Loan Premium: Friend or Foe?

Since March 2008, the mortgage market materially changed. In order to set the stage for where we go from here, we must first go back in time.

Prior to March 2008, the two Government sponsored entities (GSEs), Fannie Mae and Freddie Mac, had three main roles and in order to accomplish those goals they were "allowed" to raise funds via debt at quasi-Government rates (Agency debentures). These three goals, in my own words, were:

1. Insure loans (aka Guarantee them)
2. Support the Mortgage Backed Security (MBS) market (provide liquidity)
3. Facilitate loan sales and securitization on behalf of lenders (cash-window)

In 1992, a fourth initiative was added which would eventually, according to many, cause the sub-prime crisis. Barney Frank, ironically, pushed an "affordable" quota on the GSEs of 30%. Prior to this quota, the GSEs operated as any "private" business would: taking calculated risk to create shareholder value. However, the affordable quota introduced a new wrinkle: a minimum requirement to lend to risky borrowers. This quota rose to 50% during the Clinton administration and peaked at 55% under George W. Bush in 2007 just as the housing market was about to implode. Barney Frank would eventually have his name included in the infamous Dodd-Frank Act which went into law in 2010, designed to protect consumers sponsored by the man who, arguably, pushed the first domino which eventually led to the crisis.

Leading up to the "great financial crisis" (GFC), the GSEs competed against one another on their insurance fees (see 1 above). This led to low (in many cases too low, especially on the affordable portion of loans) insurance costs and, since Fannie had their own MBS vs Freddie, allowed the "market" to reward or punish the GSEs based on their relative security performance. If either GSE felt the market was too soft they could step in and defend their security (buy it) or if they felt the market was too aggressive, they could sell (see 2 above). Additionally, the GSEs would provide for smaller, less sophisticated lenders to sell them loans and they would securitize on the smaller lender's behalf (point 3).

As "affordable" loans became the lion's share of all loans securitized, home prices exploded higher. Investors, lenders, Rating Agencies, the GSEs and the Government failed to comprehend the impact of risky loan products combined with high home prices. By 2008, the game was over and the financial system was on the verge of collapse. In that moment, the Federal Government had two choices: let the private markets sort it out (and it could get ugly) or step in and facilitate a solution (and potentially pervert markets irreparably). As you know, the latter course was chosen and the rest, as they say, is history.

The main take-away from the pre 2008 period (avoiding the "affordable" topic) is that the GSEs themselves were solely in charge of facilitating home loans into MBS, insuring loans and policing/investing/providing liquidity/defending their securities. This balance of both having to insure and invest in their own products while competing against one another, in theory, created a balance protecting from moral hazard. If lenders acted unethically or abused the system they would be penalized (via pricing or termination) for their behavior. If lenders acted in the GSE's best interest they would be rewarded (with lower insurance costs/better pricing).

Starting in 2008, the three mandates above were no longer held by the GSEs. They would continue to do (1) insurance and (3) facilitate MBS creation but they would no longer be allowed to provide liquidity and police their markets (2). A new entity was established called the Federal Housing Finance Agency (FHFA), and over the next ten-plus years it would dictate insurance fees (gfees), upfront fees (a new concept) and ultimately attempt to remove any difference between Fannie and Freddie (push towards a single GSE). It is important to note that starting in 2008 (and still happening), the gfees and upfront fees or loan level price adjustments (LLPAs) would be pushed from 15-25 bps (pre 2008) to over 700 bps (in some instances).

On September 6, 2008, Fannie and Freddie were officially placed into conservatorship. It only took two months for the Federal Government to realize the mortgage market could not survive without anyone handling the second goal of the three we mentioned above: (2) Support the Mortgage Backed Security (MBS) market (provide liquidity).

If you look across all nations in the world, the United States stands out as the only nation where the majority of home loans have a 30 year term. The reason for this is that the longer the term, the riskier the loan. Having to predict someone's ability to pay back a loan across multiple economic cycles spanning three decades is not a risk many want to take. Especially when the primary destination for loans historically was a bank balance sheet. Banks borrow money short-term (from deposits, etc.) and lend to make a spread. Borrowing short-term and lending very long-term can be a risky game.

In order to facilitate lending, countries either guarantee banks, guarantee loans or both.

Its not surprising to see, based on the chart above, the breakdown of financing sources below.

Looking at the U.S. in the above three charts, two things should stick out as unique: the US has a tremendous percentage of 30 year fixed mortgage loans and the financing source for said mortgages is dominated by MBS. It is this unique combination that required the Government to rethink how they would handle the three original initiatives we discussed in the introduction. If the GSEs would not be able to police and protect the MBS market from disappearing, who would? Enter Quantitative Easing (QE).

