Mortgage Market: Some Observations

Here are just some thoughts about a few abnormalities in the mortgage market that I have observed.
Jumbo-Conforming Mortgage Spreads:
Jumbo spreads on 30-year fixed rate mortgages remain elevated at approx 100bps versus historical spread of 12-25bps. According to Bankrate.com, the average rate for a conforming 30yr fixed is 5.62% and 6.60% for jumbo 30yr mortgages. Jumbo mortgages are loan amounts above $417,000 which exceed the requirements for Fannie / Freddie securitization. Since jumbo loans are ineligible for Agency MBS, they are less liquid. see article (august)

Since most prime jumbo mortgages are underwritten according to Fannie Mae guidelines, the credit risk between conforming and jumbo loans are the same. That’s why borrowers could usually get almost same rate on a $416k loan as they could a $418k loan. Any spread reflects the liquidity premium of the loan, not the default risk. Now, we have seen that liquidity premium spike affecting the most creditworthy borrowers.

Conforming mortgage rates currently are in-line with the yield on the 10yr Treasury, thus the mortgage crisis has left Agency MBS relatively unaffected since it’s such a highly liquid market. Jumbo AAA paper commands 100bps premium since investor appetite has diminished.

It appears that in part, investors are suspect of the credit quality of any jumbo loan not guaranteed by one of the Agencies even if the originator claims the loan conforms to Agency underwriting standards. Certainly there is a lack of trust with regards to the composition of the underlying mortgages for private label MBS and CMOs. A MBS may be backed by 1000’s of loans from several originators or even hundreds of independent brokers, thus it’s essentially not economical to thoroughly examine each mortgage backing the security. Investors are so far removed from the point of origination that they have to trust proper procedure was followed and rely on legal recourse if originators took a short-cut.

In addition, it appears elevated spread is due to reduced confidence in private insurers ability to guarantee the principal. Historically this has not been a concern since the backers of private label MBS were financially strong and thought to have the wherewithal to handle defaults on the underlying mortgages. Low mortgage defaults coupled with high recovery rates on collateral resulted in a low number of reimbursements required by private insurers. Now that the above situation is reversed, insurers’ ability to cover losses is now a question.

I am somewhat surprised that jumbo spreads have not shown any signs of tightening. According to the graphs from Bankrate.com, jumbo rates began to decrease mid-October, yet reversed course as spreads rose again in November. This is an indication that the non-conforming mortgage market has virtually not improved since the crisis began in July.

LIBOR – CMT Disparity:
Borrowers with LIBOR ARMs scheduled to reset soon are in for a surprise. ARMs reset to a rate which is determined by adding the pre-disclosed margin to the current rate of a specified index. At the time of origination, a borrower can choose which index he/she prefers. Most common indices are the 1-year CMT (Constant Maturity Treasury) and 1-year LIBOR.

Historically, LIBOR has been roughly 50bps (40 bps since 1990) higher than CMT, thus the margin has been 50bps higher for CMT ARMs, hence equating the combined rate (margin + index). Essentially, the choice between the two is a coin flip since both mortgages will reset to nearly the same rate.

Currently, there is a huge disparity between CMT and LIBOR rates. The CMT is approx 3.10 and LIBOR is 4.45, a difference of 135bps which is 85bps higher that the historical relationship. What does this mean? Well, for borrowers that took out a LIBOR 3/1 ARM, three years ago, their mortgage will reset to a rate 85bps higher than if they had chosen CMT. The new rate for CMT ARMs would be 5.85% (2.75 margin + 3.10) and LIBOR ARMs would be 6.70% (2.25 margin + 4.45). Wow!

The short answer for why the CMT-LIBOR spread has become disconnected is because the CMT is truly risk-free rate since it is based on 1-year Treasury yields. LIBOR is the prime rate European banks charge each other and involves credit risk because banks are not government institutions. The long history of a static spread implied credit risk was not perceived as a dominant factor in the determining components of the LIBOR rate. I say this because the LIBOR spread to Treasuries had been constant, suggesting that the mark-up was more customary as opposed to changes in risk perceptions. Recently this has not been the case whatsoever. The credit risk premium is a dominant factor in LIBOR rates as evidenced by the 1yr LIBOR rate remaining high while the risk-free rate has declined. This is a clear indication that the credit quality of banks has significantly deteriorated due to risky mortgage holdings.

