The Coronavirus Mortgage Crisis
Mortgage lenders and their loan products are disappearing from the market at an alarming pace (seemingly faster than the Great Recession). There are many complex reasons behind why this is happening, which makes it vital that every buyer understands the basics and uses that knowledge to protect themselves during this crisis.
A Perfect Storm
What we are seeing behind the scenes in the mortgage markets today is truly a perfect storm. Interest rates have hit their all-time lows, and most lenders’ pipelines have reached their highest levels ever. Simultaneously, extreme interest rate volatility on a daily basis has resulted in margin calls and has left many mortgage lenders vulnerable and undercapitalized.
Some of the actions taken by the Federal Reserve – like its buying of mortgage-backed securities – have unintended consequences, that are accelerating the chaos and causing drastically more harm than good. Unfortunately, the situation is not getting any better anytime soon and is unlikely to improve until the Federal Reserve ceases its purchases of mortgage-backed securities.
How Does The Mortgage Market Work?
Most buyers are educated on how the mortgage process works on the front end, and they possess more than enough knowledge to work through it. Few, however, understand how the mortgage market works after the loan closes. We call this the secondary market, and it’s this market that is experiencing extreme chaos at the moment.
Let’s start from the beginning of the home-buying process. A buyer takes out a mortgage from a lender who has underwritten, approved, and funded the loan. The loan is then released into servicing, bundled with similar mortgage loans, and sold to mutual funds, insurance plans, and retirement accounts as a mortgage-backed securities.
Mortgage servicers typically do not own the loan; they simply manage it, make sure the monthly payments come in and the taxes and insurance are paid. Those monthly payments are ultimately passed on to whoever purchased the mortgage-backed security.
The function the mortgage servicer fulfills is crucial. Without them, liquidity in the mortgage and real estate industries dry up and cease to function properly. If people can’t access money, they normally don’t buy Real Estate.
On average, the mortgage servicer pays the lender about 1% of the loan amount to obtain the servicing rights for a loan. In return, the servicer earns roughly .3% of their investment per year. This results in a typical break-even period of three years; each year the loan stays with the servicer beyond that is profit.
However, with interest rates hitting all-time lows, the industry has seen massive waves of refinances. These refinances shorten the average lifespan of a loan below the three-year break-even point. The result of this rapid churning of loans is a drastically reduced value of the servicer’s loan portfolio.
As the servicer’s asset value decreases, so does its ability to obtain financing and lines of credit needed to purchase new loans. This ultimately will result in more margin calls and a massive liquidity crunch for the servicers.
It Gets Even Worse…
As loan servicers are experiencing a liquidity crunch due to all the refinance action, the coronavirus has created record unemployment numbers. This adds additional risk to the servicer because, even though they do not “own” the mortgage, the terms in the servicing agreement hold the servicer responsible to pay the investor who owns the mortgage-backed security, regardless of whether or not the servicer has received the mortgage payment.
Typically, the servicer has plenty of capital to make its payment to the investor who purchased the mortgage, and there are no issues. However, thanks to today’s rapid refinancing numbers, the devaluation of their servicing portfolio, and a rising number of borrowers who are requesting payment forbearance, mortgage servicers are finding themselves dangerously short on liquidity.
This liquidity crunch in servicing has begun to impact borrowers and forced lenders to re-evaluate what loans they should approve. Gone are the days where the only consideration is if the loan can get an Automated Underwriting approval – the mortgage industry now has to ask if the client getting the mortgage is likely to make the first payment.
Lenders are going to be evaluating if the borrower has sufficient liquid reserves after closing and whether or not the industry the borrower works in is likely to be cutting its workforce.
In summary, the liquidity crunch in the secondary market is beginning to have an impact on what loans will be approved or declined by mortgage lenders across the country.
Lenders Are Experiencing Liquidity Problems, As Well
Like I mentioned previously, the Federal Reserve was swift in its response to the coronavirus crisis by announcing virtually limitless amounts of stimulus. It has aggressively been buying Treasury bonds and mortgage-backed securities in an attempt to reduce long-term interest rates. On the surface, this is a good move, since lower interest rates should help stimulate the economy by increasing demand for housing.
