The LoanStreet Beat - March 2024

Welcome to the second edition of The LoanStreet Beat. In addition to our recap of an active economic news cycle and our observations on loan trading trends, for this month we take a deep dive into the impact that COVID-policy-related low mortgage rates are having on home sales and prepayments. Enjoy, share and please comment below!

LoanStreet Market Commentary

The Fed narrative certainly became more complicated over the last couple of weeks. While the latest Personal Consumption Expenditures (PCE) measure came in within expectations, those expectations called for a month-over-month increase of 0.4%, as compared to the decreases we’ve seen over the last few months. Further, personal income rose by 1.0%, well above the 0.3% forecast, mainly driven by an increase in dividend income. The last Consumer Price Index (CPI) report showed higher-than-expected inflation, once again driven by shelter costs, which accounted for more than two-thirds of the increase in inflation.

Of greater concern, the Fed likes to focus more on so-called “supercore inflation,” which excludes inflation of goods, energy and cost of housing, as a measure of wage-driven inflation. This measure also increased in the last report, 0.9% month-over-month and 4.4% year-over-year, an 8-month high.

In addition, the Producer Price Index (PPI) also came in above expectations, meaning that producers are paying more than expected for materials, costs that are usually passed on to consumers. On top of this data, we have a stock market that is at a record high and home prices at near-record highs, which means consumers (at least the more well-to-do) are feeling wealthier, which results in more spending (wealth effect) and further upward pressure on inflation.

On the other hand, companies continue to announce layoffs at the fastest pace since Q1 of last year while delinquencies continue to trend higher across all asset classes as consumers appear to have more difficulty in handling their ever-growing debt. This points to a vulnerable economy that is largely driven by consumer spending. For now, consumer spending remains robust, although some of that could be attributed to the wealth effect mentioned earlier. As asset prices reach record-level evaluations, they can become more volatile, as can be seen by the large moves in some of the mega-cap stocks. On the whole, should inflation and rates remain elevated, that could impact asset prices, such as tech stocks and housing, which could lead to lower spending as the consumer feels poorer and is threatened by job cuts. This could quickly turn the soft-landing narrative into a hard-landing.

Loan Trading Trends and Implications

On the LoanStreet Marketplace, we are seeing a strong pick up in buy-side volumes, particularly in autos and HELOCs, even as loss-adjusted spreads on autos have moved from 250 bps to 150 bps in a matter of 2 months. This is likely a result of consumer spending in the sector declining in response to higher car prices and loan rates. Furthermore, with captives offering financing as low as 0%, it becomes difficult for any lender, credit unions included, to compete for new auto loans. With the Manheim Used Vehicle Index declining, overall unit car sales also declining, and new auto loans going to captives, a perfect storm for a decline in CU originations in auto loans is forming. With that in mind, for sellers, this presents an opportunity to sell loans at spreads we haven’t seen in two years. For buyers, they should expect lower yields and less leverage when it comes to carving out a pool they might want to purchase. With that in mind, non-bank origination partners continue to be a great option for financial institutions looking to add more loan volume.

Rate Trapped: Homeownership and Low Mortgage Rates

During the pandemic, many homeowners took advantage of the extremely low mortgage rates, either refinancing their existing mortgage or using the opportunity to move/upgrade their home. Today, the significantly higher mortgage rates have created a strong disincentive for these homeowners to move, as this would require taking out a new loan at a materially higher rate. This logjam in home sales has resulted in limited supply, which in turn has led to higher home prices. In this month’s commentary, we take a deeper look at the extent of this dynamic, and what it may take for things to turn around.

For this analysis, we extracted the 30-yr fixed-rate mortgage data from the publicly-available FNMA Monthly Loan Level File from January 2024, and for prepayment speeds, compared it to the file from January 2023. This won’t be a complete representation of the mortgage market as there are other mortgage products (15-year, ARMs, etc.) as well as the size restrictions of the Agency conforming limit, but it will give us a good starting point. First, let’s look at the distribution of interest rates. The following graph shows the distribution by outstanding balance and by loan count:

With current mortgage rates of approximately 7%, roughly 97% of the loans currently outstanding, by either balance or count, are at below-market rates. But what does this mean for the borrower? Why should this have such an impact on a homeowner’s willingness to move? The answer is, of course, money.?

The following table shows two different ways of looking at the impact of taking out a new mortgage at 7% versus their current loan. This assumes a new loan in all cases, though the existing loan would likely be a year or more old. The first column shows how large the payment change would be should they keep the balance the same; the second shows how much less they can borrow and keep the payments the same:

So a homeowner that has a 2.5% rate mortgage and is considering moving could either borrow the same amount and see a payment change of over 68%, or borrow approximately 40% less, neither of which is very attractive. How big an impact does this have on prepayments? To evaluate that question, we looked at what percentage of loans, by count, paid off between the 2023 and 2024 tapes[1].

The following graph shows the relationship of the observed prepayment rates by interest rate bucket versus the natural log of the ratio of the new monthly payment to the existing monthly payment, as well as a fitted linear regression:

The intercept of the fitted line indicates that the expected prepayment rate for a mortgage with the current interest rate would be 10.7%, which conforms with general expectations. The observed prepayment rate for loans in the lowest interest rate bucket, 1.75% - 2.00%, is approximately 2%, an incredibly low prepayment rate that likely reflects only life events such as job loss, death and divorce. However, a decrease in the payment shock, even small ones, does create the necessary incentive to have some homeowners move, assuming that the life events previously mentioned are not correlated with loan rates, a fairly safe assumption.

