Volatility, especially for those not utilizing mortgage pipeline hedging, can erode profit margin rapidly. Since the Fed announced a 75 bps rate hike last week, we have seen increased volatility amid markets attempting to come to grips with how to weigh inflation concerns versus recession concerns. As these stagflation worries rage, we saw a large decline in the MBS market leading up to the FOMC meeting and a massive rally in the market this week.
Last month’s increase in the inflation rate to 8.6% (squashing any talk of peak inflation being in the rearview mirror) and Fed’s pivot from an expected 50 bps rate hike to an actual 75 bps rate hike at its June meeting has also increased market expectations for the size of upcoming rate hikes by the FOMC. To simplify things, higher interest rates increase the costs of things like mortgage loans and company borrowing, which slows business growth and translates into less hiring. As the job market weakens, paycheck growth slows and further tamps down spending activity.
Fed policy is meant to influence the demand side of the equation. When fewer people shop for houses because home loans are expensive and the economy feels less secure, a smaller supply might be enough to satiate demand without causing prices to keep rising. But make no mistake: crushing demand is at best unpleasant and often agonizing. To provide some historical context, the Fed pushed interest rates to double-digit levels in the early 1980s to bring down rapid inflation, but that caused back-to-back recessions that pushed the unemployment rate to nearly 11 percent. The economy is humming along right now with the unemployment rate at the low level of 3.6 percent, but that rate is expected to rise as the Fed continues to tighten policy.
Fed Chair Powell headed to Capitol Hill this week for his semiannual Congressional testimony. He reiterated the Fed’s commitment to reducing inflation and candidly admitted a recession is a possibility. The pace of rate changes will continue to depend on the incoming data and evolving outlook for the economy. That uncertainty is anathema to those tasked with managing margins.
Risk is inherent for anybody involved in the loan sale process, but there are sound ways to mitigate risk in volatile and deteriorating markets. We are seeing higher coupons being originated than what the Fed is purchasing as we have moved toward the 5 and 5.5 as the new market coupons. Newly traded coupons are experiencing abnormally wide bid-offer spreads, especially for GNMA securities. In times like these, stay on top of production and roll out of non-production traded coupons to reduce basis risk exposure.
When it comes to pricing and locking, either discontinue granting or avoid free extensions if you have not already. Limit or discontinue locks outside of market hours, including overnight and weekends. We have seen some clients add in temporary margin to offset the risk of market volatility, and this can typically be programmed in your PPE without having to affect core company margins.
When it comes to originations, non-vanilla product talk was all the rage at the recent Mortgage Bankers Association Secondary Marketing Conference in May. Lenders are looking for secondary market outlets and premium pricing for ARMs, home equity products, non-QM, second homes, and investment properties, and other non-conforming products. Lenders are also looking for extended locks, lock and shop programs, rate buydown products, and construction financing options.
While the next year or two for the mortgage industry are certain to be less enjoyable than the past year or two, market cycles are an expected and manageable part of doing business. Having a scalable and efficient operation is the name of the game. And for secondary marketing heads, being appropriately covered to minimize interest rate exposure is paramount. Keep communication with your trading team a top priority and reach out to your MCT trader with and questions or concerns you may have.