However, there are significant and unintended consequences of the Federal Reserve’s massive buying of mortgage-backed securities. These consequences are now causing liquidity problems for lenders and ultimately making it harder for borrowers to obtain financing.
When a mortgage company locks a borrower’s interest rate, it is promising to reserve a block of money at that rate for a specified number of days. For example, let’s say you locked in at a 3.5% interest rate for forty-five days, but between the lock date and closing date the market interest rate moved to 4.0%. Under this scenario, the lender would need to buy down the interest rate because the market moved before the loan was able to close and be sold.
To protect themselves from scenarios like this, lenders hedge their locked loan pipeline. This hedge provides the lender protection against the interest rate market moving higher before the loan can close. Essentially, if a buyer has locked their loan and the market interest rate moves higher, the lender still has to buy the interest rate down, but they make up the difference by profiting from their hedge position. In a normal market, this is a low-risk strategy that allows lenders to lock loans without taking on excessive rate-movement risk.
Due to the Federal Reserve’s intense investment in the mortgage-backed security market, interest rates are at an all-time low. Normally, as rates moved lower, the lender’s potential profit would increase on the locked loans but would cause their hedge positions to incur significant losses. However, in the end, everything would balance out because the two positions offset one another.
Unfortunately, the financial institutions (called broker dealers) that provide the hedge position for lenders have very little patience; and when the lender’s hedge positions show losses, they enforce margin calls.
Lenders have seen intense margin calls resulting from upside-down hedge positions on their locked pipelines. With some of the larger lenders, we are talking about numbers approaching hundreds of millions of dollars.
Many lenders will not be able to fund these margin calls, some have stopped taking or honoring rate-lock agreements with their clients, and some lenders will disappear forever.
Should You Buy During the Coronavirus Crisis?
The short answer, as crazy as it seems, is YES. Overall, prices for residential Real Estate are not expected to drop much, if at all. But what will definitely go up, is interest rates. Most buyers are primarily concerned with what their monthly payment is. Buyers who are on the fence about purchasing, thinking that it is best to wait for the market to go down, will have a rude surprise if interest rates jump and loan qualifications are more difficult to obtain. This will erode buyers purchasing power and make it so that they will get far less house for the same payment amount. There is a lot of data indicating that prices will not fall drastically, during this crisis, as opposed to the last recession, where homeowners watched their equity plummet. Even if values do pull back some, the loss in value will be utterly insignificant, as opposed to the challenge of tighter lending conditions, limited loan programs and a steadily climbing interest rates.
The mortgage and financial markets are under massive stress due to the coronavirus and the ensuing liquidity crunch in many areas of the economy. The result of this is going to be tighter underwriting guidelines in the mortgage market. There will be some buyers who may have qualified for financing just days or weeks ago, but are no longer eligible today.
Buyers with low credit scores, high debt-to-income ratios, minimal reserves, and unique circumstances are going to be the hardest hit by this new reality. If you are not picture-perfect for their financing, it is going to be increasingly difficult to obtain underwriting approval.
You should also be aware of potential underwriting delays and extended closing timelines. We are seeing some banks posting forty-five to ninety-day turn times for underwriting due to all the refinance volume moving through the markets.
Underwriting guidelines and loan programs are changing on a daily basis, and an increasingly chaotic loan process is likely to continue until we see unemployment numbers dropping and people going back to work.
We are confident that we will get through this crisis, as a nation, one day at a time, one problem at a time. If you have any questions about the market in general, how you will personally be affected if buying, or selling in this market climate, feel free to contact me directly at 801-554-3743, or at Marc.Huntington@UtahHomes.com
Marc Huntington is an award-winning top producing Real Estate professional. He has nearly 20 years of experience in the Real Estate profession. He has owned and operated a residential appraisal business, as well as having over 10 years as a practicing Realtor, where he has consistently ranked in the top 5% of all Utah agents in terms of sales. Marc has also spent time as a Real Estate coach, mentoring and assisting agents from all across North America, with their Real Estate businesses, to improve customer service systems and increase sales and profitability. Marc is dedicated to serving his local community and putting his client’s needs and interests as his primary concern.