FNMA - FHLMC MBS Price Spread:
Another thing that I have noticed recently is that Freddie Mac MBS are trading about 4 ticks or 1/8 pt worse than Fannie Mae MBS. This is strange because Freddie Mac Gold PC pays on the 15th of the month while Fannie Mae payments are 10 days later on the 25th. Since Freddie MBS CFs occur sooner than FNMA, investors should “pay up” for Freddie MBS because its PV of cash flows is larger than PV of FNMA MBS, all else equal.

Freddie Mac MBS always traded at a premium to Fannie throughout my experience on a mortgage trading desk, just as logic would suggest. Recently, Fannie MBS has garnered a slightly higher price despite the payment delay, which raises the question “Why?” Ostensibly the price inversion is due to concern over Freddie Mac’s ability to back its mortgage bonds. Obviously, fears are not paramount, else the spread would be much greater, but this does illustrate that investors are paying attention to something that historically was just a given.

Generally speaking, Freddie and Fannie MBS have had the perception of being free of credit risk due to the implicit guarantee by the Federal Government. Ginnie Mae MBS carries the full faith and credit of the US Government. Agency MBS are backed by high quality mortgages and 80 LTV (PMI required if LTV >80); Fannie and Freddie haven’t ever incurred significant losses from mortgage securitization. In fact, they make a handsome profit securitizing, because the revenues generated from guarantee fees (insurance premiums) far exceeds the losses covered on mortgage loans.

Now, there are questions about the actual risk inherent to both Freddie and Fannie. Both have engaged in risky side businesses that may have impaired their primary business of backing prime MBS. Another concern is the possibility of a higher than expected default rate on mortgage collateral of MBS they issue. Hence, guarantee fees charged for securitization are way to low with respect to actual losses.

Given the major problems announced at Freddie Mac recently, investors are apprehensive as evidenced by Freddie MBS trading back to Fannie MBS, the reverse of historical norms.

Mortgage Fears Past Us?

Discussion and debate about the mortgage upheaval has been relatively limited the past few weeks even though the risks have not gone anywhere. Maybe since that mortgage mess is becoming more like “old news” is the reason for the slip in attention, but more likely it’s the Fed’s 50 bps rate cut that has ushered in a tide of silence. Instead, increased focus has been given to a returning of the Bull Market coupled with the opportunities in the Tech space. The resulting implication is that the market is confident that the Fed will act to resolve lingering mortgage and housing threats, as the air swirling around Wall Street suggests that the problems are past us, or at least, have been identified.

With so much origination of Alt-A and sub-prime mortgages the past two years, problems have not had enough time to fully appear. In addition, home values are now falling thus more loans will go bad due to borrowers’ inability to liquidate at a price high enough to satisfy the outstanding loan balance.

Don’t get me wrong, nobody is dismissing the crisis, but with the averages roaring back and hitting all-time highs, it does raise a question. “What was the purpose for the exacerbated volatility and nasty market declines we observed in August?” Or, “Was it because the market was afraid the Fed wouldn’t cut? And now that it did problem solved?”

I don’t, and I bet many other’s don’t either, think the mortgage and housing woes can be directly cured by monetary policy. I believe that there are still a few banks and mortgage finance players walking the planks of the gallows. Additionally, the effects of ARM resets and foreclosure possibilities hasn’t fully encumbered the consumer, a situation that will broadly affect the economy.

Credit Suisse published a terrific Mortgage Research Report which illuminates the difference in the residential market five years ago versus last year, including the evolving trend to where we are today. A glaring statistic is the mix of purchase money mortgage originations: In 2002, subprime 6% and Alt-A 5% compared to 2006, sub-prime 20% and Alt-A 20%. Remember, Alt-A is not “Almost prime” as it is sometimes referred; It’s essentially sub-prime dressed up, in my opinion. So, we have 40% of purchase originations with questionable credit quality versus 11% just 4 years earlier.

