreciating as job growth and income growth remain limited.

Companies that have fully “right-sized” can be profitable in this size market, and gain-on-sale margins remain fairly stable. Other lenders are looking at several areas of potential growth outside of the mortgage space, including commercial lending, held-for-investment loans in the mortgage space (primarily jumbo), leasing, and asset-based lending. Others are expanding their servicing operation, some even looking at the MSR subservicing opportunity. Still others are looking at new channels, like correspondent, to try to gain market share. And others yet continue to look at acquisitions.

And yet another area of growth is geographic expansion for the regional players. Some lenders have held off becoming licensed in any more states recently, but others are quietly obtaining licenses in states outside of their current footprint. For them, expansion into new geographies remains a key driver of growth.

Overall, the market is relatively healthy. QM was rolled out in January, and lenders continued to lend. Several investors have promoted their non-QM line-up of products, offering those primarily through their wholesale channels to brokers or smaller lenders. But even in the correspondent channel, Chase is buying non-QM loans from specific clients.

Lastly, banks and lenders continue to merge. The activity has been especially prevalent among commercial banks, with dozens merging every month due to various reasons such as efficiencies, geographic footprint, business models, and so on. But this is also taking place in mortgage banking as smaller lenders become part of larger lenders. The smaller lenders are often brokers that became bankers, but have grown increasingly worried about the current environment, and would prefer to focus on originations rather than compliance, HR, secondary marketing, accounting, etc.

Every retail loan officer follows pricing. And for the last several months, every retail LO has seen the price of jumbo products through banks such as Wells or Chase actually price out at better levels than conforming products. What is going on out there? Capital Markets staffs are being asked, “Doesn’t the government guarantee mean anything anymore?”

The fact of the matter is that banks (Wells, Chase, and the thousands of smaller regional and community banks) are retaining more high-quality loans that in the past would have been sold in the secondary markets. The majority of banks’ cost of funds is much less than 1%, and lending on commercial or industrial loans has been limited. Even conforming mortgages, which banks would normally securitize or sell to Fannie Mae or Freddie Mac, are being held in portfolio.

So what loans are banks selling to the Agencies? Analysts have raised the issue that the banks may be adversely selecting the weakest loans for the government-sponsored enterprises. The banks are in talks with Fannie to determine if guarantee fees need to be raised to cover the higher risk to the GSE of holding more loans with less-than-stellar credit characteristics. The banks contend they are still delivering loans of high quality to Fannie. The GSEs routinely evaluate the mix of loans being delivered to them and hold banks accountable if that mix deviates significantly from the past.

Fannie and Freddie have made a concerted effort to attract business directly from small and mid-size lenders, thus bypassing the aggregators. These aggregators are usually banks (Wells, Citi, Chase, US Bank). The risk profile of this product is similar to that in the past, but of a higher quality. In addition, by buying loans from smaller lenders, Freddie and Fannie stand to reap the benefits of putting together “specified pools” that trade for higher prices than regular pools.

The larger banks also have the ability to put together specified pools, earning that price pick up, but also have the ability to retain whatever loans they chose. At that point Freddie and Fannie often engage in a conversation about the risk profile of what the banks would deliver and make sure they are pricing appropriately. Put another way, F&F don’t want the loans that the bank does not want to hold, and do not want to be adversely selected against and therefore are very focused on any shift in the profile of risk. An article in American Banker mentions that Chase has decided to keep anywhere from 10% to 25% of higher-quality conforming loans that it normally would sell to the GSEs.

So what if a bank could originate loans to conventional conforming guidelines, but not add in the guarantee fee that Fannie & Freddie charge? Fannie and Freddie’s guarantee fees are typically embedded in mortgage rates to protect investors from losses on home loans. As opposed to ten years ago when gfees were in the teens, borrowers now pay roughly 57 basis points in guarantee fees and more in so-called loan level price adjustments assessed by the GSEs based on a loan’s characteristics. Those fees alone can add up to 75 basis points to the mortgage rate, a significant cost to selling a loan to Fannie or Freddie.

And so if a bank can save that for itself, why not? Banks are extremely comfortable with the loans they are retaining, which have high FICO scores, low loan-to-value ratios, and are well appraised – and thus are most likely to have low defaults. And what bank does not want high-quality loans on its balance sheet? But then again, so do Fannie and Freddie.

Last week the industry saw a few major pieces of news come out of the Agencies. Although not all lenders sell loans directly to them, or securitize FHA & VA loans, it is important to know what the Agencies have in mind as it impacts the markets (and residential lenders) from top to bottom.

First off, there was a lot of discussion about the potential expansion of mortgage credit availability given the speech on Tuesday by Mel Watt, Director of the Federal Housing Finance Agency (FHFA). Among other things, the speech focused on the need to provide more certainty for lenders related to rep and warranty risk. While the proposed changes were not that material, there was a lot of discussion among investors about whether this signaled a new focus from FHFA on increasing credit availability.

The changes to reps and warrants also focused the industry’s attention. It is generally thought that putback risk will be reduced by 2/3 on all new mortgages after July 2014 (2x DQ requirement versus 0x – going from about 11% of loans exposed to 4% per historical performance). The announcement also led analysts to theorize that it likely widens the credit box somewhat, which may nudge lenders to increase their willingness to lend. This item was aimed at the purchase market, and most believe that it should increase the supply (to any extent that credit is restricting purchases currently).

The announced rep & warrant changes may also encourage more cross-servicer refis in a small way. The changes may also impact likely small principal balance and HARP loan refi speeds, although the industry thinks that many borrowers who can refinance have already done so. HARP is already relieved after 12 months anyway, and the only change to HARP is for borrowers that did have at least one delinquency now need to be current in year 3 instead of year 5.

Speaking of HARP, these loans will be subject to heightened QC, so if lenders were to run HARP loans through a more stringent QC process then it could reduce HARP production further. So the QC process is a new wrinkle.

Further confusing things was the announcement by HUD Secretary Shaun Donovan that the FHA would be rolling out the “HAWK” program. The Federal Housing Administration (FHA) says that qualified buyers are currently underserved by the housing market and has issued a new handbook titled “Blueprint for Access” outlining additional steps the agency is taking to expand credit access to these borrowers guided by several principles to do so responsible.

The first is to encourage housing counseling to ensure borrowers are well-educated about home-buying and mortgage financing. The second is to establish clear rules of the road for lenders to ensure them they can make loans without fear of unanticipated consequences, and the third is to avoid unsound lending practices by building on the reforms already in place to support safe lending. As the first step in the new Blueprint for Access, FHA is launching the HAWK pilot program, Homeowners Armed with Knowledge.

The four-year pilot will permit homebuyers to qualify for savings on FHA-insured mortgages if they complete HUD-approved housing counseling provided through independent nonprofit organizations. Homeowners who complete the counseling before signing a home purchase contract and then complete additional pre-closing counseling will receive a 50 basis point reduction in the upfront FHA mortgage insurance premium (MIP) and a 10 basis point reduction in the annual FHA MIP. Choosing to participate in post-closing counseling and maintaining the mortgage for two years with no serious delinquencies will bring participants an additional 15 basis point reduction in annual MIP.

The industry is still ruminating on these changes, but it is obvious that the government is sensing that the lending restriction pendulum has swung too far and is impacting borrowers and the housing market.

With Johnson-Crapo on hold, and not much going on in the markets, it gives us a little time to look at the make-up of mortgage-backed securities. More specifically, securities made up of adjustable-rate mortgages. ARM loans are running at about 8% of the number of applications, but 18% of the total dollar volume: most are going into portfolios. And the agency’s ability to securitize their own products remains open to speculation – so lenders may be left to their own devices when it comes to creating ARM pools.

