Mortgage industry executives are on alert amid the global stock-market meltdown caused by fears that the Federal Reserve may have kept the federal funds rate too high for too long, which could bring the U.S. economy into recession.
Tensions in the bond markets have provoked a decline in mortgage rates, which is good news for originators since they could have more demand for loans. Operationally, leaders must decide when to add capacity — if they haven’t already — and how to manage the incoming volume. They will also monitor early payoffs (EPOs), the fees that investors impose whenever a borrower pays off their mortgage, usually within six months of funding.
When considering the servicing business, a sharp decline in rates reduces the fair value of mortgage servicing rights (MSRs), which can impact lender earnings if they haven’t protected their portfolio against these moves. If the answer is no, there is one caveat: The cost of hedging can go up in times of volatility.
The market turmoil started when the jobs report released on Friday showed the unemployment rate at 4.3% in July, up from 4.1% in the previous month, while total nonfarm payroll jobs rose by 114,000, below analysts’ expectations.
Investors started a sell-off that resulted in the two-year Treasury yield shrinking from 4.12% on Friday to 3.87% at its lowest point on Monday, higher than the low level of 3.66% for the 10-year Treasury. When the curve is inverted, with higher short-term yields, it’s a signal of recession. On Tuesday, bond yields partially recovered, with the two-year at 3.93% and the 10-year at 3.83%.
Melissa Cohn, regional vice president for William Raveis Mortgage, said the market reacted to weaker-than-expected economic reports that show the U.S. is likely headed into a recession. This means that Fed officials should have cut rates at their July meeting. Geopolitical realities, like tensions in the Middle East, only add to the volatility.
“If you look at the jobs report, and that trend goes on for another month or two, the answer is yes: the economy will go into recession,” Cohn said. “Will the Fed come and do an emergency rate cut? I don’t know. I think we get a few more days of extreme volatility. We’re going to be very much in a rollercoaster. But we haven’t fallen off the cliff yet.”
In the mortgage market, this was reflected by mortgage rates dropping to the “high 5s” on Friday for borrowers with strong credit and rebounding to the “low 6s” on Monday, according to Cohn. She added that conforming loans “have taken a much bigger drop than in the jumbo space, where some banks have reduced rates cautiously.” Meanwhile, rates are “slower to come down” in the nonqualified mortgage business.
Getting ready for lower rates
William Chang, senior managing director and chief investment officer at Pennymac, said that Monday morning saw a “violent move both in the equity and bond markets at the open when there was a flight to safety trade, with investors loading up on Treasurys.”
“Mortgages were underperforming throughout early Monday morning, but the markets seem to have leveled out a little bit in the afternoon,“ mainly because data shows that the services sector expanded in July, Chang added.
“If you do have a continued move down in the Treasury yield, you are going to see originators bring some capacity back on,“ he said. “It just depends on how quickly that move happens. If you have a big move and rates go down, the refinance bubble market will grow all of a sudden, but if you have a stairstep move in the rates, it’ll be more gradual. People will be able to adjust their capacity accordingly.”
Chang said that a big move in the market to bring in more refinance business will “set up for potentially better margins” since some companies will be short on capacity. That’s when originators would grant their borrowers longer lock-in periods. Some lenders will wait to add capacity, but others may feel compelled to hire LOs.
According to industry executives, early payoffs are a side effect of a refinance wave, which has yet to been noticed in the market due to the recent drop in mortgage rates. Another effect of lower rates is the impact on servicing portfolios, with a reduction in the fair value of MSRs. Lenders protect their balance sheets by hedging their books.
“We want to help preserve our book value and minimize earnings volatility. But we also borrow against our MSRs, so if we’re subjected to a margin call, for example, we do want to have hedged gains that we can utilize to help offset the fair value decline and help us meet those margin calls if necessary,” Chang said.
Pennymac will look at “basically 125 basis points higher and 125 points lower” when planning its hedging position, Chang said. He added that the company “went into this current period of market volatility having optional coverage,“ but if “we were to buy more options now, it would be very expensive.”
At United Wholesale Mortgage, volumes increased over the past few days due to a reduction in rates, which the company expects to continue through the end of the year, according to chief strategy officer Alex Elezaj.
“People are locking in loans over the past couple of days in the high 5s because there are millions of consumers out there who have mortgages at high 6s, 7s or 8s,” Elezaj said. “Historically, what you see as rates go down, margins generally expand — but I think it’s hard to tell, especially because it’s only been a couple of days. The dust needs to settle before people get excited one way or another.”
Elezaj said UWM invested in technology, hired people and improved its processes so brokers could close loans within 14 days and remove the need to extend lock-in periods to borrowers. And when the refi wave hits, he said EPOs are a “good problem,” meaning “that’s part of doing business.”
UWM has taken a different approach from other competitors, selling MSRs to focus on the origination business. According to Elezaj, loan production works like a “natural hedge” to the servicing portfolio.
