It’s an early close today and the bond market is closed on Memorial Day, which allows us a chance to take stock of where the mortgage secondary market is headed into summer. We saw a decline in mortgage rates this week from recent highs, which was to be expected once the Fed gave more clarity on its policy plans and Treasuries settled down. Shrinking MBS spreads have helped to push down borrowing rates, though the economy has been posting poor housing figures that give pause to how strong lending volume will really be over the next several months and underscore concerns about the overall strength of the economy. Let’s talk about rates, then the housing market, the Fed’s impact on things, and finish with some recommendations.
Bond markets are moving toward pre-pandemic normality, with benchmark inflation-adjusted Treasury yields climbing above zero. The 10-year U.S. Treasury yield has hit 3%, a point at which equities and fixed income stop moving in unison. Stocks have dropped and bonds have held firm, a common occurrence when anxious investors are cashing in risky assets and seeking havens in a weakening economy. The price pattern also suggests growth is replacing inflation as the biggest fear. Because bond prices are inversely related to their yields, the buying of bonds and subsequent pushing up of their price leads to lower longer-term rates. It’s the bond market’s job to send warnings on inflation, but the function was smothered by all the bond buying done by the Fed this past decade.
MBA has been forecasting that mortgage rates are likely to plateau near current levels, and Freddie Mac’s latest rate survey showed U.S. mortgage rates recently posted their biggest weekly drop in more than two years. Fixed mortgage rates declining offers homebuyers a slight reprieve from this year’s massive surge in borrowing costs. The rise in rates over the last four months has seen the cash out refinance market evaporate and lenders having a hard time originating high LLPA products. Even with the recent decline in rates, we are still around 2% above the level at the end of last year. ARM products are becoming more popular amongst borrowers, but ARM rates are at the highest level in 12 years. Refinance demand is not expected to increase any time soon.
There has certainly been a transition up the coupon stack as markets have attempted to price in the impact of Fed actions over this cycle. The New York Fed Desk’s latest Agency MBS purchase schedule, covering the May 27 to June 13 period, is the sixth consecutive schedule that will not see any new additions to the Fed’s balance sheet, and sees 4% added to 15-year operations. The total amount the Desk is targeting for each specific coupon has changed as the bank’s focus moves up the coupon stack and monthly reinvestment falls to an estimated $25 to $30 billion by mid-summer. Numerous Fed members have voiced support for sales of agency mortgage-backed securities, with the latest minutes revealing, “After balance sheet runoff is well under, it would be appropriate for the Committee to consider sales of agency MBS to enable suitable progress toward a longer-run SOMA portfolio composed primarily of Treasury securities. Any program of sales and agency MBS would be announced well in advance.” Clarity on the desired composition of the Fed’s balance sheet is a good thing, and once we are past this rate spike and associated volatility, MBA expects that potential homebuyers may be more willing to re-enter the market.
That would be welcomed across the mortgage industry, with low inventory now mixed with 20% annual gains in home prices and the highest mortgage rates since 2009 expanding costs. Previous reports on existing home sales, mortgage applications, and homebuilder confidence have all turned lower, but U.S. new home sales falling 16.6 percent during April to a seasonally-adjusted annual rate of 591k, well below consensus estimates and a level typically seen in the 1970s and 1980s, is the sharpest indicator yet of a dour housing market. Separately, pending home sales have posted six consecutive months of declines to register the slowest pace in nearly a decade. Home prices remain firm, however, with shortages of listings persisting across most U.S. metropolitan areas. The vast majority of homeowners are enjoying huge wealth gains and are not under financial stress with their home as a result of having locked into historically low interest rates, but that same trend has left homeownership out of reach for many younger people who are forced to widen their geographic search area to more affordable regions. Inflation and affordability pressures are pertinent but cooling demand for housing as mortgage rates rise is expected to slow price growth and the speed of home sales which may alleviate some pressure on home builders and result in fewer groundbreakings.
The Fed actually needs Americans to curb spending, even if it requires an economic slowdown to get there. The hope is that the combination of rising borrowing costs and its shrinking balance sheet will deliver a soft landing that avoids a recession while tamping down the hottest inflation since the early 1980s. It may not be possible to reduce job openings and slow wage growth to a pace consistent with the Fed’s 2% inflation goal without sharply raising unemployment beyond the current level of 4% and hurting economic growth. The main strategies to get inflation back down are to stop the quantitative easing strategy started at the beginning of the pandemic and hike rates. Markets have already priced in the Fed raising rates 50 bps over the next couple of meetings, but traders have “dialed back” expectations for rate hikes needed to get to a neutral rate after poor U.S. economic data recently. There is no quick fix to solving inflation, and the last time we had a combination of declining GDP and high inflation was during 2008- 2009. Mortgages performed well and exhibited less risk than corporate debt in that environment.
For those looking at opportunities to make more cash, mortgage servicing rights (MSR) valuations are at highs not seen in years. The relationship between MSRs and interest rates (e.g., rates go up, MSR valuation goes up as prepayment chances decline) moves inversely to how TBAs react to interest rate moves (e.g., rates go up, TBAs go down). This inverse relationship could enable hedging a portion of the mortgage pipeline with the mortgage pipeline’s servicing rights. With profit margins shrinking, hedgers have multiple things to consider, including what is happening in the market, interest rate sensitivity of specified/special products, impact of the servicing valuation, and portfolio cross hedges to succeed in today’s volatile markets. Factors such as prepayment risk and credit risk of the underlying borrower drive the majority of MSR valuation changes, and if you are not accounting for this, you could be incurring unnecessary hedge cost.
Some other recommendations from us? Pricing can be used for capital management as well as manipulating volumes and exposure, but should always be open to review. Consider moving from best efforts to mandatory, allowing you to pick up the time value of money by delivering your loan before the lock expires. A seven-day delivery difference used to be 3 bps. Now it’s four or five times that. On the investor side, pricing is being worsened on best efforts rate sheets as you go out in lock term versus the beginning of the year. And have you viewed our latest MCT Industry Webinar? Improve Profitability to Counter Market Headwinds. In this webinar, MCT’s Phil Rasori, Justin Grant, and Andrew Rhodes explain how MCT is helping clients Bring BPS Back and improve profitability to counter market headwinds. That’s all for this week. Join us next week when we discuss how to squeeze every basis point from your loan sale execution strategy.