Given the backdrop, at the time, of plummeting home prices, failing Investment Banks, Insurance Companies, etc. and massive increases in unemployment its easy to see how no one would want to be the buyer of last resort for Mortgage bonds thus, less than three months after placing the GSEs into conservatorship, the Fed began purchasing Fannie and Freddie MBS.

Over the next 14 years the FHFA would continue to crank up gfees (congress would even get in on the fun and tax every homeowner 10 bps), increase loan level price adjustments and, since Congress never figured out what to do with the GSEs or the MBS market, the Fed would constantly be forced to re-enter the MBS market to support mandate number 2 again (provide liquidity).

Its important to note that while the fees borrowers were being charged were being pushed higher and higher (well beyond anything that existed pre 2008) new compliance rules were enacted that had two major effects: 1) dramatically increased the cost of doing mortgage loans 2) changed how a borrower could be charged costs.

As a society, we decided to no longer trust adults to make their own decisions (perhaps for good reasons) and instead Lender's were forced to prove a borrower could afford a loan via the "Qualified Mortgage" Rule (QM rule), Regulation Z and the "ability-to-repay" rules which were all part of the Dodd-Frank Act. No longer allowing a borrower to tell a lender what they make, how much they can afford etc. forced lender's to add processes, compliance staff, legal staff, training and operations staff which increase the costs to do a loan which increases the cost to a borrower. In fact, the cost to do a mortgage loan exploded post Dodd-Frank and has more than doubled to nearly $11k per loan (excluding any gfees or LLPAs). On an average loan size of $300k this is nearly 370 basis points (bps)!

As part of the QM rule, something called the "points & fees" test was introduced. This test was designed to protect a consumer from being "overcharged" for a loan. Essentially, and oversimplifying dramatically, the borrower cannot be charged more than 3%. The caveat here is how the rule works and what types of fees can be included or excluded. The punchline is that the rule essentially "prefers" a borrower has to finance points instead of pay them up-front. In other words, as long as the borrower agrees to take a higher interest rate instead of paying points and getting a lower rate, everything is ok. However, if they want to take a lower rate they are limited on how many points they can pay. This is a key "point" we will return to and is integral to understanding how this rule and loan premiums go hand-in-hand. For more details on QM rules:

If you've been paying attention you might be asking yourself the following question: if it costs a lender 370 bps to do a loan (before gfees and LLPAs) and a borrower can only be charged 3 points, how does this work? Especially when Gfees are ~50 bps and cumulative LLPAs can be over 700. A sample of LLPAs from one of the GSEs is below (keep in mind these are cumulative and not capped):

As you can see, there are a lot of LLPAs and they can add up quickly. Its also important to understand the timeline of the LLPA increases and what was occurring when the Dodd-Frank rules were enacted. By the time the QM rules were in place, the Fed was already on QE3, and the pricing construct for MBS was already severely out of whack (thanks to Fed buying perverting market prices and pushing premiums to unprecedented levels).

March 2008, Guarantee fees (gfees) increased, introduction of 25 bps adverse market charge & the introduction of loan level price adjustments (LLPAs) based on FICO/LTV.

July 30, 2008, Housing and Economic Recovery Act signed into law (created the Federal Housing Finance Agency FHFA)

September 6, 2008, Fannie Mae and Freddie Mac (GSEs) placed into conservatorship

November 25, 2008, Fed announces QE1 will purchase Fannie and Freddie MBS.

March 16, 2009, Fed increases amount of MBS it will buy during QE1

March 31, 2010, QE1 terminated

November 3, 2010, QE2 begins (Treasuries only)

2008-2011 GSEs gradually raise gfees and LLPAs

July 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act enacted

December 2011, Congress directs FHFA to increase gfees by 10 bps

June 2012, QE2 terminated

August 2012, FHFA directs the GSEs to increase gfees by ~10 bps

September 2012, QE3 begins (MBS & Treasuries)

January 2014, Qualified Mortgage rule goes into effect (sets max points-and-fees test)

October 29, 2014, QE3 terminated

September 2015, FHFA removes adverse market charge (25 bps) but introduces increases in LLPAs for cash-out refi, jumbo conforming, investment properties, loans with secondary financing and high FICO/Low LTV loans

