What if I told you the Agency/Government market has been broken for a decade?

Bryan A. Filkey

Servicing. MSR. Margin calls. Hedging. These terms are the foundation of mortgage pricing and are making headlines in today’s liquidity constrained times. If you are in the mortgage business, you should be intimately familiar with these concepts as they are the lifeblood of your livelihood. For those of you interested in learning more, read on my friends.

After the subprime/financial crisis of 2008, the Federal Reserve launched several “unconventional” monetary policy tools. There were several reasons for each but there were two broad categories: liquidity and affordability. The former was to “grease” the wheels of a financial system built on maximized leverage (i.e. very little appetite for short term disruption); the latter was to combat the psychological and financial ramifications of consumers (who drive ~70% of our economy via consumption) if they were to lose 30%+ equity in their homes (or walkaway).

Prior to the crash in ’08, more than 1 out of every 2 loans done in America was private (not Govt guaranteed). As a result of dramatic steps taken post crisis, now more than 9 out of 10 loans are backed explicitly by the U.S. taxpayer. Now the average borrower in the USA will shop around to save $2 off a dozen eggs, they will visit 10 websites to save on shipping or cut coupons to save $5 off a meal. However, when it comes to the largest purchase of their lives (a home) they don’t look at the price of the house, they ask: “How much will this cost me every month?”.

Enter the Fed. With the Fed/Treasury facing a significant decline in home prices and the real possibility of homeowners walking away from their residences, they came up with a plan. Lower monthly payments as far as possible making it cheaper for citizens to stay in their home than to rent or walk away. This was done by buying trillions of dollars of Treasuries and MBS, driving rates down and thus lowering monthly payments. A low monthly payment (driven by a low interest rate) allows a borrower to afford more home. The higher home prices go, the more taxes get collected and thus the Federal Government had a plan to bail out both consumers and state tax coffers (remember when home prices fell, state budgets were decimated as they rely on high home values and taxes to fund their expenses).

Additionally, Ginnie Mae expanded at an unprecedented rate post crisis, essentially moving into the subprime space to fill the financing gap/void left after the private sector imploded. While these Ginnie loans were not neg option arms, 2/28s, 80/10/10, etc. They were nearly 100% LTV to many low credit borrowers. At one point during the early 2010s, Ginnie Mae issuance was second to only Fannie Mae (it was larger than Freddie Mac).

With the Fed entering into the market, rates hit historic lows never before seen and the consumer was offered “no closing cost” options at an unprecedented rate. Prior to the crisis, there was something called a “par coupon”, meaning a rate a borrower could get but they would have to pay comp, closing costs, etc. out of pocket. As the Fed decided what to do in order to refi the most possible borrowers, the situation took care of itself as high premium TBA prices allowed for closing costs and broker comp to be taken out of the premium pricing and thus created little disincentive for borrowers to refi. And refi they did. Over and over.

The rise of Lender Paid Compensation (LPC). As consumers lined up around the block to refi their mortgages, brokers decided to increase the amount of compensation they would charge on agency and govt loans. An added side benefit of low rates and little to no out of pocket expenses: homeownership affordability increased and thus helped to inflate prices people would pay to purchase a home (a major goal of the Fed). Remember, the average consumer cares about how much this will cost them per month, not how much will this cost them in total (life of loan).

Servicing. Many, if not most, of the non-bank lenders in this country (as a % of total lenders not as a percentage of origination volume) do not have the capital necessary to invest in mortgage servicing. Prior to the crash, banks originated the vast majority of agency and government loans. Regulatory changes to MSR forced banks to the sidelines and leveled the playing field for non-banks to enter the lending game. As a result, many non-banks that hold servicing raise capital and with each loan they fund they place an asset on their balance sheet and show an accounting gain. However, from a cash perspective this transaction actually depletes cash. Its akin to buying a stock for the dividend. While the purchase of the stock costs you cash, the dividend (servicing payment) will pay you over time and you can always sell the stock (MSR) if you need to raise cash. However, unlike stocks which trade very frequently at an obvious price (highly liquid) MSRs are not quite so.