Most pass-throughs are backed by fixed-rate mortgage loans; however, adjustable-rate mortgage loans (ARMs) are also pooled to create the securities. Most ARMs have both interest rate floors and caps, setting minimum and maximum interest rates on a loan. These option-like characteristics require that pass-throughs backed by ARMs have higher yields than pure floating-rate debt securities.

Lenders know that residential ARMs don’t begin adjusting immediately. Popular ARMs currently are fixed for a period of time, usually 3 years, 5 years, or 7 years. A hybrid adjustable-rate mortgage blends the characteristics of a fixed-rate mortgage and a regular adjustable-rate mortgage. This type of mortgage will have an initial fixed interest rate period followed by an adjustable rate period. After the fixed interest rate expires, the interest rate starts to adjust based on an index plus a margin. The date at which the mortgage changes from the fixed rate to the adjustable rate is referred to as the reset date.

Processors, doc drawers, and funders know that ARM loans can be a little tricky. And every Capital Markets person who has been around for any length of time has had to work on the resolution of an ARM loan that is incorrect: something is wrong with the index, the margin, the change dates, or the caps.

Among the most common indices are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). A few lenders use their own cost of funds as an index, rather than using other indices. This is done to ensure a steady margin for the lender, whose own cost of funding will usually be related to the index. Consequently, payments made by the borrower may change over time with the changing interest rate (alternatively, the term of the loan may change).

But Capital Markets personnel need to be aware of other ARM features. There is the initial interest rate (the beginning interest rate on an ARM). The adjustment period is the length of time that the interest rate or loan period on an ARM is scheduled to remain unchanged; the rate is reset at the end of this period, and the monthly loan payment is recalculated. The index rate, noted above, is another feature. The margin is the percentage points that lenders add to the index rate to determine the ARM’s interest rate. Interest rate caps are the limits on how much the interest rate or the monthly payment can be changed at the end of each adjustment period or over the life of the loan. Some ARM products have a conversion feature that allows the buyer to convert the ARM to a fixed-rate mortgage at designated times. Lastly, some ARMs require the buyer to pay special fees or penalties if the ARM is paid off early. Prepayment terms are sometimes negotiable.

So why would anyone want to own a security made up of adjustable-rate loans? Well, they appeal to investors looking for assets to match short-term liabilities and liabilities with floating rates. Generally, ARMs in a pipeline are hedged with 15-year securities due to illiquidity in the ARM MBS market, but knowing the feature of ARM loans is important for anyone in capital markets.

Ed DeMarco was a relatively vocal director of the Federal Housing Finance Agency, the boss of Fannie & Freddie. The current director has publicly said little, but that may change here this week. FHFA director Mel Watt will finally make public statements this week after taking the job a few months ago. It is not clear whether there will be any major policy announcement, but next major policy steps are likely to be geared towards easing of credit standards with an eye on recent housing data.

I mention this because there seems to have been a clear shift in market sentiment around expected gross and net issuance due to weaker-than-expected housing and refinancing indicators, mostly in the agency MBS sector. Sure, we recently had a jumbo security issued – but for the first quarter the total jumbo issuance amounted to a small percentage of agency issuance. And volumes have plummeted everywhere, which is attributable to both fewer refis and new loans being more expensive to obtain.

Mortgages broadly did well also due to a shift in sentiment – investors are moving up in coupon, and there is some interest in interest only securities. The drop in lending volumes is forcing lenders to ease standards, but the process has been slow. During Q1 there was a significant drop in lending volume for most lenders except for Quicken. How these specialty lenders react is one of the most important themes to watch.

But what is driving the MBS market, and why are prices doing better than Treasury prices? Weaker home sales indicators and lukewarm purchase and refinancing applications activity have caused a shift in investor sentiment, as weather can no longer be blamed for the weaker housing data. As a result, prepayment fears have not escalated at all into the rally in rates, MBS have outperformed relative to their rate hedges, and they have tightened on an OAS basis. 10-year rates are close to 6-month lows, FN 3.5 prices are at a 6-month high, and the refinancing index is at a 6-year low!

With volumes down, non-QM lending on the rise, and the apparently lack of interest in either supplying more non-agency loans to securitize or banks simply putting those loans into their portfolio, one must ask what the FHFA, and thus Fannie & Freddie, is thinking. We may soon know, as there is a live webcast hosted by the Brookings Institution in which they will have a conversation with Federal Housing Finance Agency Director Mel Watt about the future of Fannie Mae and Freddie Mac. Director Watt has maintained radio silence after taking this new job as the FHFA director, and this is the first time in 5 months that he will be making public statements. At this point, it is unclear if he will make any major policy announcements, but it is likely that the recent slowdown in housing activity has caught his attention. It is expected that a major focus has to be making lenders comfortable with the GSE credit box so that they become more willing to make loans to first-time home buyers with lower credit scores (700-740).

But analysts believe that credit standards remain very tight and are not reflective of where we are in terms of the credit cycle. In contrast to residential mortgages, lending standards have eased much more for other consumer products like auto loans and credit cards. Many lenders seem open to reconsidering their credit overlays. In fact, Wells Fargo’s retail group lowered the minimum FICO for conventional mortgages from 660 to 620. However, one has to keep these announcements in perspective as average FICO for purchase originations is still around 750. The FHFA director could potentially take steps to help accelerate this process, which in turn would mean a possible increase in purchase and refinancing activity leading to possibly higher MBS issuance.

Part of the capital markets function is not only knowing what mortgage-backed securities exist, but also how they trade and what constitutes the various securities. For example, in the last week or so 30-year production coupon MBS passthroughs have outperformed their Treasury hedges by about .125. Home sales have been weaker than expected, and the demand for MBS is strong – thus the price movement. But these are generally “TBA” securities – To Be Announced – the universal hedge vehicle for locked pipelines and “buckets” into which mortgages are placed.

There is a “new kid” on the block that capital markets staffs should be aware of: modified pools. Recently, issuance of Freddie Mac M (modified) pools has increased, and there have been a number of trades in derivative and CMO form. People involved in capital markets should be aware of the make-up of these pools, their issuance, and their role in the market.

The Government-sponsored Enterprises (GSEs) have significant holdings of re-performing loans, and one way that Freddie Mac has started to work through its portfolio of distressed loans is by issuing wrapped pools backed by modified/re-performing collateral. In November 2011, Freddie started securitizing re-performing (i.e., reinstated) loans. To be eligible for securitization the reinstated loans must be current at least four consecutive months at the time of securitization. From October 2013, Freddie started securitizing performing HAMP and non-HAMP modified mortgages that were held in its investment portfolio. To be eligible for securitization, these modified loans needed to be current for at least six consecutive months.

The various types of these pools were created so as to provide liquidity and transparency of pricing for reinstated and modified loans that could allow Freddie to sell more of the distressed loans held in its investment portfolio. We now have reinstated (‗R‘) pools and re-performing modified pools (‗M‘ and ‗H‘). Neither are TBA deliverable, but roughly $8 billion of these pools has been issued to date. And there is certainly demand for them by investors, and supply from Freddie Mac. In recent months, issuance of M pools has picked up meaningfully, totaling about $840 million in March and $1.9 billion in April, more than 90% of which is in 40 year loans. Recent issuance was concentrated in the 3.5s through 5s coupon.

The biggest factors driving prepayment expectations for these pools are HARP eligibility and involuntary CPRs in the near term. For the majority of loans making up M pools, the borrowers had their terms extended to 40 years. As a result, borrowers are amortizing their loan at a slower pace versus 30 year loans and also require a greater rate incentive to refinance into a 30-year loan. Most loans were modified in 2010 and 2011 and are now 3–4 years past the mod date. And investors believe that the pooled loans were positively selected and should have experienced significant credit improvement since the modification, and thus default rates are low and should continue to trend lower. The updated FICOs for these borrowers at the time of issuance are approximately 40–60 points below their original FICO due to credit issues prior to the modification.