November 2016, FHFA sets minimum gfees by product type

February 2019, both GSEs now charge additional 25 bps for 2nd homes

June 3, 2019, Uniform Mortgage-Backed Securities (UMBS) replace Fannie and Freddie specific MBS (retiring the Gold/Fannie swap)

March 2020, QE4 begins (MBS & Treasuries)

April 2020, FHFA forbearance LLPA 500-700 bps

September 1, 2020, GSEs introduce 50 bps Adverse Market Refinance Fee

August 2021, removed 50 bps Adverse Market Refinance Fee

March 2022, QE4 terminated

April 1, 2022, FHFA raises LLPAs on high balance (25-75 bps) and second home loans (112.5-387.5 bps)

When the Fed started QE they had one goal in mind: keep the economy from imploding. In order to do this they had to save homeowner balance sheets, corporate balance sheets and State balance sheets. At the intersection of all three of these: home prices. If home prices tank, consumers will either walk away from their home, spend less or both. Additionally, states will likely go bankrupt if home prices fall far enough since tax revenue is tied to home prices. Since consumers generally have no idea how much "house" they can afford and compliance rules focus more on the percentage of income a person spends on housing, the main question people ask: How much will this cost me every month? Enter the Fed.

Since how much "house" someone can afford is tied to how much it costs them every month, one way to push up home prices (or expand how much "house" someone can buy) is to reduce the monthly cost. How does one do this? If you have a few trillion dollars lying around this is how: first buy a lot of Treasuries (QE) to push down rates. Then buy a lot more longer term Treasuries (Operation Twist) to push longer term rates down even more (mortgage rates are tied directionally with Treasury rates), then when that's not enough: buy a lot more MBS, no matter what the price (premium).

Below is a chart showing the 10 year Treasury yield vs Mortgage rates (and the spread between them) going back to 2008.

As you can see from the green line above, the Fed was successful in both bringing down mortgage rates and compressing the spread. You'll see when QE stopped (for brief periods) is when the spread widened back out, the most obvious being the current period where the spread has risen from a median of ~170 bps to over 315.

In 2008, the Fed took over the "liquidity" mandate from the GSEs. The important difference between when the GSEs did it vs the Fed, is that the GSEs were trying to make money. The Fed, on the other hand, was trying to spend money to get rates down to get home prices up. If the Fed wasn't getting what they wanted? Spend more. Since mortgage prices behave like almost everything else in economics if demand exceeds supply: prices go up.

Enter loan Premiums.

The "Premium" on a loan is how many points above 100 a buyer is willing to pay. If the buyer is willing to pay a "one point premium" that equates to a 101 price. A two point premium is 102, 3 point premium is 103 and so on. The other way to think about premium is in terms of the loan itself. A three point premium means paying $103,000 for each $100,000 loan you acquire. As demand outpaces supply, premiums go higher and higher and at many points during aggressive QE loan premiums hit 105 or 106 (or more). Without complicating things too much, its important to understand that only the loan amount is guaranteed. In other words, if you pay a five point premium (105) or $105,000 for a $100,000 loan only the $100k is guaranteed. If you pay $105,000 and the next day the borrower refinances or sells their home you lose $5,000. A "normal" investor or a normal "liquidity" provider (the GSEs pre 2008), tries to avoid "too much premium". A Fed hell bent on driving rates lower? Not so much.

The above chart shows an MBS backed by loans that generate a 4% coupon. I have it set to a five point premium (105) and along the row that says "vary" I have increasing (from left to right) "prepayment" speeds. The prepayment speed is how much of the loans pay-off in a one year period. As we discussed, an investor gets 100 cents back on the 105 cents they paid when a loan prepays (pays off). The prepayment speeds matter and they matter more the further from 100 the price goes. In the example above the blue "1" shows the yield on a $105 priced 4% MBS at a prepay speed of 6% (3.36%). The blue "2" shows what happens to that yield when prepayment speeds jump to 60% (-0.57%). If it is not obvious, I will state it for the record: investors do not want to see negative numbers.

