February 16, 2023 | A reader of our friend Rob Chrisman recently chastised us for being “wrong” about double digit mortgage rates. In fact, when mortgage rates peaked in October of 2022, the loan coupons on high-LTV, low FICO conventionals and jumbos were well into double digits. As the headline rate for a FHLMC 30-year fixed coupon loan peaked over 7%, lenders were losing money on almost every loan. And they still are, but hold that thought.
As we’ve noted previously in The Institutional Risk Analyst, thanks to the machinations of the Federal Open Market Committee, some two-thirds of the $13 trillion in agency and government mortgage-backed securities have coupons between 2% and 4%. Rates have to fall a lot from present levels before any of the loans inside these MBS are in the money to refinance.
Given the impact of QE on the distribution of existing residential mortgage loans, you can appreciate that mortgage lenders currently have a stronger bias that normal toward lower interest rates. Thanks to the Fed's manipulation of the mortgage market during 2020-2021, lenders are going to continue to set rates below economic levels for months to come. The FOMC-induced movement of short-term and long-term interest rates over the past year has left the term structure of interest rates a complete mess.
Normally the note rate on an MBS is a point below the mortgage loan coupon that the consumer pays. The difference pays for servicing, other fees and maybe a small profit for the lender to recoup some of the expenses incurred making the loan. In today’s market, however, lenders are setting coupon’s below 6% on those prime, 20% down loans, and then selling these mortgage notes into a 5.5% MBS for delivery in the too-be-announced (TBA) market next month.
Many smaller lenders who do not have access to term financing must also sell the mortgage servicing right (MSR) to recoup some of their cash losses. As you can see in the snapshot below from the Bloomberg, a 5.5% TBA for March delivery is trading near par. During COVID, the on-the-run MBS was trading at 103-104. So when you as a lender sell that ~ 5.875% loan into a TBA 5.5%, you mostly lose money. Instead of writing loans in the high 5s, lenders should be writing loans with 7% coupons.
Source: Bloomberg
The negative impact of the Fed’s action on housing finance and the larger corporate debt market cannot be overestimated. Bloomberg reports that “a wall” of $6.3 trillion in debt is coming due by the end of 2025. Much of this “debt” will be turned into equity via restructuring. The same volatility that has left many banks insolvent on a mark-to-market basis has also left a number of corporate borrowers in similar circumstances, with refinance levels hundreds of basis points above the coupon on existing debt.
The ebb and flow of interest rates, as a result, has become the primary directional indicator for stocks with exposure to interest rates, either directly or indirectly. When interest rates peaked in Q4 2022, the financials proceeded to rally and spreads on everything from corporate debt to mortgage loans eased. Just as mortgage lenders continue to dream of rates in the low 5s, corporate treasurers likewise are hoping for a chance to refinance liabilities at lower cost.
The fly in the proverbial ointment is credit, both individually and collectively. The Treasury is headed for a default by mid-year if the Biden Administration and Congress cannot agree on a budget deal. More important, credit costs are rising pretty much across the board as consumers and corporate issuers run out of COVID cash. Banks have begun to re-price assets that were created during the pandemic. Emerging companies are now submerged in terms of access to new credit or even repricing existing debt.
In addition, the impact of COVID on the reality and the presentation of GAAP earnings is a big negative eroding investor sentiment in terms of credit. The YOY comparisons for many financials, for example, are truly ghastly. Whereas Fannie Mae received a $5.1 billion benefit to earnings from returning COVID credit reserves back to income in 2021, last year Fannie Mae put aside $6.3 billion for future credit losses and related expenses.
Fannie also reported $300 million in losses on “significant decrease in the market value of single-family loans that resulted in valuation losses on loans held-for-sale as of December 31, 2022, as well as lower prices on loans sold during the year.” Look for this number to go significantly higher. Like many banks and corporate issuers, the GSEs have significant unrealized losses on low-coupon assets created during COVID.
The narrative on Wall Street continues to focus on the pace of Fed short-term rate increases, yet in fact interest rates beyond four years continue to fall. Beyond ten years, dollar swaps continue to move lower. The bond market rally pushed stocks higher and some credit spreads lower through the end of January, but the short-end of the curve has lifted since that time as the reality of higher for longer sinks in for equity managers.
The big surprise for the Buy Side will come when the FOMC breaks with the “soft landing” narrative and pops a couple more 50bp rate increases to get SOFR closer to 6% than 5%, where the consensus currently sees the rate hike pain ending.
When Cleveland Federal Reserve Bank President Loretta Mester said that there was a “compelling” case for a 50bp hike in January, the markets trembled. “At this juncture, the incoming data have not changed my view that we will need to bring the fed funds rate above 5% and hold it there for some time,” Mester said. The Cleveland Fed President will make a great Fed Chairman one day.
Everyone from President Joe Biden to the CEOs of a lot of heavily over-leveraged corporate debt issuers are betting Mester is wrong. But fact is, if the Fed continues to hike short-term interest rates and eventually forces longer maturities higher, the cost in terms of credit will be as outsized as was the move lower in rates during COVID.
Source: FDIC/WGA LLC
Bottom line: As the FOMC moves short-term rates towards 6%, we expect to take another run at double-digit rates for prime residential mortgage loans. At some point, the survivors in the world of lending are going to have to start pricing loans to make money rather than defend market share. This process is already underway in corporate debt markets, where banks are making life and death decisions about corporate issuers that are now cut-off from the bond markets. Stay tuned.
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