But some investors prefer lower-FICO, high LTV pools, right? The thinking is that these borrowers will be less likely to refinance – they’d don’t have the credit. The average updated FICO of these pools is significantly below the average 705 FICO of new FHA originations and 740 FICO for Freddie refi loans. So the belief is indeed that it is unlikely that most of these borrowers would qualify for a non-HARP loan until they experience more credit improvement. And approximately 30% of loans have a LTV greater than 100, and another 42% of loans have an LTV between 80 and 100.

Analysts think that over the long term, prepayments on M pools should converge with prepayments on fully eligible conventional pools of the same coupon due to credit curing and LTV improvements. However, in the medium term prepayment expectations depend on the duration of the HARP program. HARP is currently scheduled to sunset at the end of 2015 although it seems likely that this date will be extended. So although one can’t make a silk purse out of a sow’s ear, there is demand for these pools, once again helping the security’s price and helping liquidity in the marketplace.

“What are rates going to do tomorrow?” That was, and perhaps still is, the classic question asked by a loan originator of their secondary marketing staff. It is usually asked ahead of Non-Farm Payroll Friday, or the meeting of the Fed. Usually Capital Markets staffs wiggle their way through some kind of answer, although everyone involved knows that no one knows what rates are going to do for sure.

But Capital Markets staffs know what the general trends are, especially over the last week or so. Thus they know that while overseas events (especially in Russia, China, or Europe) can overrule U.S. economic news, the trend here in the U.S. is toward higher rates. And after a couple of months of disappointing economic data, indicators for March have begun to reflect more robust rates of economic activity. So although rates are not going to skyrocket, there is a general feeling that they are going to slip higher.

Retail Sales posted a sizable 1.1 percent jump for the month, while housing starts and industrial production both posted positive gains in March. Analysts’ expectations since the year began were for more solid GDP growth beginning in the second quarter after the severe effects of weather and a slower pace of inventory building weighed on growth in the first quarter. So although some believe that first-quarter GDP growth will come in around 0.4 percent, it will then accelerate to 2.8 percent in the second quarter.

As mentioned, Retail Sales for March rose a strong 1.1 percent, and the increase was relatively broad based. It was driven in part by a sizable jump in automobile sales (no pun intended). Other sectors contributing to the stronger March sales figures were furniture, building materials, general merchandise, non-store retailers and eating and drinking places. The stronger sales figures for March and the upward revision to February’s reading reinforce the idea that weather effects were the primary culprit behind the slowdown in consumer spending. For those who love nitty-gritty details, the control group within retail sales, which feeds into the calculation of GDP, rose 0.8 percent in March following a 0.4 percent reading in February. Some believe that these stronger “control group” numbers are consistent with the view for 2.1 percent annualized growth in real consumer spending in the first quarter.

Also on the consumer front, March consumer prices rose slightly more than expected, climbing 0.2 percent as food and shelter prices edged higher for the month. The CPI is now up 1.5 percent on a year-over-year basis. With import prices, producer prices and the CPI all edging higher, there now appears to be some upside risks to the inflation outlook throughout the remainder of this year. Industrial Production jumped .7 percent, adding to the thinking that the economy is doing pretty well.

But March housing starts rose 2.8 percent, less than expected, to a 946,000-unit pace while February’s starts were revised higher. The housing starts report last week confirmed suspicions that home construction activity was negatively affected by the winter weather and now appears to be poised for a pick up as the spring progresses. Single-family starts drove the increase in the headline reading for the month, rising 6.0 percent. Forward-looking building permits fell 2.4 percent following a sharp 7.3 percent rise in February. Even with a drop in permitting activity, many continue to expect home building to accelerate in the coming months with housing starts averaging around 1.07 million for the year.

LOs are often looking for economic data to nudge fence-sitters to lock in a loan for a purchase or refi. And last week gave those LOs enough ammo to do just that. But as mentioned, no one has a crystal ball. But put another way, there is little reason to think that rates will head much lower.

One common question that Capital Markets staff receives is, “Do you ever sell loans to REITs (real estate investment trusts), or do you use their prices on your rate sheet?” Mortgage REITS (aka, mREITs) are definitely involved in the demand for mortgage products, and therefore determine the price of many mortgage products indirectly. And although there are typically few, if any, direct links between a lender and an mREIT, it is important for capital markets personnel to know what mREITs are doing in the current market.

First off, as a reminder, a REIT is a company that owns and, in most cases, operates income-producing real estate (commercial real estate, such as office and apartment buildings, warehouses, hospitals, shopping centers, hotels and even timberlands) but also engage in financing real estate. There are tax advantages to the REIT structure, but broadly speaking mREITs were designed to provide a real estate investment structure similar to the structure mutual funds provide for investment in stocks.

Many mREITs trade up and down with the stock market. With the broader market heading toward official “correction” territory and mortgage REITs off to a strong start in 2014, they are attracting the attention of investors. And if mREITs are doing well, price-wise, that will impact their demand for mortgage product, with, in theory and simply stated, the demand for mortgages increasing the price and dropping the rates to borrowers.

Current mREIT pricing, broadly speaking, is about a 10% discount to book value. So analysts believe downside risk seems fairly limited (barring a surprising economic turnaround and change of heart from the Fed). In a turbulent market where “value” is suddenly replacing growth, investors and analysts alike are bullish on mREITs.

Slower mortgage refi activity tends to be a positive for mREITs, so banks reporting mortgage production down quarter over quarter, and year over year, is positive for mREITs. But the case analysts make for owning mREITs doesn’t depend on bad economic data or global central bankers deciding to fill in the gap that Fed tapering has left in QE. Continued economic growth, even at a moderately better pace than the past four years, is also friend to the mREITs. That’s because what’s “priced in” is some kind of sharp uptick in growth, or surprise Fed tightening, which is what would be required to send book values plummeting again and dividends being cut.

Investors believe that discounts to book value averaging 10% offer downside protection. It’s important to recognize book value is a fully marked-to-market net asset value of each company’s assets and hedges. An mREIT at a 10% discount to book can be viewed similarly to a closed end bond fund at a 10% discount to book: it’s effectively a statement by equity investors that bond investors are mispricing bonds to the high side. Perhaps that made sense a few months ago, when enthusiasm was high that the economy was poised for strong acceleration in 2014. With economic and earnings data disappointing, bonds firmly in rally mode, and bond yields back below their 200 day moving average this implicit expectation of bond market collapse looks increasingly misplaced.

What does all of this have to do with the rates borrowers see when they obtain a loan from a lender? Sure the Fed controls rates – but typically short term rates. Long-term rates are controlled by supply and demand (the reason why QE has been effective through increasing the demand). And if there is increased demand by mREITs for residential mortgage product, that will help push prices higher and rates lower. And that is easy for someone in Capital Markets to explain to an LO.

The odds of serious reform this year of Fannie Mae or Freddie Mac continue to be low. It is an election year, there are multiple bills, and given their collective profitability for the U.S. Government, the motivation is lower than it might otherwise be. That being said, continuing to keep the two under conservatorship is an unstable situation, and it is important for those involved in capital markets to understand the latest developments.

Two new bills have been introduced in Congress recently, one in the Senate, authored by Senators Tim Johnson (D-SD) and Mike Crapo (R-ID), and one in the House, authored by Rep. Maxine Waters (D-CA). Both the Johnson-Crapo Bill and the Waters Bill build on the Corker-Warner Bill of 2013 and call for a wind down of Fannie Mae and Freddie Mac, along with the establishment of a new housing finance regulator modeled after the FDIC. Analysts believe that the final resolution will contain elements of both, and it is good to the key points of each bill dealing with GSE reform.