What could break this logjam? The first and obvious thing would be lower mortgage rates. Reducing the payment shock associated with taking out an at-market rate mortgage will help nudge people into moving. However, with ? of the mortgages under 4%, and 50% under 3.5%, it seems unlikely that rates will decline sufficiently to completely remove the disincentive, however, as noted above, every little bit helps in increasing mobility.

The second thing that can help is just simply the passage of time. This has several effects. First, the balance of the loan declines due to amortization, thereby reducing the size of the payment shock. Second, time usually means inflation, in both housing (HPA) as well as in goods and services (CPI). HPA will help in particular those looking to downsize as, over time, the buildup of equity will reach the point where they will be able to move to a smaller, less expensive home with a reduced amount of debt, or possibly, no debt at all, thereby reducing or eliminating any payment shock.?

The following table is similar to the one above, except it takes a look at downsizing only and shows the break-even cumulative HPA necessary for a homeowner to keep their mortgage payments the same while selling their home and downsizing into a home worth 75%, 80% or 85% of the selling price of their existing home. The analysis assumes 5% broker/closing fees, 20% down on the original house and ignores amortization and any constraints due to LTV or the need for the borrower to provide equity on the new loan, as well as any additional savings in reduced property tax or home insurance:

As an example of how to interpret the table, consider a homeowner with a 3.5% mortgage and looking to downsize to a home worth 25% less than their current home value. In order to keep their monthly mortgage payments the same, they need to have experienced an approximately 30% increase in home value, with the math working as follows:?

The initial home purchase is $100 with $80 in financing and $20 in equity. If the home value becomes $130.02, they can sell, pay off the existing mortgage, 5% in closing costs and have $43.52 in cash. The new home is targeted to be 75% of $130.02, or $97.52. Applying the equity from the sale, they would need to borrow $54.00, which from our previous analysis is exactly the amount they can borrow at 7% and keep their mortgage payments the same [(1-32.5%) * $80).

As can be seen, given HPA since COVID, some loans have already reached these break-even levels, with others likely to follow. And the more a homeowner is willing to downsize, either by moving to a less-expensive area or being willing to take an even smaller house, the more the break-even HPA figures drop.

General inflation (CPI) helps by reducing the relative magnitude of any payment shock – it’s a major financial impact when your mortgage payments increase and it represents 30% of your income, but it becomes less of an issue when it’s only 10% of your income thanks to inflation-related wage increases. Lastly, over time, some families will simply need to move regardless of the new mortgage rate as they have outgrown their existing home.?

These events are also synergistic in that, as time passes, it doesn’t take as large a rate move to have it make more sense to consider moving.

One final thought on a way to break the logjam – retroactively make mortgages portable (this is different from an assumable loan where the new buyer takes over the previous owner’s loan). Unlike the previous logjam breakers, this does not require either an unlikely decline in rates or waiting for enough time to pass, this would immediately allow people to move as the shock would be removed. The cost to the lender is small in that they are not giving anything away - the loan was unlikely to prepay any time soon regardless, so this does not materially extend the loan. While some restrictions will likely be needed, i.e., a borrower in good standing with no past due payments, limits on the new LTV, etc., this could be broadly applied.?

Contrary to many of the costly steps taken to rescue housing in the Great Recession, this strategy of making mortgages portable is not a loss-mitigation one, so it may not be a modification generally permitted under a servicing agreement and therefore may require the federal government to get involved. Given the societal costs of high home prices and low affordability, the cost/benefit here seems fairly lopsided.

This is not something we’ve heard discussed, so if it gains some traction, remember, you heard it here first!

[1] As we did not track individual loans, just aggregate loan count, it’s possible that some additional loans were sold to FNMA in the interim, but this seems unlikely to have a material impact.

Monthly Economic Data Summary

• Based on the 2/13/2024 CPI report, headline inflation increased by 0.3% MOM and 3.1% YOY.? This was above the expectations of 0.2% monthly and 2.9% annually.?
• From the same report, core CPI, which excludes food and energy, rose 0.4% MOM and 3.9% YOY.? Above the expected 0.3% and 3.7%, respectively.?
• On 2/16/2024 we received the latest US producer prices index (PPI), the MOM increase of 0.3% was above the projected 0.1% and the YOY increase of 0.9% came in above the 0.7% expectation.?
• The latest jobless claims report as of? 2/29/2024, showed an increase of 13k jobless claims to a total of 215k as compared to the expectation of 210k.
• The latest Manheim Market Report for mid-February show a continued downtrend in prices of 0.9% MOM and 13.8% YOY, on an adjusted basis.?
• The Case-Shiller home price index showed national home prices decreasing MOM by 0.4% while increasing YOY by 5.5% .? These are lagging data and reflect the CS indices for 12/23.
• Based on the CME market watch tool, the expectations of the first rate cut was pushed back from May to June 2024, with a 68% chance of a cut being announced at that time.?

This article was authored by Eric Marcus, Managing Director and Head of Trading, and Matt Rudzinski, Director of Sales and Trading.

For more market commentary and to learn more about LoanStreet's solutions, visit www.loan-street.com

Disclaimer

LoanStreet is not a Registered Exchange, Financial Planner, Investment Adviser, or Tax Adviser. The information provided herein is for general informational purposes only, and does not, and is not intended to, constitute legal, financial, investment, or tax advice.