Alt-A purchase originations hovered around 5% during 2001-2003, then tripled to 15% in 2004, and rising again to 18% in 2005 up to 20% in 2006. My educated theory for the spike (educated since I am a former mortgage professional), was due to the slowdown in mortgage originations after the re-finance boom after rates bottomed in 2003. After the most credit-worthy borrowers had taken out mortgages, the primary source of new originations would have to come from more risky borrowers.

Lenders needed the origination income and investors needed the yield. Both were willing to accept the higher risk. Partially, because home values were rising at an astonishing clip, this assuaged foreclosures since periled borrowers could unload their property to satisfy mortgage obligations if needed. In essence, at the onset, foreclosures were below trend due to the strong housing market, and lenders and investors extrapolated this trend forward in support of their heighten risk-taking endeavors. Many borrowers were given mortgages that were way out of their league. Lenders grasped assurance from the underlying collateral, since home appreciation had been so robust. In reality, rising home prices were supported by the increased number of buyers able to receive financing. Lending to risky borrowers causes home values to rise, and rising home values makes the loans appear less risky, so even more lending results, followed by additional home demand and subsequent appreciation.

The problem with Alt-A mortgages is that many lack documentation of income and assets. Many will only require a credit score if there is typical 20% down payment. The problem with a credit score is that it’s calculated from a credit history, and history is no certain indication of the future. Additionally, an individual may have good credit because he/she has never a challenging debt load. The best indication of loan performance is the borrower’s income; the stability and the amount it exceeds loan payments. In order to ascertain the cash amount a borrower is capable of paying out, one must know how much cash the borrower has coming in. Without verified income, it’s very difficult to gauge the credit quality of a mortgage.

Teaser rate, Interest Only, and Payment Option ARMS provide initial affordability with low monthly payments. These low payments eventually reset to much higher amounts, many times beyond the borrower’s reach. Several years ago, borrowers who faced this dilemma could refinance into a new mortgage thus keeping their payments low. Yet, today, lenders have tightened the credit clamp eliminating this potential alternative to default.

The key issue is that many more loans populate the “probable default universe” than what we are currently seeing. We have just begun to see mortgages go bad, yet there are potentially many more loans that haven’t had enough time to appear as troubled. Falling home values will unveil the trouble that has been obscured by the creative mortgage products.

Homeowners unable to service their mortgage are confronted by a housing market with less demand due to tightened credit standards. Rising negative equity enhances the incentive to default, as opposed to exploring every possible alternative to avoid foreclosure. Lenders reaction to increased defaults only guarantees that there will be many more to come, especially since lax underwriting guidelines tempered defaults for the past few years (either via refinance or property sale).

Many banks own these risky loans in their investment portfolios. It’s tough to profit under flat and inverted yield curve conditions, and Alt-A and IO mortgages allow extra yield to mitigate high cost of funds. Banks prefer short maturity assets due to the short duration of their liabilities, thus ARMs best suit their investment objectives. 3 and 5 year ARMs are popular holdings which mean many still have yet to reset. Borrowers facing dramatic payment increases due to ARM resets have been able to refinance into another mortgage to avoid the rate increase. Now that credit has tightened, it is likely that many borrowers will be unable to escape payment resets by refinancing into another mortgage. Additionally, lenders have curtailed offerings of the “initial low-payment” mortgage products allowing borrowers to refinance out of loans scheduled to reset.

With tightened credit standards and the elimination of these creative loan products, future mortgage originations should fall drastically. Housing market will experience increased weakness due to less qualified borrowers providing the demand needed to offset the enormous home supply. Builders and other related industries are feeling the pain. Mortgage lenders have either closed their doors or made significant reductions. These woes could affect demand in other non-related industries. Homeowners witnessing the decline in their home value could decrease consumption due to a contraction in the wealth effect. Yet, according to the stock market, it appears we have nothing to worry about.

