Volatility is the enemy

Mortgage banks are, by definition, entirely bound to interest rates and the difference or “spread” between Treasury bonds and mortgage loan coupons. Note, however, that markets set bond yields, but lenders set loan coupons. So when the volatility of interest rates and spreads explodes, as it has done since the onset of COVID, pricing all types of loans becomes a crapshoot or worse. 

Federal Reserve Bank of Atlanta President Rafael Bostic stated the obvious about interest rates and volatility: “I would like to reach a point where policy is moderately restrictive — between 4 and 4 1/2 percent by the end of this year — and then hold at that level and see how the economy and prices react,” he said in prepared remarks on October 5.

Well, markets are already reacting and the results are not entirely good. As Treasury yields have risen, market volatility has also gone up dramatically. Some smaller issuers have abandoned interest rate hedging entirely because of volatility in the to-be-announced or “TBA” market. Issuers have gone back decades to “best efforts” underwriting for correspondents, meaning no more correspondent channel. 

TBAs, as they are known, represent the foundation of the secondary mortgage market and also the market for hedging other interest rate exposures from Treasuries to non-QM mortgages. But when the bond market is moving intraday by double digits in terms of yield, up and down, how exactly does one generate premium in loan sales? No surprise, non-QM issuers have seen bank lines disappear along with the takeout bid from investors.

Volatility in the interest rate markets is one of the downsides of the Fed’s radical monetary policy known as quantitative easing or QE. The cost of hedging low-coupon MBS created during 2020-2021, for example, is now a multiple of the cost of hedging 6 percent MBS, currently the on-the-run conventional contract for delivery in November. Dare we suggest a 7.5% loan coupon as a breakeven rate? Recent volatility suggests that could change, up or down, in a matter of hours or days.

How do you hedge a mortgage loan pipeline given such market volatility? The answer is that you don’t. Some of the best and oldest operators in the industry eschew hedging for just this reason. Mortgage servicing rights held in portfolio provide an ample and natural negative duration hedge for the lending book, so why do we hedge? Earnings volatility. Smart issuers don’t spend money on hedging and focus instead on lending and acquiring MSRs. 

Another new expense related to volatility for independent mortgage banks is mark-to-market calls from lender banks on whole loans, a recent development that is again a function of the market volatility caused by QE and its aftermath. Dealers are also collecting FINRA margins on TBAs between trade date and settlement. 

In the wake of QE, volatility in loan prices has exploded. Billions in low coupon delinquent government loans bought out of pools (a.k.a. EBOs) are now trading in the low 80s, choking both investors and lenders alike. Many of these EBOs were purchased above par, say 103, when the TBA was a 2% MBS trading at 106. But no more.  

The sharp markdown of EBOs illustrates the problematic aspect of market volatility and how it impacts the value of the assets of mortgage banks in times of illiquidity.  Yet note that it is the loan asset and not the MSR that are the true source of market risk for government issuers in the post-QE world.

Several lenders tell NMN that upward movement in benchmark interest rates during Q3 further increased the value of MSRs but pushed EBO valuations lower. In addition to market risk, however, issuers now face a new source of regulatory risk with the proposed issuer rules from Ginnie Mae. 

Specifically, industry executives think there could be more than 15 significant Ginnie issuers out of compliance with the new “risk based capital rules” due to the movement of the Treasury market in Q3, including some of the largest owners of Ginnie Mae MSRs. This is what is known as “regulatory volatility.” 

The Ginnie Mae issuer eligibility rule is a piece of progressive social engineering that has no real legal basis. Ginnie is not a prudential regulator and there is no grant of authority from Congress to HUD to make wholesale changes in market structure. Yet the proposed rule abruptly forces mortgage banks to operate at lower leverage than the commercial banks and investors support today in the private credit market. 

When the proposed RBC rule from Ginnie Mae is adopted, no matter how long issuers are given to “implement” the rule, the mortgage and banking industries could be forced to write-off $20-30 billion in MSRs. Effective leverage on the Ginnie Mae MSR could drop by one third from the 70% maximum for government assets today for most large bank lenders, to below 50% under the new Ginnie Mae rule.  Lower leverage on the Ginnie Mae MSR means that yields must rise and prices must fall, thus the prospective catastrophic markdown of MSRs. 

Perhaps more significant is how the Ginnie Mae risk-based rule will destroy the ecosystem in the secondary market for government loans. We hear in the servicing channel that implementation of the Ginnie RBC rule will effectively force larger nonbank firms to exit correspondent lending entirely and also cease providing liquidity to small lenders.

The very small banks and mortgage companies focused on the mission of the VA or the FHA serving low-income communities will be orphaned under the Ginnie rule and left with few outlets to finance and sell loans. This will reduce the availability and increase the cost of credit for low income borrowers, veterans and rural communities that depend upon smaller banks and nonbank lenders.

In the brave new world at Ginnie Mae, where MSRs are considered a liability and not a crucial capital asset and negative duration hedge, the secondary market for government loans becomes a barren wasteland. Liquidity now provided by commercial banks, via secured loans to nonbanks, will ebb and fail, forcing agencies such as the Veterans Administration, U.S. Department of Agriculture and FHA alike to pare back loan programs. Without liquidity, the Ginnie Mae MSR is worthless.

Ginnie Mae says it does not want to disturb the markets with the RBC rule, but the damage already has been done. The Fed may be the big factor in the massive waves of volatility seen daily in the TBA markets, but traders and credit analysts now also fear a new problem in the heretofore peaceful world of Ginnie Mae. As we’ve noted in The Institutional Risk Analyst, the Ginnie Mae rule on top of the current bond market volatility could cause serious problems in the government loan market in the months ahead.