Liquidity moves markets!Follow the money. Find the profits!
And there were lighter moments. Federal Housing Finance Administration head Mark Calabria continued to backpedal skillfully regarding the prospects for taking Fannie Mae and Freddie Mac out of conservatorship. In a matter of weeks we’ve progressed from the status quo is “unacceptable” to a plea for power to create more GSEs to a concession at the GNMA event that Congress needs to get involved. Odds of seeing a roadmap for GSE reform from the Trump Administration in 2019 are fading fast. Hit the bid.
One of the more important topics of discussion at the event was the high level of prepayments experienced by holders of GNMA mortgage backed securities (MBS), particularly from loans guaranteed by the Veterans Administration. Investors in MBS are getting killed by prepayments, but lenders are cheering because cheap refinance volumes are a welcome relief after years of declining profits. And this is a problem that affects GNMA and the GSEs Fannie Mae and Freddie Mac equally.
After all, if you are the Bank of Japan and you’re paying 105 for a GNMA MBS, receiving prepayments at par when a mortgage loan is refinanced is painful. We recall years ago having similar discussions with Japanese banks and insurance companies. And we were always sympathetic.
Mindful of the stress felt by its precious global investor base, the folks at GNMA and the Federal Housing Administration have sought to shift the blame for high prepayments to lenders and servicers. In January, GNMA imposed restrictions on loanDepot for allegedly “churning” loans to veterans. Previously, similar restrictions were imposed on Freedom Mortgage and GoldenWest.
“Ginnie Mae cracked down on what it believes is unnecessary loan churning in its VA pools. Said actions are understood to be the result of those efforts,” Housing Wire reported. Like Freedom, loanDepot will see the removal of such restrictions “based on the Issuer having demonstrated to Ginnie Mae’s satisfaction that (a) its prepayment speeds are substantially in-line with those of equivalent multi-Issuer cohorts, and (b) such improved performance is sustainable,” GNMA said in a statement.
The actions of GNMA against specific issuers is more politics than substance. Members of Congress like the idea of getting tough on “VA churning,” even though the problem may not actually exist. It kind of reminds us of the Congressional hearings on CIA waterboarding of Al-Qaeda, which featured several terrorists who were never actually tortured. In Washington, fake news is only exceeded by imaginary policy.
It’s high time that GNMA realized that persecuting issuers for supposed “churning” of VA loans is not going to solve the far broader problem of higher prepayment speeds. Just watch the earnings bloodbath in mortgage servicing rights (MSRs) this quarter by banks and non-banks alike. Does GNMA actually think that owners of MSRs among its issuer community want to push prepayment speeds higher? Really? But lenders do understand that when mortgage rates are cut by 1/3 in six months, somebody somewhere is going to make a new loan.
When our friends in the third-party MSR valuation channel show constant prepayment rates (CPRs) surging over 20% of the remaining value of loan pools given a 50bp decline in rates, what more needs to be said? The 10-year Treasury note is down over a point in yield since December 2018. More important, the shape of the yield curve and the volatility surface have also shifted since December. New production pricing for conventional loan servicing assets is down by a third since October.
First, our friends at GNMA have forgotten (or perhaps never knew) that you should listen sympathetically to investors who are experiencing prepayment risk and related convexity – but that’s all. Express concern, then put the phone down and go back to work. This is one of the first lessons you learn on the Street.
Given that the problem of prepayments has to do with interest rates, which are controlled to some degree by the Federal Open Market Committee, there seems to be little real utility to GNMA in beating on its shrinking pool of issuers. Since Fed Chairman Jerome Powell did his first pirouette in December, as deft a political repositioning as you’ll ever see, the rate of prepayments across the mortgage industry has soared. Powell has continued the policy shift with some striking fouettés, but medium to long-term interest rates continue to fall. Good for lending, bad for MSRs.
Second, GNMA and the GSEs need to recognize that loan servicers do not control prepayment rates. The fact that they know the address of the obligor is helpful, but the pitiful, sub-25% refinance retention rate in the mortgage industry suggests that servicing the loan does not necessarily lead to future business. Fact is that with rates falling precipitously, refinance loans are going to be made. Of note, modeled prepay speeds for 4 percent coupon conventional loans across the country are into the mid to high teens and may go higher. That means the MSR will basically amortize and disappear in five years or
The third key factor we’d offer up to the folks at GNMA regarding prepayments is the economy. When interest rates gyrate as they have for the past six months, an American family are faced with the prospect of saving hundreds of dollars a month on a mortgage deserves that opportunity. Why shouldn’t a young military family benefit from a lower mortgage? The logic of GNMA looks dangerously like the predatory actions of the GSEs after 2008, when increased loan level pricing adjustments were used by Fannie Mae and Freddie Mac to deliberately prevent refinancing of loans held in GSE portfolios.
Given the fact that home owners have the legal right to refinance without penalty, we think it is appropriate to ask why GNMA has chosen to punish lenders and issuers who ultimately have little control over the rate of prepayments. We hear that the folks at Fannie Mae and Freddie Mac have similar concerns. Well, get used to it. Capitalization level assumptions for new production MSRs peaked last Fall and are falling dramatically due to falling interest rates and high levels of prepayments. Ponder conventional 4s that traded at over 4x cash flow in 2017 now trading below 3x cash flow as average lives tumble. GNMA discount coupons are heading towards 2x multiples.
All we can say is that rates are headed lower, perhaps sub 2% for the 10-year note for an extended period. And frankly the mortgage industry, which also talks to investors in mortgage backed securities, is already exercising considerable restraint in regard to prepayments. “The mortgage industry could double prepayments,” one prominent mortgage executive told The IRA last week at the Ginnie Mae Summit.
If GNMA really wants to make a difference for investors and the issuers who comprise this $2 trillion asset market, they should focus on how to streamline the loan resolution process and eliminate bottlenecks that costs GNMA servicers thousands of dollars on a foreclosure. And specific to GNMA concerns about maintaining market liquidity of MSRs, when the resolution costs are level with the GSEs, then GNMA mortgage servicing assets should trade at a premium to GSE assets instead of a discount as today. Now that would be something to celebrate for investors and issuers alike.
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