Sub-Prime Fears Affect Prime Borrowers

Sub-prime woes are showing signs of pinching the most credit-worthy borrowers as jumbo-conforming spreads on prime mortgages have sky rocketed. Mortgages are considered “Jumbo” for amounts over $417,000. Fannie Mae and Freddie Mac will only securitize mortgages with conforming loan balances into an Agency MBS which trade in a highly liquid market. The spread has generally been about 1/8 – 1/4 pt higher in rate for those High balance loans. As of this week, the spread has risen to roughly 80 bps (0.8%) according to Bankrate.com. That’s a national average, for some lenders it’s much worse. The WSJ reported last week that a broker informed them that Wells Fargo had raised their jumbo 30yr rate from 6.875% to 8% effectively suspending production for that loan program. Why? Ostensibly from an absence of demand on Wall Street.

Banks seek to match the duration or “Life” of assets and liabilities. It’s very risky to borrow short-term, i.e. deposits, CDs, etc. and lend long-term for 15-30 years. Generally, financial institutions have a mortgage company/division responsible for originating mortgages and then selling to the secondary market. The mortgage division sells short maturity adjustable-rate mortgages to the bank to satisfy their loan investment portfolio objectives. Longer maturity conforming FRM are assembled into pools that FNMA, FHLC, or GNMA securitizes into MBS which mortgage bankers then sell to Wall Street. Non-conforming mortgages: jumbo, Alt-A, zero-down etc. are bulked up and then sold to Wall Street firms who use that paper to securitize “private-label MBS” or create CMO/CDO structures they offer to investors such as hedge funds.

Agency MBS is an extremely liquid market. Non-conforming mortgages are much less liquid since they are not securitized by a quasi-government agency so finding buyers can be difficult. I worked on a mortgage-trading desk for one of the top 15 largest banks for three years beginning back in 2004. Finding buyers for non-conforming paper was not hard then. Actually, Wall Street firms, especially those in the currently in the headlines, would be beating down our door for as many mortgages they could get their hands on. Lately it appears phones on trading desks at mortgage companies are silent. Certainly the case for Wells Fargo since it’s essentially curtailing jumbo mortgage production. Lenders do not want to originate mortgages they will not be able to sell.

Since most prime jumbo mortgages are underwritten according to Fannie Mae guidelines, the credit risk between conforming and jumbo loans are the same. That’s why borrowers could usually get almost same rate on a $416k loan as they could a $418k loan. Any spread reflects the liquidity premium of the loan, not the default risk. Now, we have seen that liquidity premium spike affecting the most creditworthy borrowers.

The credit risk of conforming MBS and jumbo MBS is significantly different. Agency MBS essentially has no credit risk since they are assumed to be backed by the Federal Government. Jumbo MBS or “Private Label” are backed by whichever Wall Street firm (and mortgage insurers) securitizes them. Thus, the credit risk associated stems from the issuer of the jumbo paper not the underlying loans per se. The credit risk on the mortgages are equal, yet the MBS credit risk is quite different.

In the past, investors assumed that jumbo MBS had minimal credit risk because the financial institutions backing them had enough capital to cover any defaults and that they were “too big to fail.”
Now, given the sub-prime fears, investors worry that non-prime defaults will hamper the backing institution’s ability to cover defaults on prime mortgages. Investors are calling into question the “too big to fail” cliché. Wall Street firms will find it difficult to sell additional mortgage-backed products to investors who are already worried about the fate of the current mortgage fund holdings.

With respect to jumbo spreads, it can be said that the sub-prime mess is spilling into the prime mortgage market. Homeowners trying to sell above $417k face significant challenges opposed to selling at a lower price. Sellers who have been asking slightly higher than the conforming limit may be forced to lower their price causing further downward pressure on home values. Think about how many homes were purchased above $417 during the explosion in home prices. Think about how many of those inflated home values were beyond the actual reach of buyers, but were purchased with a non-traditional mortgage. Interest-only, option payment, and adjustable-rate mortgages with low teasers allowed borrowers to afford expensive homes due to the low payments required during the loan’s early stages. As rates reset higher and monthly payments increase, borrowers will be more likely to default. To avoid foreclosure borrowers will try to sell at the amount owed on their mortgage, but with falling home values and ubiquitous home supply, it will be challenging for sellers to get what they owe.