At first glance, this seems like a dumb question. The Freddie Mac 30 year mortgage rate is approximately 3.75%, near its all-time low. Based on this rate, the median income family can afford to purchase 200% of the median priced home. This so-called “affordability” measure is the highest it has been in twenty years.
Although this is certainly good news for prospective home buyers, there is an argument that mortgage rates should be substantially lower. The mortgage rate paid by the borrower is called the “primary market rate” and is usually established as a spread over the “secondary market rate” which is the current market yield on mortgage backed securities (MBS). Thanks in large part to the Federal Reserve program of quantitative easing, the secondary market rate has declined in the past three years by 200 basis points (a basis point is 1/100 of a percent) to 2.75%. Meanwhile, the primary market rate, the rate actually paid by home buyers, has only fallen 150 basis points. The reason for the discrepancy is that the primary/secondary “spread” has risen by 50 basis points.
Historically, the primary/secondary spread has averaged about 50 basis points. For example, suppose a borrower takes out a loan with a note rate of 3.5% and pays 1 point in fees. The borrower’s effective rate (the primary market rate) is approximately 3.75%. Now, further suppose that this loan is put into an MBS with a 3.0% coupon and that security trades in the market for a price of 99 (1% discount to par). Then the secondary market yield would be near 3.25% and the spread between the primary and secondary market rates would be 0.5% (50 basis points). But in today’s world, MBS prices have been pushed higher so that the yield on the MBS is closer to 2.75% leaving a 100 basis point spread between the primary and secondary rates.
The primary/secondary spread reflects several factors including the cost of credit enhancement (most mortgage-backed securities are credit enhanced), the cost of servicing the loan, and the profit of the various participants in the securitization process including the loan originator. Most loans made today are guaranteed by Freddie Mac or Fannie Mae (the GSEs), and the GSE guarantor fee (in return for which the GSEs guarantee principal and interest payments to the investor in the MBS) had gone up a lot, even though the actual risk transferred is lower. The actual risk transfer is lower because it has become apparent that the GSEs are much more aggressive in pushing lenders to buy back loans that go bad than in the past.
Thus, lenders are actually taking on more credit risk, even as they pay higher GSE fees. Lender costs are also going up due to greater regulatory demands stemming from the Dodd-Frank Law. Yet, even with the higher costs, lender profits are soaring. For example, the leading lender is Wells Fargo (WFC). WFC reported for mortgage originations volume for the quarter ended December 31, 2012 of $125 billion and pre-tax profits on mortgage originations of $3.1 billion. This is more than twice the historical average profit margin. What is going on is a decline in lending capacity as many banks have stepped away from the business (most notably, Bank of America) at the same time as mortgage volume is rising due to relatively low interest rates and an improving housing market.
Meanwhile, the consumer financial watchdog, the Consumer Financial Protection Bureau (CFPB), has released a rule requiring mortgage lenders to consider consumers’ ability to repay before extending credit. The rule establishes the standard to be classified as a “qualifying mortgage loan.” Loans originated under this standard will have legal protection against lawsuits in the event that the borrower subsequently defaults. The standards include: maximum payment to income of 43%, full documentation of income, no “exotic” features like 40 year loans, interest only mortgages or negative amortization mortgages.
One good thing about this rule is that it provides some degree of certainty about what defines a qualifying mortgage and therefore provides some degree of legal protection for lenders. That may induce more lenders to enter the market (with the result being downward pressure on the primary mortgage rate).
The standards set forth in this rule are not onerous. In fact, they appear to be more lax than traditional underwriting standards. There is no mention of down payment or credit score, and the back end payment to income ratio of 43% is pretty high. And it can be even looser than that. For the next seven years, any loan which does not meet the CFPB standard but does qualify for insurance by Freddie Mac, Fannie Mae or the FHA also meets the qualifying loan standard. In this way the CFPB standards perpetuate the role of government agencies in the mortgage market. This presents the private market with a giant competitor with an unfair advantage.
Future of the GSEs – repeating the cycle
Supposedly, the plan is to wind down GSE operations over time. After the financial crisis, no one had the stomach for another $200 billion taxpayer bailout. Yet, five years later, 90% of new mortgage loans are guaranteed by the GSEs or the FHA. As noted above, originator profit margins are historically high so there is an incentive for private firms to enter the market. However, there is no operating secondary market for non-agency loans, so if originators choose to make such loans they must retain them in portfolio. Not many lenders today wish to do that. So, they concentrate on loans that can be sold, that is, loans guaranteed by the GSEs or FHA.
One of the mechanisms being used to wind down Freddie and Fannie is to raise GSE guarantee fees. A lot has been done here already and there are more GSE fee hikes coming. Apparently, the theory is that eventually primary/secondary mortgage spreads will be pushed high enough that either private sector securitization or portfolio lending will make sense. There is a certain irony in this. Back in the 1970s the U.S. mortgage market was dominated by savings banks and savings and loan associations (collectively, “thrifts”). The thrift business was killed by dramatic expansion in GSE portfolio activities. That is, with very low capital requirements and debt implicitly guaranteed by the U.S. government, the GSE’s were able to operate profitability with much lower spreads than the thrifts. The effect was to drive the primary mortgage rate so low that portfolio lending was not profitable for thrift institutions (admittedly, the interest rate spike of the late 1970s and early 1980s did not help either). Now we appear to be trying to go back to the beginning. Bring back the thrifts?
Meanwhile, both Freddie and Fannie are reporting record profits. Indeed, Fannie’s 2012 profit exceeded $17 billion, easily exceeding the mortgage profit of the largest private sector mortgage participant (Wells Fargo). At this rate, the GSEs will fully pay back the U.S. Treasury within the next five years. Then what?
I think the most likely scenario is that Freddie, Fannie and the FHA will continue to insure mortgage loans and thereby define underwriting standards for the industry. And these underwriting standards will follow a cycle. Eventually, public support for homeownership, particularly for low-income families, will create pressure to lighten up on underwriting standards. To the extent that underwriting standards have become too strict in recent years, this may be a good thing. But if history is any guide, as housing prices improve and mortgage delinquencies and foreclosures abate, there will be increasing pressures to loosen standards and replay the boom/bust cycle once again.