Blog Category: Chrisman's Corner

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

If loan that an investor expected to have on their books for a given time pays off early, the investor will seek monies from the lender. The money is typically the premium (amount above par, or 100) or the value of the servicing. As a quick simple example, a lender gives a loan for $100,000, and sells the loan to an aggregator for 102, or $102,000. A clause in the contract states that if the loan pays off prior to six months from purchase, the lender is obligated to pay the aggregator $2,000 – the amount above par.

Capital Markets staff have had trouble explaining this concept of EPOs (early pay off penalties) to originators. (Or originators have had trouble comprehending it.) Some MLOs say that EPOs should not be charged back to loan officers. “Just because a lender wrote it into their employment agreement did not make it legal or the proper thing to do. If a LO knows that the consumer is going to sell or refinance within 6-months, he has an obligation to notify his employer. If the loan officer has created a good relationship with the borrower, he should know when a borrower has had a change of circumstance and is thinking of selling or thinking of refinancing prior to the 6 month anniversary. In that case, he can discuss the situation with his employer and they can make a decision together on how to handle the situation.”

In some areas, notably Arizona or Nevada, we have and will continue to see increases in early payoffs due to raising real estate values. Lenders’ concern over EPO is that buyers holding the property will do so just long enough to re-sell it at a profit, driving up property values at quicker speeds. The QM rules have taken away pre-payment penalties which would protect a lender from consumer abuse of this using Agency financing. Apparently prepayment penalties are “toxic”. They are toxic for a borrower that lies about their intent to occupy. One possible solution to make the transaction “fair” for everyone might be to offer pricing or products that suit the short term financing needs of the investor (higher rates or points without a prepayment penalty).  Or, change the tax laws to incorporate rules that penalize borrowers that lie about their intent to occupy.

Most of the EPOs that are pushed to MLOs are due to the Agencies demanding their premiums back from the lenders. Practically every wholesale lender has this EPO policy in their broker agreements. If one is a mortgage broker, they have absolutely no choice in the matter: one either signs the agreement and hope they do not have any early payoffs, or exit the business.

It turns out, however, that some aggregators are open to negotiating a reduced fee in some cases of loans paying off prior to the expiration of the EPO period. Privately Wells or Chase will allow lenders to buy out of the EPOs for a fee per loan if the relationship is very good.

The ebb and flow, waning and waxing, of residential lending is fascinating. Of course, the supply of mortgages impacts the supply of mortgage-backed securities. And if demand is steady, changes in the supply impact the price relative to other fixed income securities. So investors are quite interested in underwriting guidelines, rules and regulations, operational backlogs, and so on since they impact the supply of loans into the secondary market pipelines. In addition, general consumer lending also influences things, since people borrowing money tends to lead to economic expansion, and potentially higher rates.

So it is with great interest that the market is seeing big banks begin to loosen their tight grip on lending, creating a new opening for consumer and business borrowing that could underpin a brightening economic outlook. Are banks increasing their appetite for risk? It seems so: the U.S. Office of the Comptroller of the Currency said banks relaxed the criteria for businesses and consumers to obtain credit during the 18 months leading up to June 30, 2013, while the European Central Bank said fewer banks in the euro zone were reporting tightened lending standards to nonfinancial businesses in the fourth quarter of 2013.

Anyone involved with a bank will tell you why this is happening: banks trying to take advantage of an economic improvement, competition for a limited pool of loans, and a sustained low-interest-rate environment all have banks lending money and reaching for returns.

Capital Markets folks are nervous. Expanding economies tend to lead to higher rates. There are indeed some pretty optimistic 2014 global growth projections. The World Bank predicts global growth of 3.2%, bolstered by stronger recoveries in the U.S. and the euro zone. The Federal Reserve predicts U.S. growth between 2.8% and 3.2%, while the euro zone is expected to grow by 1.1% after two years of contracting.

At the same time, the easing carries risks, including a return to the type of lax underwriting standards that sowed the seeds of the crisis, especially in mortgage banking. The comptroller’s report said it would still classify most banks’ standards as “good or satisfactory” but did strike a cautionary tone. “The more [banks] loan, just naturally there is going to be more risk. It’s a matter of how well they can control that risk,” said Bob Piepergerdes, the OCC’s director for retail credit risk.

