“Our indicators tell us, we’re very close to a Lehman-like drawdown,” argues Larry McDonald, a former strategist at Société Générale who now runs The Bear Traps report.
Financial Times, February 20, 2020
Destructive Unintended Consequences
The Federal Reserve’s response to the Coronavirus crisis is having a significant impact on the mortgage industry. Some industry players believe capital losses within the sector could be on par with the 2008 financial crisis. The epicenter of risk is focused on capital requirements (mortgage lenders need to function) and covenants allowing them to do business. Lets us take a look…
One Loud Backfire
From March 2nd to March 19th, the brain-trusts at the Federal Reserve took the Fed Funds target rate from 1.75% to 0.25%. During the financial crisis, they made a similar move but it was over a 3-month period, NOT 17 days. The unintended consequences of Fed policy are more than significant, the yield on the 30-year mortgage soared. Unintended Consequences: housing, over 20% of US GDP is at risk as MOST of the entire US mortgage ecosystem is currently dysfunctional.
Three Year Break-Even
Mortgage servicers typically pay 1% of the mortgage loan amount for the privilege of typically earning 0.30% of the loan amount and the responsibility for forwarding the mortgage payments to the loan originator or secondary investor, taking care of insurance, taxes, and records. Thus the break-even for the servicer is a little more than three years.
Black Swan Drawdowns
Countless ETFs in the mortgage sector have crushed investors, large and small alike. Since non-bank financial companies now service most mortgages but don’t have access to the funding window at the Fed like banks do, aren’t these companies in for a massive liquidity shock once people start defaulting on mortgages?
With the recent overnight collapse in interest rates, these mortgage loans will pre-pay rapidly. Thus the loans the servicers paid for vanish and the servicers see a loss from a wipe-out of their performing loan portfolio. Normally changes in interest rates are gradual enough such that pre-pays are gradually replaced with new mortgages. Not this time! On the other hand, unemployed mortgagers will default. When that happens, servicers still have to pay the interest to the secondary owner of the mortgage. And most servicers are levered to boot. In sum, the good loans go away, and the bad loans that remain leave no way to pay interest to secondary owners or their lenders. Most banks don’t own the mortgages. They package them up and sell them to ETFs that are bought by retired people. They sell them to pensions and insurance cos. Banks get paid to originate, not to carry them. A holiday would have minimal if any impact on Wall St., but CRUSH servicers.
“The Federal Reserve and its master (Too Big To Fail
Banks) are trying to thin [knock-out] the nonbank servicer
herd through margin calls. As usual Fed economists are too
theoretical to understand markets. Killing one, in crisis
leads to broad failures.”
Josh Rosner, New York Times Bestselling Author – Reckless Endangerment
In recent weeks, there is a meaningful amount of well-intentioned discussion about the suspension of payments (mortgage, car, student loans, etc); keep in mind contract rule of law, protection of private property (creditors) is constitutionally protected – a large reason investors flock to the USA.
Furthermore, the government has granted forbearance of mortgage payments. It is not clear that this is constitutional. Back in the depression, the Frazier-Lemke Act forbade banks from foreclosing on farms. The Supreme Court ruled that law unconstitutional. The good news is that a Mortgage Services Facility has been created to bridge mortgage servicers through this difficult period. The bad news is that it’s too little, too late.
Many mortgages were already in pre-payment and replacement just as the homeowners became unemployed. The new facility doesn’t contemplate that challenge. Defaults are not deemed collateral and the servicers are left holding the bag. Additionally, service fees have dropped from 1% to half that. While this means new portfolios may be bought less expensively, the servicers themselves are less creditworthy thus increasing their cost of capital. This loan conduit for the mortgage industry is a shadow of its former self.
Finally, lenders and servicers alike have hedged their portfolio risk against default by shorting mortgage-backed securities or their derivatives. But the Fed is buying MBS in its new QE program! Thus their portfolios have deteriorated while their hedges have run-up in their faces. The situation is so bad we believe the Fed* is about to reduce the pace of its former announce MBS buying program. The net result of the above is that the Fed’s actions restrain lending, the exact opposite of what the Fed intended. Whether or not the road to hell is paved with good intentions is a matter for debate. But the road to hell is certainly paved with the corpses of mortgage servicers.
“The Fed bought $21B today and reduced the plan for the week from $40 to $30B, no more short settlement either. There should be a liquidity facility for the originators especially since the regulators caused this problem. They can’t allow the basis to blow back out though.”
“NY Fed task force to help servicers being formed and trying to figure out how to support servicers who will have to province timely interest and principal payments to investors from those who cannot pay their mortgages (forbearance).”
“The ramp-up in MBS TBA prices has led to unprecedented levels of margin calls on mortgage originators who use the TBA market to hedge their loan production and eliminate any interest rate risk. The situation became acute Monday leasing the Fed to announce a reduction in their daily MBS purchase: the pace of its MBS buying program. Housing, over 20% of US GDP is at risk as MOST of the entire US mortgage ecosystem is currently dysfunctional. TBA prices did end the day lower than Friday’s close after being up 1/2 point in the late morning. Independent mbs issuers are over 500 firms, the entire industry with 2 more days of ramped up MBS would have been insolvent. “