February 19, 2024 | Are 30-year mortgage rates going to fall further? When? These are two of the questions that come from readers of The Institutional Risk Analyst with increasing frequency. Truth to tell, if you work in housing finance and want to see lower interest rates, then you need to start screaming about the federal budget deficit. But this is the one topic nobody in DC wants to discuss.
Confusion about the direction of interest rates is understandable. After all, the Sell Side narrative says that rates are going to fall, right? Stocks are going to go "to da moon" at the same time. But the rate-cut-soon narrative being hawked not even 30 days ago by big Sell Side firms such as Goldman Sachs (GS) is now in tatters. How does a large issuer of conventional mortgage backed securities plan for the rest of 2024?
Even industry veterans like Logan Mohtashami, media star and residential lender from Orange County, CA, have been stoking the flames of rate cut expectations ever higher. The lower rates sooner gospel has become an article of faith for struggling mortgage bankers, especially those who prefer gain-on-sale to retaining servicing assets.
We respectfully disagree and continue to believe that normalization of the yield curve is the more likely scenario. What is normal? Normal is Fed funds closer to 4% than 5.5% presently, but 10-year Treasury yields closer to 6%. Or a spread between two-year and 10-year Treasury notes over 150bp, as shown in the chart below from FRED. Note that TED was driven 1% negative during the Fed's QE madness in '20-'21.
There are, of course, two interest rates that matter in the world of housing finance. First is the rate paid by lenders to finance new mortgage loans between the time they close your mortgage and when it gets sold into an MBS. Speed is of the essence in the secondary loan market. The cost of hedging the annual percentage rate that the lender assigned to your loan at closing is part of this cost. Remember, lenders set your loan coupon rate, global markets set bond yields and spreads.
Today the cost of warehouse financing for a bank or nonbank lender from market leaders like JPMorgan Chase (JPM) or Flagstar (NYCB) is a spread over SOFR. The spread over SOFR can range from +1% and higher depending on 1) the collateral and 2) the borrower’s credit. With 30-year mortgages around 7.25%, the spread over warehouse financing is still negative for many lenders.
That 30-year fixed rate mortgage you just closed will be sold into the secondary market, resulting in a modest cash premium for the lender but nothing like the 3-4 point gains seen in 2020-2021. In fact, most lenders today are down points of cash on close because of rate pay downs and other costly incentives. The screenshot below from Bloomberg shows the too-be-announced (TBA) market for conventional mortgages being sold into Fannie Mae MBS pools for delivery in March 2024 at Friday’s close.
Source: Bloomberg (02/16/24)
You are probably selling that new 7.25% loan into a FNMA 6.5% MBS. As you can see in the nifty TBA chart above, FNMA 3s are currently trading around 85 cents on the dollar for March delivery. That's better than ~ 70 cents at the end of Q3 2023. If you are a bank selling FNMA 3s today, you are taking a 15 point loss or higher, depending on your cost basis. But 85 cents on your FNMA 3 MBS may seem like very good value a year from now. And the spread between average MBS yields and the 10-year Treasury is at the 5-year wide, as shown in the chart from FRED at the start of this comment. Hint: Most banks are paying more than 3% for funding.
Part of the suspect rate-cut-soon messaging that has been flowing from Sell Side dealers includes the idea that banks are going to start buying more MBS than they are selling. But the dealers who make markets in MBS know better. Until the Fed stops running off its balance sheet, bank deposits will continue to fall and with it investments in MBS.
For the past year and more, banks have been puking up bloody chunks of toxic waste in the form of MBS with 2% and 3% coupons originated during the COVID lockdown. As we noted in our comments on the Basel III Endgame proposal, MBS with leverage are a lot more dangerous than whole mortgage loans with government guarantees.
Source: FDIC
The big factor affecting mortgage rates is Treasury yields, but there are a host of other issues that we discussed in our Premium Service comment last week (“Interest Rates, Mortgage Lenders & MSRs”). As the remaining laggards at the Fed’s Reverse Repurchase Facility flow back into T-bills and other assets, the ebb and flow of long-term interest rates will make markets more volatile. And as the Treasury’s vast General Account grows and subsides each quarter, banks, dealers and private investors will be dragged along behind like an afterthought.
President Joe Biden and Treasury Secretary Janet Yellen never talk about the budget deficit. Former President Donald Trump doesn’t evince any worry about budget deficits either. Federal Reserve Chairman Jerome Powell does not like to lecture Congress on budget deficits. Only after JPM CEO Jamie Dimon warned of market ‘rebellion’ against $34 trillion national debt, did Jerome Powell break his silence. Powell opined boldly that it’s past time for an ‘adult conversation’ about unsustainable fiscal policy.
Chairman Powell needs to get righteous on the deficit or risk looking ridiculous. The mad dance in Washington to avoid talking in public about the Federal budget deficit is the chief reason why we expect the Treasury yield curve to normalize and 30-year mortgage rates to stay elevated or even track higher. Until Congress addresses the federal deficit by cutting spending and raising revenue, the Treasury's credibility with the markets will ebb.
The assumption is that Donald Trump won’t talk about deficits either. He actually wants to cut taxes, an idea that will doubtless find a positive reception among Republicans in Washington. Yet if President Trump were to talk about fixing the federal budget deficit and redeveloping moribund urban real estate, he’d win in November by a landslide. Joe Biden cannot even mention the word “deficit” without causing a rebellion inside the Democratic Party.
To us, all of this means that the long-end of the yield curve is headed higher for longer no matter what the FOMC does with short-term interest rates. Think of the TED spread back out to 1.5-2% within a year. Imagine how the mortgage market and related assets will look when we assume 7-8% mortgage rates for years to come. With SOFR below 5% by next year, as the forward swaps suggest, at least the few surviving mortgage lenders will be making money again. But investors are completely unprepared for a major bear market steepener as the November 2024 election arrives -- and all too soon.
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