And while we’re at it, let’s talk about inflation – even though inflation has not been an issue for a very long time. An upturn in bank lending, if taken too far, could also lead to inflation. The Fed has flooded banks with trillions of dollars in cash in its efforts to boost the economy. In theory, the printing of that money would cause consumer price inflation to take off, but it hasn’t, largely because banks haven’t aggressively lent out the money. Consumer inflation in 2013 was a percentage point below the Fed’s 2% target.

The comptroller’s survey found more banks loosening standards than tightening. The regulator said that in the 18 months leading up to June 30, 2013, its examiners saw more banks offering more attractive loans – and this study wrapped up six months ago. The trend extended to credit-card, auto and large corporate loans but not to residential mortgages and home-equity loans. So perhaps the MBS market is safe for now…

Well, it’s January, and it’s an election year. We can expect to see plenty of posturing by politicians in all aspects of our lives, and housing, and the finance of housing, is not exempt. So it is not surprising to see the first proposed legislation dealing with housing finance reform. It is worth taking a look at it, however, if only to see where the heads from a couple legislators are.

Representatives Delaney, Carney, and Himes announced a housing finance reform proposal and stated that they intend to introduce legislation in the spring. The proposal calls for a continued role for the government in supporting the secondary mortgage market combined with risk-sharing by the private sector. The bill would also essentially combine the GSE and Ginnie Mae securitization markets and back the MBS with an explicit guaranty.

Under the new proposal, all MBS issuers would be required to get 5% first loss mortgage insurance from an adequately capitalized monoline mortgage insurer, which would vastly expand the mortgage insurance market. The proposal does not specify the role of mortgage insurance for lower down payment borrowers. The mortgages can then be securitized through Ginnie Mae who would then contract with private insurers to risk share in the 95% of the risk it retained. The losses would be shared on a pari passu basis between Ginnie Mae and private insurers. This mechanism should result in market pricing for the MBS. Private capital would need to invest in at least 10% of the interest initially retained by Ginnie Mae.

Of particular interest to Capital Markets personnel is that, under this potential law, all secondary market issuance would be through Ginnie Mae and have an explicit full faith and credit government guarantee. There would be no issuance through Fannie Mae/Freddie Mac. This should meaningfully help the liquidity of the MBS market. Right now, GSE MBS trades at discount to Ginnie Mae and Freddie Mac MBS trades at a discount to Fannie Mae.

The Federal Housing Finance Agency (FHFA), the current regulator of the GSEs, would oversee the wind down of the GSEs’ ability to issue, guarantee, or purchase MBS. The GSEs could play a role in aggregating securities for smaller originators who do not have sufficient volume to create their own securities. They could also compete both as monoline mortgage insurers and as private reinsurers but their share of the market would have to be less than 30% at the end of five years, and they will no longer have any sort of government support.

Remember the Corker-Warner Bill in the Senate? This bill shares much common ground with it, and they both provide a potential frameworks for GSE reform that analysts think can be implemented without major disruption in the mortgage market. They both keep a continued role for the government combined with a significant role for private capital (although Corker-Warner has a 10% first-loss risk sharing requirement).

(The other current legislation is the PATH Act, sponsored by Jeb Hansarling in the House, which mandates the wind-down of the GSEs in 5 years and a largely private mortgage market. Most believe Hansarling’s piece of work would be very disruptive to the mortgage market.)

The proposed legislation would eliminate the current role of the GSEs. But given their profitability, is that going to gain any support from their fellow Senators and Congressmen? While they would continue to play role as a capital provider, without government support they would no longer have any cost of capital advantage. So, although it is not likely to go anywhere, we should all know that Washington is alive and well in looking at the mortgage industry.

The life cycle of a residential lender, in the past, was somewhat predictable. An entrepreneurial person found themselves in the origination business, began doing more volume, hired support staff, beefed up operations and capital markets personnel, and grew geographically. Originators started by brokering out loans to wholesalers, then obtained a small warehouse line, became a mortgage banker, and increased the number of investors and complexity of loan delivery. Brokering to 3^rd or 2^nd tier investors evolved into selling loans on a mandatory basis to top tier correspondents, and then obtaining agency approval. Many have made the leap into creating and delivering securities.

Delivering securities, arguably something lenders want the option of doing, has become more complicated. Based on recent data, investment banks are updating their TBA (“To Be Announced”, in contrast with “Specified” pool creation) deliverable assumptions for lower coupons. The changes have recently gone into effect, and change the way loans are allocated into pools. After all, secondary marketing personnel know that a given agency loan typical will have two options, easily thought of as “buckets” for delivery once the servicing (.250 for conventional conforming loans) and gfee is accounted for.