What is an MSR? An MSR is the “servicing”. What does that mean? When a large aggregator or bank purchases a loan they are investing in both the loan itself and the rights to collect those monthly payments. The latter allows the servicer to be paid for collecting the payment and the former is likely sold off into an MBS. The value of that servicing is a function of modeling the length of time the borrower will be in the loan (i.e. the number of payments that will be collected before the borrower refinances or pays off the loan). This value is commonly referred to as a servicing multiple or “mult”. Very simply stated: a mult is the number of years the servicer expects the loan to be around. So a “four mult” means approximately four years. Additionally, the probability of default or difficulty in collecting timely payments will increase the cost of servicing a loan. Therefore, lower credit/higher LTV borrowers cost more to service, on average, than high credit/low LTV borrowers.

Boring, so what? Here is where the rubber meets the road. If a non-bank servicer has $25 million to invest in MSR that means they can acquire approximately $210 million in loans per month for 12 months before they run out of cash. They have at least two options. They can decide to “leverage” their MSR portfolio, where a bank will allow them to borrow 50% of the value of the MSR to do more loans (thus buying them another ~6 months of production) or they can sell the MSR.

What happens when interest rates go down? When interest rates drop to historic lows, the value of MSR goes towards zero. As this happens, servicers who used “leverage” (see above) get margin called. A “margin call” is an agreement between two parties whereby the party who owns the asset will give a good faith deposit to the party financing the asset as “insurance” against losses. So that cash they borrowed to do more loans? It goes back to the bank as “insurance”. This cash drain makes it harder for aggregators to buy loans. Additionally, rates going down means MBS prices are going up. Aggregators sell TBAs to hedge their loan pipeline. As rates fall (and prices go up) the aggregators are margin called by their trading counterparties (this eats cash too) and at the same time the assets (the locks they are hoping to close) are not generating cash (because there is a timing difference between the margin call and when the loans actually fund, sometimes up to 60+ days). Additionally, as rates drop dramatically, the pipeline of loans may shrink as consumers shop around for lower rates. This fallout leads to a shorter position in the market which is akin to shorting a stock and watching it rise aggressively (making it more expensive to buy back and increasing losses).

As those issues occur at the same time, many originators consider “hedging” their MSR book by doing more loans (not using financial instruments). This is by no means a “good” hedge but the reasons for doing so are beyond the scope of this article.

As you can see, the negative feedback loop above leaves cash-strapped aggregators/lenders with one option: sell MSRs. The problem? Everyone else wants to sell too and the value has declined tremendously. Any good student of economics knows that a lack of liquidity, many sellers and a dearth of buyers leads to lower prices. As MSRs trade well below modeled prices, the aggregator suffers financial losses (which can be massive).

How does this affect me? Aggregators/lenders are forced to widen margins significantly as they must now generate cash from loan purchases (instead of investing cash) to make up for shortfalls and margin calls elsewhere. This leads to loan prices plummeting while TBA (MBS) prices remain static. For the non-aggregators, they now start suffering losses as their hedges are not moving in a highly correlated fashion with their locks.

High premium, low out of pocket loans make it easy for consumers and brokers to make money, GSEs collect nice guaranty checks on loans that don’t last very long and lenders are able to originate many loans as refis spike substantially. On the other hand, with little skin in the game from the consumer, MBS holders (who pay $1.05 for every $1.00 worth of loans) get burned when a loan refis (they get back 100 cents for the 105 cents they spent, thus losing 5 cents) and MSR players get back $0 for something they may have paid $3,000 for. Over the past decade, improving consumer credit, rising home prices and a tremendous amount of liquidity allowed this fragile system to work. However, with increased concerns about the economy, a major dislocation in global markets causing a liquidity crunch, a significantly higher percentage of non-bank originators (who can’t tap the Fed’s discount window for capital), and a substantial increase in low credit quality Government backed loans, we are seeing the cracks in the foundation grow and spill over into the agency/Government loan market. As servicing values drop towards zero (or go negative for loans expected to default), premiums will drop and the flaws in a business model built on leverage, LPC and little to no closing costs will be exposed.

As the Government inevitably intervenes in this market again, lets work together as an industry to lower our manufacturing costs and not line our pockets with the excess. Invest in your own future and don’t just accept ever rising costs to produce a loan. Our industry can decide to remain “Best Buy” in the face of “Netflix” and let an "Amazon" enter and dominate our market or we can work together to reduce red tape and irresponsible reliance on leverage and premium. Invest in your platforms, invest in technology, invest in our future.