If investors do not want to see negative numbers, can't they just not pay any premium? Its at this point we have to go back to the aforementioned "points & fees" test. If you recall, a lender has 370 bps of "costs", the GSEs need their 50 bps of gfee and a borrower (based on their loan characteristics) has to pay their LLPAs. Lets take an example where a borrower has 225 bps of LLPAs on a $300k loan where the Fed is paying a 5 point premium:

105-0.5 (gfee)-3.7 (lender cost)-2.25 (LLPA)-0.25 (lender profit)=98.3=loan price

In the above example, the borrower has to pay the difference between 100 and the loan price. So in this example, the borrower would pay 1.7 points for the loan or $5,100. Since this is less than 3% (the points and fees test oversimplified) this loan "passes" the test and can move forward. Keep in mind the lender may be able to offer the borrower less points if the borrower is willing to take a higher rate (where the Fed will pay a higher premium). If, for example, the Fed is willing to pay a 6.7 point premium, the borrower will not pay any points. However, lets say the borrower wants to get an even lower rate than the one that costs 1.7 points. If the premium on that loan is 101, then the borrower would have to pay 5.7 points. If the borrower has the money to pay the points it does not matter. If this loan violates the 3% rule it cannot be sold or guaranteed by the GSEs and therefore the lender cannot give that loan to the borrower. Again, as long as the borrower is taking a HIGHER rate (with enough premium) the lender can give the loan. The downside to the borrower is they will be paying those points (from the premium) for 30 years. (Now I should add there is an APOR test that helps keep the lender from overcharging in rate vs premium but that is outside the scope of this article).

So back to my question: why doesn't an investor just not pay any premium if prepay speeds are bad for them the more premium they pay? Well as you can see from our example, very few loans would pass the "points & fees" test at 100 (par) even if a loan had zero LLPAs

100-0.5-3.7-0-0.25=95.55=loan price=4.45 points

In order to get loans to pass this test, investors MUST pay a premium. The more expensive compliance rules make doing loans, the more premium an investor must pay. If a borrower doesn't want to pay points (or the rules force them to pay less points) then the investor must pay even MORE points. If the investor won't pay the points then the borrower cannot get a loan.

Hopefully its clear by now that the entire post 2008 lending market is built for high(er) premiums. Higher gfees, LLPAs, compliance costs and Dodd-Frank rules REQUIRE high premiums. Seems pretty clear: Premium = Friend.

Not so fast. If prepay speeds hurt investors who pay a premium and investors expect interest rates to fall in the future (or QE to restart) won't they be afraid/unwilling to pay a high premium? If they aren't willing to pay a premium and the GSEs are unable to fulfill the liquidity mandate while the Fed is unwilling, what happens to the mortgage market? As rates continue to go higher and the spread between Mortgage rates and 10 year Treasuries approach all-time highs, won't investors be enticed to pay the big premiums to earn all that yield? The answer: maybe

Large premiums where borrowers put little to no points down lead to larger incentives for borrowers to refinance. If a borrower pays points, up front, they don't get those back if they refi. If borrowers refi less often investors win by getting slower prepay speeds (if they paid a premium, they actually win with fast prepay speeds if they paid a discount).

The other issue with large premiums is it allows the lender to hide their high costs. If every consumer could shop for a loan and see, more explicitly, the cost differences between their lenders, they would reward the more efficient lenders by giving them their business. If however, the more efficient lenders are actually penalized (because they can refi more borrowers in a period of time) then the consumer doesn't actually win because they won't get offered the better rate. The more efficient lenders will just charge more fees than they have to, to prevent being penalized for being too efficient. While these lenders still "win" because they make more money, is this the type of behavior we want to incentivize?

Fast prepay speeds reward the GSEs explicitly. Pre-2008 it would be a mixed bag since the GSEs would win on the insurance side but lose if they held the securities themselves (at a premium). Now, however, the faster a loan prepays and the more times it prepays the better. The GSEs keep all that insurance money whether the loan pays off in 10 years or 10 minutes. Since the GSEs don't have any financial incentive to police prepay speeds, the FHFA polices the GSEs aggressively. Since there is no more Fannie vs Freddie MBS and everything is now just "UMBS", investors can't penalize Fannie vs Freddie (or vice versa) if their prepay speeds are different. Thus lenders are forced to police themselves. If they get too efficient they will get penalized if their prepay speeds spike vs their peers (because investors or the FHFA will complain to the GSEs and force them to take action). Since the mortgage market is cyclical (its either Great or Not Great), any investment that creates efficiency must have a strong return on investment. Since no one knows where interest rates will be in the future (or how long they will be there) or how efficient their competition will be when it happens, what's the incentive to invest? If QM tests don't force lenders to show consumers how efficient they are (by burying the fees in the premium), what's the incentive to invest? If every time there's an economic downturn the Fed restarts QE, pushing premiums up (without regard to prepay behavior), why not just save the money and wait for the next QE? If you're an investor who knows the Fed will do this what's your incentive to pay a premium today, knowing tomorrow the Fed might restart QE, drop interest rates or both?

But what if the Fed doesn't come back?

So Premium: Friend or Foe?