With the changes in rates, TBA deliverable assumption for conventional 30-year 2.5%-3.5% has been changed to worst to deliver within the 2013 origination, because the majority of production has now shifted into 4% securities. Lenders originating FHA & VA loans and issuing those securities have the added complexity of the Ginnie I versus Ginnie II securities. Similarly deliverable assumption for lower coupons GN1 and GN2 2.5-3.5 has been changed to worst to deliver within 2013.

Investors are keenly interested in this. Fannie and Freddie 4% 30-yr securities are now mapped to recent origination collateral while 4.5s have been mapped to the 2010 vintage. This has, as one would expect, impacted option-adjusted spreads (OAS), in this case resulting in an OAS reduction of 9-10bp on 4s while OAS on 4.5s has risen by 2.4bp. Investors are now “mapping” Ginnie II 4s to recent origination collateral as well; however, Ginnie I 4s have been mapped to 2011 vintage because recent production has almost entirely shifted to Ginnie IIs. The OAS effect on GN2 4 TBA is -10bp while that on GN1 4 TBA is almost flat.

Those who follow 15-year securities are seeing, and doing, a similar re-mapping. Fannie & Freddie 2% and 2.5% securities have been changed to 2013 origination, while 3s are now mapped to recent origination. Fannie & Freddie 15-year 3.5s have been mapped to worst to deliver within 2012 vintage while 4s and 4.5s have been mapped to 2010 vintage.

“So what?” Well, investors are keenly aware of potential prepayment speeds of mortgage-backed securities. And those prepayment speeds are often a direct result of the coupons of the mortgages contained in those securities. For example, two Fannie 3.5% securities may have very dissimilar pool characteristics, due to the interest rates of the mortgages contained therein. If and when rates move, a pool composed of 3.75% mortgages will behave differently than that of a pool filled with 4.125% mortgages.

The pricing of those pools will also behave differently. Banks, insurance companies, etc. – whoever owns those pools, will see their price move differently relative to the Treasury market, and benefit or suffer because of it.

Last week we noted that the Volcker Rule, part of the Dodd-Frank banking reform legislation that bans “proprietary trading” among banks, is more directed at “covered funds.” These are among the investments banks are no longer allowed to hold under the Volcker Rule, and the banks have until July 2015 to get rid of them. After the American Bankers Association and several community banks sued the regulators in federal court to throw out the ban on “covered funds” investments, the bank regulators and the SEC said they would review the Volcker Rule again and make a final determination on the CDOs backed by trust preferred securities by Jan. 15. But pipeline hedgers who use TBA mortgage-backed securities are safe.

But the discussion and conjecture about the Volcker Rule continues, especially the effect of the Volcker Rule and Basel III revisions on securitized products. As noted last week, US agencies have adopted the final version of the Volcker rule, while the Basel Committee issued a second consultative document revising its risk-weighting securitization framework in the past few weeks.

Although the proprietary trading restrictions of the Volcker Rule have generally garnered the most media attention, analysts believe that the effect on securitized products from this provision of the rules will be limited. Banks can continue to perform market making, underwriting, and hedging functions in all securitized product asset classes and can even trade agency MBS in a principal capacity.

The Volcker rule prohibits banks from owning or acquiring covered funds. One can expect most first-order securitizations to be exempt from the covered funds portion of the Volcker Rule. However, some re-REMIC, CDO, and esoteric asset-backed security (ABS) positions may be considered covered funds if they do not qualify for one of the exemptions under the Investment Company Act (ICA) of 1940.

It is possible that regulators address the re-REMIC exemption in coming weeks as they provide clarifications. However, in the absence of an exemption, the only feasible solution for these specific securities to be exempt from being defined as a covered fund would be to amend the trust documents to qualify for one of the Investment Company Act exclusions. In the absence of a blanket exemption, when amending the documents is not possible and where the re-REMIC, CDO, or esoteric ABS do not otherwise qualify for an exemption, banks would be required to divest these holdings prior to July 2015. While not outright disastrous, one would expect spreads on these securities to widen in that scenario. So although hedging will not be impacted, the change in demand for certain securities may be felt by Optimal Blue clients.

Moving from the Volcker Rule to Basel III, remember that although the US version of the Basel III rules was finalized in July 2013, the Basel Committee is still making some modifications to its securitization framework. It recently proposed a new hierarchy of approaches that banks would be required to follow to assign risk weights on their securitization positions. If finalized in their newly proposed form, these revisions are likely to primarily affect European bank securitization holdings and not those in the United States.