First, know that the Johnson-Crapo Bill is largely similar to the proposed Corker-Warner legislation of 2013 in that it calls for the wind down of the GSEs and the establishment of new housing finance regulator modeled after the FDIC. Representative Maxine Waters introduced her housing finance reform bill on March 27. It, too, is very similar to the Corker-Warner Bill. All the bills call for the wind down of Fannie Mae and Freddie Mac. The five-year transition from the Corker-Warner Bill will be maintained in both bills – so it is highly unlikely to happen overnight.

Both bills would create a new housing regulator. Just what the industry needs, right? The regulator would be fairly similar under both bills, and would have supervisory powers over the housing finance industry and would also be charged with maintaining a reinsurance fund capitalized by companies in the industry.

The Johnson-Crapo Bill would require that private capital take the first 10% of credit risk on all guaranteed mortgages while the Waters Bill would require first loss of 5%. In addition, the insurance fund, capitalized by fees from the companies that participate in the program, would hold 2.5% capital under both plans. The full faith and credit of the United States supports all payments that are required out of the fund, and payments would be required only if the first loss risk sharing is insufficient to cover losses.

Both the Johnson-Crapo Bill and the Waters Bill support the creation of a new securitization platform. The Waters Bill establishes the Mortgage Securities Cooperative as the sole issuer of government insured securities, and each member of the cooperative would have one vote. The Johnson-Crapo Bill also calls for the new securitization platform to be an independent cooperative or other corporate entity acting as a utility.

What does all this mean? Both appear to be viewed as analysts as good templates for GSE reform. After all, they are very similar. Both bills provide practical ways to approach GSE reform. In order for GSE reform to not be disruptive to the housing market, GSE reform needs to preserve the government’s backstop role in the mortgage market, and both bills support that outcome.

But the devil is in the details. And an industry focused on CFPB examinations and penalties, buybacks, and dwindling volumes and margins will be hard pressed to grapple with the changes that these bills will bring. But the change is inevitable, and following the developments in Washington, regardless of time frame, is something in which the large banks/aggregators are involved.

Sometimes personnel involved in capital markets are so focused on setting rates, delivering loans, fending off buybacks, or handling dozens of other tasks that they lose sight of some of the basic events in the marketplace. And explaining them to LOs or borrowers. For example, as QE winds down, and the Federal Reserve moves toward raising their interest rates, how does this affect borrowers?

Capital markets staff should remind LOs that the Federal Reserve directly controls two interest rates, the Fed funds rate and the discount rate. At its policy meetings the Fed Board of Governors set these rates. But taking an even broader look at things, The Fed is the central bank for the United States and controls our nation’s money supply. It was formed by Congress in 1913 and is formally charged with three objectives: maximum employment, stable prices, and moderate long term interest rates. Over time the role of the Fed has expanded to include regulation and oversight of U.S. banks, monetary policy and ensuring our banking system is stable.

Part of regulating banks is setting the reserve requirements, the amount of money banks must have on hand in cash in vaults or on deposit with the Federal Reserve, as a percentage of their deposits; i.e. the amount of loans a bank can have outstanding. For most banks in the United States the reserve requirement is 10% of deposits. So if you have a bank with $1 billion in deposits you must at all times have at least $100 million in cash or deposits with the Fed, in other words your outstanding loan balances cannot exceed $900 million.

What happens if a bank falls short of the 10% reserve requirement? The bank would go to the Federal Reserve and borrow enough money to covers its reserve shortages, either by borrowing from other banks who have excess reserves on deposit at the Fed or from the Fed directly through the “discount window.” Borrowing from the other institutions the bank is charged the Fed funds rate, borrowing from the discount window the bank is charged the discount rate.

That is all well and good, but how is the average homeowner, and average American in general, affect by the Fed increasing the Fed funds rate and discount rate? By raising these rates the Fed increases the costs to banks to borrow money. And if it costs a bank more to borrow money it will either a) charge more to its customers for loans, and/or b) loan less money to ensure it does not fall short on its reserve requirements. Both of these options result in higher interest rates on credit cards, auto loans, signature loans and home loans. It is a ripple effect: the Fed raises rates, the banks raise rates.

Separate from the Fed but directly impacted by it is the Prime rate, which is generally described as the rate banks charge their best and most credit worthy customers. The Prime rate is not set by any one body but is generally about 3% above the Fed fund rate. While every bank can, and does, set its own Prime rate, the most commonly accepted prime rate is the Wall Street Journal prime rate which is published using the corporate loan rate from 75% of the nation’s thirty largest banks.

Borrowers who have a Home Equity Line of Credit (HELOC) will see that most of them are tied to the prime rate, and either have a rate equal to the prime rate or is the prime rate plus a margin of some amount. If the prime rate is generally the funds rate plus 3%, if the Fed increases the funds rate by 1% then interest rate on the HELOC increases 1%. Borrowers who have an adjustable rate mortgage (ARM) will experience the same thing since ARM loans are typically tied to a short term rate, usually the LIBOR, 11th District Cost of Funds, or short term Treasury.

Capital markets staff should remind their LOs that rates tend to go higher when the economy is picking up. Most housing markets are appreciating, unemployment is dropping, and so more borrowers are in better shape to possibly refinance or look at a new home. And experienced LOs will often recommend that borrowers who have an ARM or HELOC may want to convert to a fixed rate mortgage.

It must not be much fun to work for Fannie Mae or Freddie Mac. Sure, there’s the feeling of camaraderie, watching the profits escalate, and knowing that at some level you’re helping the housing market. But with regulators looking over your shoulder, embittered lenders arguing over gfees and buybacks, and occasional Congressional salvos fired your way about eliminating your company, the Happy Hour cheer must be diminished somewhat.

I mention this because we’ve had the full draft of the Crapo-Johnson housing reform legislation (S.1217) released. And the friend of lenders and banks, Maxine Waters, is expected to release her version in a matter of weeks. The Crapo-Johnson bill hews closely to the Corker-Warner bill released last year. It is important to compare the two, if for nothing else than to calculate where politician’s heads are when it comes to the Government Sponsored Agencies.

The new proposed bill creates a transition from the GSEs to FMIC (Federal Mortgage Insurance Corporation), with a system certification date within five years. The system certification date is defined as date on which GSEs can no longer engage in new business (see exceptions below), in turn defined as the date on which the FMIC Board of Directors certifies that the FMIC can fulfill all its duties and certain minimum housing finance criteria have been met (mostly related to all risk transfer mechanisms and aggregators, guarantors, etc. being in business).

Exceptions include refis of existing GSE guaranteed loans (no cash-outs), regardless of underlying loan characteristics. The system certification date needs to be within five years of enactment, with extensions by the FMIC Board of Directors possible. The FMIC can start issuing securities before the system certification date.

What about the trillions of existing Fannie & Freddie securities that are out in the marketplace? The bill says that legacy GSE securities will gain the full faith and guarantee of the new entity. All GSE debt and guarantee obligations (including guarantees after system certification date) gain full faith and credit, although the timing of guarantee is unclear. From six months after enactment, outstanding MBS securities can gain the FMIC “wrap” for a fee. The FMIC may also facilitate exchange of legacy MBS for new FMIC securities, the exchange of Fannie and Freddie MBS, or other such security exchange.

Under the new bill, Fannie and Freddie portfolios will be wound down. Within nine months of enactment, the GSEs are required to develop a resolution plan for an orderly transition. Single-family whole loan mortgage assets at the GSEs will be required to shrink 15% annually. On system certification date, the FMIC is to decide the amount of such assets that can still be held by the FMIC.

