August 8, 2024 | The market tantrum which began on Friday was largely over by the market close on the following Tuesday. While a number of individual stocks have gotten crushed because of earnings misses and other offenses, the markets overall have muddled through. JPMorgan (JPM) is off just 5% vs the end of Q1 2024, hardly a market debacle. But there certainly has been a lot of movement within the WGA Bank Top 100 since March and total test scores have fallen significantly for the entire group. Index constituents are now available to subscribers to The IRA Premium Service.
Of note, the high levels of delinquency seen in the JPM portfolio of home equity loans continues, as shown in the chart below from BankRegData. JPM is charging off the portfolio rapidly, but the fact remains that this largely “prime” portfolio of bank-owned HELOCs is displaying a level of delinquency several times higher than many other loan categories. Note that the delinquency rate on JPM's HELOCs is 6x the delinquency rate on JPM's 1-4s, but the bank does not mention this fact in JPM's earnings release. The bank's form 10-Q was not released until August 4th.
JPMorgan | Q2 2024
Source: FDIC
The brief market rally provided some hope that the poor performance of mortgage assets is coming to an end. “Thanks to the strong relative outperformance of MBS vs Corporates over the past few months, MBS Excess Returns have finally caught up to, and currently match, those of corporates on a YTD basis,” writes Scott Buchta of Brean. Yet yields on longer-dated Treasury debt have backed up with the 10-year note again at 4%. While the Street is anticipating another interest rate bonanza a la 2020-2021, this time the increase in loan volumes may disappoint some expectations.
"Mortgage rates falling to their lowest in more than a year increases the potential of loans issued since 2022 being refinanced and has worsened convexity for the MBS index," according to Bloomberg Intelligence. "Duration hedging may start to have a knock-on affect for rate shifts,” BI strategist Erica Adelberg wrote Wednesday. Fannie Mae 6s for delivery in August are trading 100-22 this AM.
"The recent rally in interest rates increased the share of coupons in the MBS index trading above par to about 17%," writes Adelberg. The share above $102, which are especially sensitive to refinancing risks, has risen to 8% after falling to near zero last year," she notes. Speaking of hedge risk, the table below summarizes the option-adjusted duration for Fannie Mae 30-year MBS. Notice that the duration of Fannie Mae 6s is just above 2, but lower coupons of 4% and lower where most of the market resides is over a 6 duration.
TBA Monitor
Source: Bloomberg (8/07/24)
“While another large refinance wave is unlikely in the foreseeable future, lenders are using new strategies to incentivize homeowners to refinance their mortgages,” notes Ginnie Mae in the most recent global market analysis. “One lender recently rolled out a new program, offering a 125-bp incentive fee for most Veterans Affairs (VA) and Federal Housing Administration (FHA) streamline refinancings.”
That lender, of course, was United Wholesale Mortgage Corp (UWMC), which has been conducting an unrelenting price war in the wholesale channel for buying mortgages. How does UWMC afford to spend 1.25% on additional incentives to brokers when they are paying 1-2% for every loan? By selling mortgage servicing rights (MSRs). But buying loans with the MSRs on a 6-7x multiple and selling the MSR on a 4-5x multiple is a bad trade IOHO.
“While we also like this backdrop for other originator/servicers, we especially like UWMC's move to sell MSRs again last quarter in an effort to shed risk and focus on its core competency of being the industry's centralized hub for mortgage brokers,” writes Eric Hagen at BTIG. But of course when we shed “risk” and "leverage" in MSRs, we are also shedding future cash flow, new loan recapture and customer relationships. The latter intangible assets is perhaps most valuable of all. The table below shows sales of MSRs and comes from the UWMC 10-Q.
UWMC | Q2 2024
Now the little downward move in mortgage rates is going to help the results for issuers considerably in Q3 2024. Business already in the pipeline is going to become more profitable and production for the rest of the quarter will feel a growing tailwind. Issuers will win big on the cash side, selling higher coupons into a declining rate market, but lose money on the hedge. Yet the important thing to keep in mind is that the vast majority of residential mortgage loans are still points out of the money for refinance, as the two great charts from Ginnie Mae illustrate.
How much do rates need to fall before we start to really see significant refinance activity? We need to see new-issue MBS yields closer to 4% than to 5%, but this assumes that the Treasury market cooperates. If yields on Treasury 10s on out the curve remain elevated as and when the Fed does cut the target for federal funds, then hopes for a mortgage market rally will be disappointed. In the meantime, look for competition for those few refinance transactions to intensify.
For months now Sell Side analysts have hoped for tighter spreads between MBS and Treasuries. Just as issuers like UWMC must pay-up for loans in today’s supply constrained market, so too we cannot get spreads between mortgage rates and Treasuries to come in until the vast damage of quantitative easing is repaired. Even if the Fed resumed purchases of MBS tomorrow, we’re not sure this would offset the net sale of MBS exposures by banks into synthetic risk transfer deals.
Meanwhile, Treasury Secretary Yellen announced the most recent expansion of the Treasury buyback program, where it acquires low coupon securities created during COVID for current coupons. This is a tacit admission of the negative result of QE and other market manipulations such as “Operation Twist” when Yellen was Fed Chair. We are dealing with this period in a new chapter of “Inflated,” to be released by Wiley Global in 2025.
In market terms, those Treasury 2s and 3s that Secretary Yellen is repurchasing, as well as comparable vintage MBS, are hundreds of basis points under water vs the cost of funds to dealers. If the FOMC were to find it in its heart to move federal funds down to 4.5% or even 4%, that is more than enough headroom to restore profitability to many dealers and perhaps even help restart asset backed securities issuance. But then the Fed should stop and start asking the Congress to cut the federal deficit to fight inflation.
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