Blog Category: Chrisman's Corner

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.