This bill introduces two specific counter-cyclical measures to maintain credit availability in times of stress. First, the FMIC may provide insurance on securities that do not meet the risk transfer requirements or on the risk transferred piece itself during “unusual and exigent” circumstances that threaten credit availability. HUD can also relax the provisions for approved entities. And if home prices fall nationally for more than two quarters, the FMIC may allow guarantees on eligible mortgages on covered securities to transfer onto refinanced loans, regardless of the value of the underlying collateral. This can be seen as a version of HARP that grants LTV waivers for underwater loans.

The FMIC is required initially to set up one small lender “mutual”, and outline guidelines for the future establishment of other such mutual, which will facilitate access to the secondary market by small lenders. The mutual will operate a cash window for small lenders, and membership restricted to depository institutions with certain asset, origination, or net worth requirements.

The passage of this bill is unlikely, given numerous hurdles: it is an election year, there are competing bills, the agencies are making money for the government, it is a complex issue, and so on. In fact, many analysts believe that nothing will happen, Congress-wise, until 2015, and then it will take years to make any changes.

Interest rates, and the market in general, have taken a back seat for quite some time to general regulatory or compliance issues facing residential mortgage lenders. After all, what difference does it make where rates go if you can’t afford to set up a compliance department, or have buybacks totaling more than your net worth? But still, everywhere across the United States, capital markets personnel are asked about where rates are going, and why. Nothing ever goes up or down forever in the financial markets, but few people predicted rates to drop during the first two and a half months of 2014 as they have. What gives?

The beginning of 2014 has been marked by weaker economic data, but most believe that this is a temporary “soft patch” and for growth to rebound as better weather settles in. Although it is difficult to determine how much can be blamed on the weather, there were several hints last week that the slowdown will be temporary. The first is that, despite more snow and ice in February, retail sales posted a 0.3 percent gain in the month, which reversed two consecutive months of sizable declines. Most of the previous losses can be attributed to a drop in vehicle and parts sales, which also managed to reverse its downward trend in February.

In addition, furniture sales ticked up after three straight months of losses, and the sale of building materials continues to climb higher, both of which bode well for the housing market and construction. Some economists believe that the sluggish residential construction may have more to do with insufficient labor and lots, than a falloff in demand, judging by remarks by homebuilders. Besides, JOLTS data show a marked improvement in the job openings rate for construction. Inflation, which has not been a serious issue for decades, remains benign as evidenced by the Producer Price Index (PPI) ticking down 0.1 percent in February which should allow the Fed to maintain its current pace of expansionary monetary policy.

Turning to the Federal Reserve, which meets this week, even with three nominees to the Fed, two of whom are new, most economists have not changed their outlook on a rate hike. Stanley Fischer, the impending vice chairman, does seem to be slightly more hawkish than Chair Yellen, with testimony to the Senate Banking Committee that included a remark about the problems of high inflation, but he also seems committed to seeing more improvement in the labor market. Most believe that the Fed will reduce its large-scale asset purchases to a $55 billion monthly pace this week.

Activity overseas, however, is a huge wild card. As we have seen in recent weeks, activity in Russia and China, and before that with the “emerging” nations in Europe, seems to have moved our interest rates more than our own economic news. How is anyone in Capital Markets expected to foresee that? Problems in Europe led to flight to quality by using dollar-denominated assets – which, of course, include Treasury securities and to some extent residential mortgage-backed securities. And thus prices rose and rates dropped.

Bu in recent weeks China and Russia have taken over center stage. Recent data show that the Chinese economy continues to have forward momentum, but the pace of growth has clearly slowed. Industrial Production there in the first two months of the year rose 8.6 percent, the slowest year-over-year growth rate since the end of the global recession in 2009. Growth in retail sales, which was running in the 13 to 14 percent range through most of last year, downshifted to 11.8 percent in the first two months of 2014.

But the big wild card this week will be the impact of the vote in Ukraine. Some think that the pressure being applied to Moscow by financial markets will likely help resolve the crisis more than any diplomatic process can (although threats of sanctions are contributing to the financial stresses). The Russian 10-yr yields were above 9.5% late last week due to nervousness: Russia resumed war games on the border of Ukraine and is sending more military resources into Crimea. Investors are largely resigned to Crimea leaving Ukraine – either being formally annexed by Russia or existing in a state of sovereign limbo for the foreseeable future. The big unknown is if the crisis stops with the weekend referendum or if the conflict escalates further – at the moment odds favor the former but the risks of the later have risen.

Anyone involved in, or who has watched, road bike racing (think Tour de France) has seen how the field of riders forms into a “peloton”. A peloton is the main group of riders in a bicycle race, but it is easy to think of other examples of groups sticking together – like a school of fish or a flock of geese. Birds, bikes, or fish, the reasons for staying in a group are well documented, and anyone that breaks away from the pack is often pulled back into it – eventually.

Something similar exists in residential lending. There are scores of correspondent lenders, recently led by Wells Fargo, Chase, U.S. Bank Home Mortgage, PennyMac, Flagstar Bank, Branch Banking & Trust, Franklin American Mortgage, CitiMortgage, SunTrust Mortgage, Nationstar Mortgage, Stonegate Mortgage Corporation, PHH Mortgage, Provident Funding Associates, Ocwen Loan Servicing, Walter Investment Mgmt., M & T Mortgage, and Fifth Third Mortgage. It is not surprising to see Wells’ production typically equal that of the next 4-6 combined. One might say that Wells has been out in front of the correspondent peloton for quite some time – but its market share has slipped. The peloton is catching up…

For a school of fish, usually fish that are preyed upon by larger fish, there is safety in numbers. The odds are that if you’re in a school of 1,000 fish, and a predator is only going to eat one, the odds are 1 in 1000 that it will be you – but if you’re alone, and seen by a predator, the odds could be as much as 100%.

Now, I am not saying CFPB exams, buybacks, pricing, and so on are symbolic of predators. But let’s face it – lenders feel that there is safety in numbers. Few lenders want to be the only one to offer a particular program, to consistently price aggressively. A few are venturing into non-QM, but on a wholesale basis; none that I have seen or buying non-QM loans through their correspondent channel. Very few lenders want to be the only originator of a particular loan unless a) they have a need for it in their portfolio, or b) they have a “big money” investor that will provide an outlet for the product. Few, if any, want to break away from the peloton.

But that is only one aspect of positioning oneself in the correspondent pack. The other key component is price. (Remember – companies sell price, product, and service, and at this point every lender has great service levels.) For example, there are always rumblings about some investor “breaking away” from the pack in terms of price. For example, Chase is currently rumored to be offering its correspondent clients an aggressive price, depending on geographic foot print. Alternatively, Wells Fargo seems to rarely offer the best price by a noticeable margin. The pricing group with Wells seems acutely aware not only of where its competitors are priced, but more importantly where margins should be, and the type of product they want to add to their portfolio.

But to finish up with the bicycling analogy, no investor ever “breaks away” forever. Guidelines and prices come and go, and various lenders alternate with each being more or less aggressive than the others – than the peloton. And it is a long race, not a sprint.

When people think of mortgage banking, they think of loans, rates, picking a lender, and an originator at that lender. But usually only those involved in capital markets, and senior management, pay attention to what is happening in the higher echelons of the bond markets, the supply and demand components, and who is doing what “behind the scenes” that directly impacts a borrower’s rate.

For example, how are mortgage-backed securities behaving relative to Treasury securities? The mortgage market has moved from one consensus to another over the last 18 months, and the latest consensus believes mortgages will widen (i.e., do worse than Treasury securities) in the summer as supply picks up on the heels of continued Fed tapering of about $5 billion per month. But will supply really pick up? Or will prices be more influenced by the Federal Reserve reducing its MBS purchases?

The bigger question might be whether an event, that is very well understood, can have an impact significantly beyond what is already priced in? Investors are focused on who is the next marginal buyer of MBS as supply picks up. But will supply really increase? Certainly heading into the spring and summer purchases pick up, but refis are expected to be anemic.