The revised securitization framework mandates that banks apply, in order of priority, the internal-ratings based method, the external ratings-based approach, and the standardized approach on their securitization exposures. The revised proposal is also more lenient on securitizations by reducing the risk weight floor, applying a risk weight cap for senior securitization exposures, and reducing the supervisory parameter “p” in the standardized approach.

The changes are likely to be most beneficial for senior securitizations rated below BB- (e.g., legacy non-agencies), as many of these bonds are likely to receive lower risk weights than the high risk weights they are assigned under the current ratings-based approach. In contrast, highly rated, investment grade securitizations may experience an increase in their capital requirements.

Comparing the revised Basel securitization framework with the final US version of Basel III, analysts believe that capital requirements under the revised proposal will generally be higher relative to the US SFA method but lower relative to the US SSFA method. But all in all, the impact on hedging, and holding residential MBS, is thought to be minimal at this time.

The residential mortgage industry has had to deal with unintended consequences of rules and regulations for several years, and 2014 will be no exception. Most of this has come from Dodd-Frank. Now, however, what is turning banker’s heads is the Volcker Rule. In fact, just last week three Congressmen from Arkansas sent a letter to Federal Reserve Chairman Ben Bernanke, Comptroller of the Currency Thomas Curry, and Federal Deposit Insurance Corporation (FDIC) Chairman Martin Gruenberg expressing concern about the unintended consequences of recently finalized rules implementing Section 619 of the Dodd-Frank Act, commonly called the Volcker Rule.

Their focus, unlike bankers who were concerned about being able to use agency mortgage backed securities to hedge their locked pipelines, is on Collateralized Debt Obligations (CDOs). Zions Bank recently made headlines by having to sell CDOs at a loss. Banks with balance sheets that include CDOs backed by Trust Preferred Securities are concerned about the treatment of them via the Volcker Rule. The bank announced it had determined that “substantially all” of its investments in trust preferred collateralized debt obligations (CDOs) would be disallowed under Volcker. The company said it would record a fourth-quarter other-than-temporary impairment charge of $629 million on the transfer of disallowed held-to-maturity securities to held-for-sale. The bank also said it had until July 21, 2015 to sell the trust preferred CDOs, “unless, upon application, the Federal Reserve grants extensions to July 21, 2017.”

And New York’s Community Bank System ($7.3 billion in assets) announced it had “sold its entire portfolio of bank and insurance trust preferred collateralized debt obligation (CDO) securities in response to uncertainties created by the announcement of the final rules implementing the Volcker Rule.”

This has little or nothing to do with hedging pipelines.

But let’s return to using agency MBS to hedge locked pipelines, which in turn allows banks to offer more competitive pricing to clients or borrowers. Late in 2013 five US regulators writing the Volcker rule ended three years of debate and approved a ban on proprietary trading by some banks. The Commodity Futures Trading Commission, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Federal Reserve and the Securities and Exchange Commission voted in favor of the rule, which also holds bank CEOs more accountable. “The rule also imposed tighter restrictions on hedging, providing banks less leeway for classifying bets as broad hedges for other risks. To pursue a hedge, banks would need to provide detailed and updated information for review by on-site bank supervisors.”

The actual 71-page Volcker Rule, effective 4/1/14, can be found here:http://www.fdic.gov/news/board/2013/2013-12-10_notice_dis-a_regulatory-text.pdf. Does it end hedging, and therefore mandatory locks, for banks? The MBA weighs in: “Required under Dodd-Frank, this final rule would prohibit bank holding companies and their subsidiaries from engaging in certain forms of proprietary trading. While an exemption is provided for risk mitigating hedging activities, compliance will require a “hedge effectiveness” analysis. The hedging provisions can be found on pages 15-17 of the rule. Excluded from the rule’s prohibitions are purchases and sales of loans and GSE and GNMA securities (pg. 18).

The Volcker Rule is the part of the Dodd-Frank banking reform legislation that bans “proprietary trading” among banks. “Covered funds” are among the investments banks are no longer allowed to hold under Volcker, and the banks have until July 2015 to get rid of them. After the American Bankers Association and several community banks sued the regulators in federal court to throw out the ban on “covered funds” investments, the bank regulators and the SEC said they would review the Volcker Rule again and make a final determination on the CDOs backed by trust preferred securities by Jan. 15. But pipeline hedgers are safe.