Last week Fed Chair Yellen’s Senate testimony covered little new ground, with eyes turning towards March Non-Farm Payroll and the FOMC meeting, although few anticipate that either event will move bond prices out of the range they’ve been sitting in for the last few weeks. But looking ahead, there are several factors potentially affecting mortgage performance. While the Fed will certainly play a role, given current market expectations, moves in rates, volatilities and cross asset valuations are likely to play an even larger role.

The market’s expectations for gross issuance and Fed purchases over the next year, assuming a consistent $5 billion in MBS tapering per month, are of interest. In January, the Fed purchased almost 90% of gross issuance in the agency MBS market. By December, many expect Fed purchases to fall to near 20% of gross issuance. With this massive drop in demand moving into the summer, the critical question for investors over the next few months is whether the significant change in Fed demand will translate to a move in market pricing.

That the decline in Fed demand is fully anticipated suggests the answer should be “no.” If historical experience is any guide, look for an argument that the market participants are overestimating the impact of flow effect. At the end of QE1 and QE2, and the start QE3 tapering, the absence of flow effect did not result in higher rates and wider spreads. Given the extent of their purchases, the critical factor investors have begun to consider is, “Who can take the Fed’s place as the marginal buyer of MBS?” However, just as important as this flow effect are moves in rates, volatility and cross asset valuation, which is likely to end up dominating market pricing.

Over the past year and a half, no investor category has been a net purchaser of MBS (excluding the Fed, of course). While this to some extent may have been inevitable given the size of Fed purchases relative to net issuance, it nevertheless leaves a large unknown when considering who will step in to purchase what the Fed had previously been taking down, and at what level would they be willing to do so.

So who will end up as the marginal buyer of MBS, and at what level will they come in? We are pretty much left with the usual suspects, depending on what happens to the components listed above: money managers if prices look good on a relative basis; life insurers, banks and REITs if yields look attractive; foreign investors if safety is critical.

The market is carefully watching the latest developments in the servicing arena. Namely, when a New York banking regulator (Benjamin Lawsky, the head of NY’s Department of Financial Services) halted the sale by Wells Fargo of $39 billion in servicing to Ocwen, it turned some heads. After all, if non-bank servicers can’t buy servicing, and banks are limited by Basel III from holding more than 10% of Tier 1 capital in mortgage servicing rights (MSRs), we could definitely see a price hit. And if we see a price hit, the borrowers will be impacted even more. But should we be worried?

First, let us take a very brief look at Ocwen Financial. Its name came from “New Co.” spelled backwards, and it made a name for itself servicing subprime loans, delinquent loans, and so on – in many cases distressed loans that other companies did not want on their books. Ocwen has emerged from the financial crisis as a growing – but much criticized – presence. It is a non-bank servicer of home loans that has ridden the fallout from the housing bust to multiply its revenues fivefold over the past six years.

Basel III rules that force banks to hold more capital against MSRs have proved a bonanza for Ocwen and other specialist servicers which are less constrained by the regulation. Ocwen, and others such as Nationstar or Walter, has been purchasing big portfolios of MSRs – especially the rights to distressed loans. Ocwen has increased the amount of outstanding mortgages it services from $43 billion in 2005 to more than $500 billion.

Shareholders have taken note, with the stock price up more than 600 per cent since 2008. Is it a bubble in the making? The stock move and capital levels have certainly attracted the attention of regulators who are concerned about Ocwen’s ability to service its rapidly expanding portfolio. Investors including Pimco and BlackRock are considering legal action against Ocwen due to the belief that it has caused undue losses for some bondholders thanks to loan modifications that reduce mortgage payments. Ocwen has always been known as an “aggressive servicer”, but anyone in the industry will tell you that this style is needed with non-performing loans, or tough-to-refinance loans.

As noted above, Ocwen is not alone in its expansive growth. Four of the top 10 mortgages servicers in the US are now non-banks, compared with just one non-bank servicer in the top 10 in 2011, according to Mortgagestats.com. In its part, to aid its growth Ocwen has built a corporate empire that extends from its headquarters in Atlanta, Georgia to offshore staffing centers in India and Uruguay, to corporate tax havens in Luxembourg and the US Virgin Islands, where Ocwen’s chairman, William Erbey, has his home. Mr. Erbey is still the biggest shareholder in the company he has helped grow since the late 80s.

And this also has its critics. Ocwen’s effective tax rate (12%) is far lower than the 38% paid by Nationstar, its closest competitor. The company maintains that its ability to service mortgages for about 70 per cent less than the industry average is down to its use of specialized technology – an excellent thing, and certainly something other companies aspire to have.

But regulators have expressed concern that the company’s focus on low costs has impacted the services it provides to borrowers. Those concerns culminated in a run-in with the Consumer Financial Protection Bureau, which accused Ocwen of a string of failures including charging unauthorized fees and making improper foreclosures. Ocwen settled the claims with the CFPB a few months ago, agreeing to forgive an extra $2 billion of mortgage principal balances. But did Ocwen really own the principal, giving it the authority to settle?

Most analysts think that Ocwen can fend off regulatory scrutiny and legal clashes with investors. But the market is worried, as it should be, about what happens when its MSR purchasing spree ends. While the company estimates that banks still have $1 trillion worth of MSRs to sell, the question may be who will buy them.

When a fixed income investor purchases an asset, the investor has certain expectations of that asset, including its risk, its return, its liquidity, and so on. Included in that list are expectations of its duration: how long it will continue to pay interest. Typically the investor wants the bond to continue to pay interest, especially in a declining rate environment. Unfortunately this is contrary to what a loan originator (MLO) wants. The MLO is compensated based on volume, and their livelihood is based on being able to either lender to a new borrower or refinance an existing borrower. In this last case, a problem arises.

If loan that an investor expected to have on their books for a given time pays off early, the investor will seek monies from the lender. The money is typically the premium (amount above par, or 100) or the value of the servicing. As a quick simple example, a lender gives a loan for $100,000, and sells the loan to an aggregator for 102, or $102,000. A clause in the contract states that if the loan pays off prior to six months from purchase, the lender is obligated to pay the aggregator $2,000 – the amount above par.

Capital Markets staff have had trouble explaining this concept of EPOs (early pay off penalties) to originators. (Or originators have had trouble comprehending it.) Some MLOs say that EPOs should not be charged back to loan officers. “Just because a lender wrote it into their employment agreement did not make it legal or the proper thing to do. If a LO knows that the consumer is going to sell or refinance within 6-months, he has an obligation to notify his employer. If the loan officer has created a good relationship with the borrower, he should know when a borrower has had a change of circumstance and is thinking of selling or thinking of refinancing prior to the 6 month anniversary. In that case, he can discuss the situation with his employer and they can make a decision together on how to handle the situation.”

In some areas, notably Arizona or Nevada, we have and will continue to see increases in early payoffs due to raising real estate values. Lenders’ concern over EPO is that buyers holding the property will do so just long enough to re-sell it at a profit, driving up property values at quicker speeds. The QM rules have taken away pre-payment penalties which would protect a lender from consumer abuse of this using Agency financing. Apparently prepayment penalties are “toxic”. They are toxic for a borrower that lies about their intent to occupy. One possible solution to make the transaction “fair” for everyone might be to offer pricing or products that suit the short term financing needs of the investor (higher rates or points without a prepayment penalty).  Or, change the tax laws to incorporate rules that penalize borrowers that lie about their intent to occupy.

Most of the EPOs that are pushed to MLOs are due to the Agencies demanding their premiums back from the lenders. Practically every wholesale lender has this EPO policy in their broker agreements. If one is a mortgage broker, they have absolutely no choice in the matter: one either signs the agreement and hope they do not have any early payoffs, or exit the business.

It turns out, however, that some aggregators are open to negotiating a reduced fee in some cases of loans paying off prior to the expiration of the EPO period. Privately Wells or Chase will allow lenders to buy out of the EPOs for a fee per loan if the relationship is very good.

The ebb and flow, waning and waxing, of residential lending is fascinating. Of course, the supply of mortgages impacts the supply of mortgage-backed securities. And if demand is steady, changes in the supply impact the price relative to other fixed income securities. So investors are quite interested in underwriting guidelines, rules and regulations, operational backlogs, and so on since they impact the supply of loans into the secondary market pipelines. In addition, general consumer lending also influences things, since people borrowing money tends to lead to economic expansion, and potentially higher rates.

So it is with great interest that the market is seeing big banks begin to loosen their tight grip on lending, creating a new opening for consumer and business borrowing that could underpin a brightening economic outlook. Are banks increasing their appetite for risk? It seems so: the U.S. Office of the Comptroller of the Currency said banks relaxed the criteria for businesses and consumers to obtain credit during the 18 months leading up to June 30, 2013, while the European Central Bank said fewer banks in the euro zone were reporting tightened lending standards to nonfinancial businesses in the fourth quarter of 2013.

Anyone involved with a bank will tell you why this is happening: banks trying to take advantage of an economic improvement, competition for a limited pool of loans, and a sustained low-interest-rate environment all have banks lending money and reaching for returns.

Capital Markets folks are nervous. Expanding economies tend to lead to higher rates. There are indeed some pretty optimistic 2014 global growth projections. The World Bank predicts global growth of 3.2%, bolstered by stronger recoveries in the U.S. and the euro zone. The Federal Reserve predicts U.S. growth between 2.8% and 3.2%, while the euro zone is expected to grow by 1.1% after two years of contracting.

At the same time, the easing carries risks, including a return to the type of lax underwriting standards that sowed the seeds of the crisis, especially in mortgage banking. The comptroller’s report said it would still classify most banks’ standards as “good or satisfactory” but did strike a cautionary tone. “The more [banks] loan, just naturally there is going to be more risk. It’s a matter of how well they can control that risk,” said Bob Piepergerdes, the OCC’s director for retail credit risk.

And while we’re at it, let’s talk about inflation – even though inflation has not been an issue for a very long time. An upturn in bank lending, if taken too far, could also lead to inflation. The Fed has flooded banks with trillions of dollars in cash in its efforts to boost the economy. In theory, the printing of that money would cause consumer price inflation to take off, but it hasn’t, largely because banks haven’t aggressively lent out the money. Consumer inflation in 2013 was a percentage point below the Fed’s 2% target.

The comptroller’s survey found more banks loosening standards than tightening. The regulator said that in the 18 months leading up to June 30, 2013, its examiners saw more banks offering more attractive loans – and this study wrapped up six months ago. The trend extended to credit-card, auto and large corporate loans but not to residential mortgages and home-equity loans. So perhaps the MBS market is safe for now…

Well, it’s January, and it’s an election year. We can expect to see plenty of posturing by politicians in all aspects of our lives, and housing, and the finance of housing, is not exempt. So it is not surprising to see the first proposed legislation dealing with housing finance reform. It is worth taking a look at it, however, if only to see where the heads from a couple legislators are.

Representatives Delaney, Carney, and Himes announced a housing finance reform proposal and stated that they intend to introduce legislation in the spring. The proposal calls for a continued role for the government in supporting the secondary mortgage market combined with risk-sharing by the private sector. The bill would also essentially combine the GSE and Ginnie Mae securitization markets and back the MBS with an explicit guaranty.

Under the new proposal, all MBS issuers would be required to get 5% first loss mortgage insurance from an adequately capitalized monoline mortgage insurer, which would vastly expand the mortgage insurance market. The proposal does not specify the role of mortgage insurance for lower down payment borrowers. The mortgages can then be securitized through Ginnie Mae who would then contract with private insurers to risk share in the 95% of the risk it retained. The losses would be shared on a pari passu basis between Ginnie Mae and private insurers. This mechanism should result in market pricing for the MBS. Private capital would need to invest in at least 10% of the interest initially retained by Ginnie Mae.

Of particular interest to Capital Markets personnel is that, under this potential law, all secondary market issuance would be through Ginnie Mae and have an explicit full faith and credit government guarantee. There would be no issuance through Fannie Mae/Freddie Mac. This should meaningfully help the liquidity of the MBS market. Right now, GSE MBS trades at discount to Ginnie Mae and Freddie Mac MBS trades at a discount to Fannie Mae.

The Federal Housing Finance Agency (FHFA), the current regulator of the GSEs, would oversee the wind down of the GSEs’ ability to issue, guarantee, or purchase MBS. The GSEs could play a role in aggregating securities for smaller originators who do not have sufficient volume to create their own securities. They could also compete both as monoline mortgage insurers and as private reinsurers but their share of the market would have to be less than 30% at the end of five years, and they will no longer have any sort of government support.

Remember the Corker-Warner Bill in the Senate? This bill shares much common ground with it, and they both provide a potential frameworks for GSE reform that analysts think can be implemented without major disruption in the mortgage market. They both keep a continued role for the government combined with a significant role for private capital (although Corker-Warner has a 10% first-loss risk sharing requirement).

(The other current legislation is the PATH Act, sponsored by Jeb Hansarling in the House, which mandates the wind-down of the GSEs in 5 years and a largely private mortgage market. Most believe Hansarling’s piece of work would be very disruptive to the mortgage market.)

The proposed legislation would eliminate the current role of the GSEs. But given their profitability, is that going to gain any support from their fellow Senators and Congressmen? While they would continue to play role as a capital provider, without government support they would no longer have any cost of capital advantage. So, although it is not likely to go anywhere, we should all know that Washington is alive and well in looking at the mortgage industry.

The life cycle of a residential lender, in the past, was somewhat predictable. An entrepreneurial person found themselves in the origination business, began doing more volume, hired support staff, beefed up operations and capital markets personnel, and grew geographically. Originators started by brokering out loans to wholesalers, then obtained a small warehouse line, became a mortgage banker, and increased the number of investors and complexity of loan delivery. Brokering to 3^rd or 2^nd tier investors evolved into selling loans on a mandatory basis to top tier correspondents, and then obtaining agency approval. Many have made the leap into creating and delivering securities.

Delivering securities, arguably something lenders want the option of doing, has become more complicated. Based on recent data, investment banks are updating their TBA (“To Be Announced”, in contrast with “Specified” pool creation) deliverable assumptions for lower coupons. The changes have recently gone into effect, and change the way loans are allocated into pools. After all, secondary marketing personnel know that a given agency loan typical will have two options, easily thought of as “buckets” for delivery once the servicing (.250 for conventional conforming loans) and gfee is accounted for.

With the changes in rates, TBA deliverable assumption for conventional 30-year 2.5%-3.5% has been changed to worst to deliver within the 2013 origination, because the majority of production has now shifted into 4% securities. Lenders originating FHA & VA loans and issuing those securities have the added complexity of the Ginnie I versus Ginnie II securities. Similarly deliverable assumption for lower coupons GN1 and GN2 2.5-3.5 has been changed to worst to deliver within 2013.

Investors are keenly interested in this. Fannie and Freddie 4% 30-yr securities are now mapped to recent origination collateral while 4.5s have been mapped to the 2010 vintage. This has, as one would expect, impacted option-adjusted spreads (OAS), in this case resulting in an OAS reduction of 9-10bp on 4s while OAS on 4.5s has risen by 2.4bp. Investors are now “mapping” Ginnie II 4s to recent origination collateral as well; however, Ginnie I 4s have been mapped to 2011 vintage because recent production has almost entirely shifted to Ginnie IIs. The OAS effect on GN2 4 TBA is -10bp while that on GN1 4 TBA is almost flat.

Those who follow 15-year securities are seeing, and doing, a similar re-mapping. Fannie & Freddie 2% and 2.5% securities have been changed to 2013 origination, while 3s are now mapped to recent origination. Fannie & Freddie 15-year 3.5s have been mapped to worst to deliver within 2012 vintage while 4s and 4.5s have been mapped to 2010 vintage.

“So what?” Well, investors are keenly aware of potential prepayment speeds of mortgage-backed securities. And those prepayment speeds are often a direct result of the coupons of the mortgages contained in those securities. For example, two Fannie 3.5% securities may have very dissimilar pool characteristics, due to the interest rates of the mortgages contained therein. If and when rates move, a pool composed of 3.75% mortgages will behave differently than that of a pool filled with 4.125% mortgages.

The pricing of those pools will also behave differently. Banks, insurance companies, etc. – whoever owns those pools, will see their price move differently relative to the Treasury market, and benefit or suffer because of it.

Last week we noted that the Volcker Rule, part of the Dodd-Frank banking reform legislation that bans “proprietary trading” among banks, is more directed at “covered funds.” These are among the investments banks are no longer allowed to hold under the Volcker Rule, and the banks have until July 2015 to get rid of them. After the American Bankers Association and several community banks sued the regulators in federal court to throw out the ban on “covered funds” investments, the bank regulators and the SEC said they would review the Volcker Rule again and make a final determination on the CDOs backed by trust preferred securities by Jan. 15. But pipeline hedgers who use TBA mortgage-backed securities are safe.

But the discussion and conjecture about the Volcker Rule continues, especially the effect of the Volcker Rule and Basel III revisions on securitized products. As noted last week, US agencies have adopted the final version of the Volcker rule, while the Basel Committee issued a second consultative document revising its risk-weighting securitization framework in the past few weeks.

Although the proprietary trading restrictions of the Volcker Rule have generally garnered the most media attention, analysts believe that the effect on securitized products from this provision of the rules will be limited. Banks can continue to perform market making, underwriting, and hedging functions in all securitized product asset classes and can even trade agency MBS in a principal capacity.

The Volcker rule prohibits banks from owning or acquiring covered funds. One can expect most first-order securitizations to be exempt from the covered funds portion of the Volcker Rule. However, some re-REMIC, CDO, and esoteric asset-backed security (ABS) positions may be considered covered funds if they do not qualify for one of the exemptions under the Investment Company Act (ICA) of 1940.

It is possible that regulators address the re-REMIC exemption in coming weeks as they provide clarifications. However, in the absence of an exemption, the only feasible solution for these specific securities to be exempt from being defined as a covered fund would be to amend the trust documents to qualify for one of the Investment Company Act exclusions. In the absence of a blanket exemption, when amending the documents is not possible and where the re-REMIC, CDO, or esoteric ABS do not otherwise qualify for an exemption, banks would be required to divest these holdings prior to July 2015. While not outright disastrous, one would expect spreads on these securities to widen in that scenario. So although hedging will not be impacted, the change in demand for certain securities may be felt by Optimal Blue clients.

Moving from the Volcker Rule to Basel III, remember that although the US version of the Basel III rules was finalized in July 2013, the Basel Committee is still making some modifications to its securitization framework. It recently proposed a new hierarchy of approaches that banks would be required to follow to assign risk weights on their securitization positions. If finalized in their newly proposed form, these revisions are likely to primarily affect European bank securitization holdings and not those in the United States.

The revised securitization framework mandates that banks apply, in order of priority, the internal-ratings based method, the external ratings-based approach, and the standardized approach on their securitization exposures. The revised proposal is also more lenient on securitizations by reducing the risk weight floor, applying a risk weight cap for senior securitization exposures, and reducing the supervisory parameter “p” in the standardized approach.

The changes are likely to be most beneficial for senior securitizations rated below BB- (e.g., legacy non-agencies), as many of these bonds are likely to receive lower risk weights than the high risk weights they are assigned under the current ratings-based approach. In contrast, highly rated, investment grade securitizations may experience an increase in their capital requirements.

Comparing the revised Basel securitization framework with the final US version of Basel III, analysts believe that capital requirements under the revised proposal will generally be higher relative to the US SFA method but lower relative to the US SSFA method. But all in all, the impact on hedging, and holding residential MBS, is thought to be minimal at this time.

The residential mortgage industry has had to deal with unintended consequences of rules and regulations for several years, and 2014 will be no exception. Most of this has come from Dodd-Frank. Now, however, what is turning banker’s heads is the Volcker Rule. In fact, just last week three Congressmen from Arkansas sent a letter to Federal Reserve Chairman Ben Bernanke, Comptroller of the Currency Thomas Curry, and Federal Deposit Insurance Corporation (FDIC) Chairman Martin Gruenberg expressing concern about the unintended consequences of recently finalized rules implementing Section 619 of the Dodd-Frank Act, commonly called the Volcker Rule.

Their focus, unlike bankers who were concerned about being able to use agency mortgage backed securities to hedge their locked pipelines, is on Collateralized Debt Obligations (CDOs). Zions Bank recently made headlines by having to sell CDOs at a loss. Banks with balance sheets that include CDOs backed by Trust Preferred Securities are concerned about the treatment of them via the Volcker Rule. The bank announced it had determined that “substantially all” of its investments in trust preferred collateralized debt obligations (CDOs) would be disallowed under Volcker. The company said it would record a fourth-quarter other-than-temporary impairment charge of $629 million on the transfer of disallowed held-to-maturity securities to held-for-sale. The bank also said it had until July 21, 2015 to sell the trust preferred CDOs, “unless, upon application, the Federal Reserve grants extensions to July 21, 2017.”

And New York’s Community Bank System ($7.3 billion in assets) announced it had “sold its entire portfolio of bank and insurance trust preferred collateralized debt obligation (CDO) securities in response to uncertainties created by the announcement of the final rules implementing the Volcker Rule.”

This has little or nothing to do with hedging pipelines.

But let’s return to using agency MBS to hedge locked pipelines, which in turn allows banks to offer more competitive pricing to clients or borrowers. Late in 2013 five US regulators writing the Volcker rule ended three years of debate and approved a ban on proprietary trading by some banks. The Commodity Futures Trading Commission, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Federal Reserve and the Securities and Exchange Commission voted in favor of the rule, which also holds bank CEOs more accountable. “The rule also imposed tighter restrictions on hedging, providing banks less leeway for classifying bets as broad hedges for other risks. To pursue a hedge, banks would need to provide detailed and updated information for review by on-site bank supervisors.”

The actual 71-page Volcker Rule, effective 4/1/14, can be found here:http://www.fdic.gov/news/board/2013/2013-12-10_notice_dis-a_regulatory-text.pdf. Does it end hedging, and therefore mandatory locks, for banks? The MBA weighs in: “Required under Dodd-Frank, this final rule would prohibit bank holding companies and their subsidiaries from engaging in certain forms of proprietary trading. While an exemption is provided for risk mitigating hedging activities, compliance will require a “hedge effectiveness” analysis. The hedging provisions can be found on pages 15-17 of the rule. Excluded from the rule’s prohibitions are purchases and sales of loans and GSE and GNMA securities (pg. 18).

The Volcker Rule is the part of the Dodd-Frank banking reform legislation that bans “proprietary trading” among banks. “Covered funds” are among the investments banks are no longer allowed to hold under Volcker, and the banks have until July 2015 to get rid of them. After the American Bankers Association and several community banks sued the regulators in federal court to throw out the ban on “covered funds” investments, the bank regulators and the SEC said they would review the Volcker Rule again and make a final determination on the CDOs backed by trust preferred securities by Jan. 15. But pipeline hedgers are safe.