The Coronavirus Meltdown

The current Coronavirus crisis is having a critical impact on the Mortgage Industry, which could potentially make the 2008 financial crisis pale in comparison. The pressing issue centers around capital that’s required by Mortgage Lenders to be able to function and meet covenants that are required for them to continue to lend.

Here’s How The Mortgage Market Works

Let’s begin with the mortgage process. A borrower goes to a Mortgage Originator to obtain a mortgage. Once closed, the loan is handled by a Servicer, which many or may not be the same company that originated the loan. The borrower submits payments to the Servicer, however, the Servicer does not own the loan, they are simply maintaining the loan. This means collecting payments and forwarding them to the investor, paying taxes and insurance, answering questions, etc. While they maintain or “service” the loan, the asset itself is sold to an aggregator or directly to a government agency like Fannie Mae (FNMA), Freddie Mac (FHLMC), or Ginnie Mae (GNMA). The loan then gets placed inside a large bundle, which is put in the hands of an Investment Banker. That Investment Banker converts those loans into a Mortgage Backed Security (MBS) that can be sold to the public. This shows up in different investments like Mutual Funds, Insurance Plans, and Retirement Accounts.

The Servicer’s role is very critical. In order to obtain the right to service loans, the Servicer will typically pay 1% of the loan amount up front. The Servicer then receives a monthly payment or “strip” equal to about 30 basis points (bp) per year. Because they paid about 1% to obtain the servicing rights and receive roughly 30bp in annual income, the breakeven period is approximately 3 years. The longer that loan remains on the books, the more money that Servicer makes. In many cases, the Servicer might want to use leverage to increase their level of income. Therefore, they may often finance half of the cost of acquiring the loan and pay the rest in cash.

Servicer Dilemma

As you can imagine, when interest rates drop dramatically, there is an increased incentive for many people to refinance their loans more rapidly. This causes the loans that a Servicer had on their books to pay off sooner…often before that 3-year breakeven period. This servicing runoff creates losses for that Mortgage Lender who is servicing the loan. The more loans in a Mortgage Lender’s portfolio, the greater the loss. Servicing runoff, or even the anticipation of it, can adversely impact the market valuation of a servicing portfolio. But at the same time, Lenders typically experience an increase in new loan activity because of the decline in interest rates. This gives them additional income to help overcome the losses in their servicing portfolio.

But the Coronavirus has caused a virtual shutdown of the US economy, which has created an unprecedented amount of job losses. This adds a new risk to the servicer because borrowers may have difficulty paying their mortgage in a timely manner. And although the Servicer does not own the asset, they have the responsibility to make the payment to the investor, even if they have not yet received it from the borrower. Under normal circumstances, the Servicer has plenty of cushion to account for this. But an extreme level of delinquency puts the Servicer in an unmanageable position.

“I’m From The Government And I’m Here To Help”

In the Government’s effort to help those who have lost their jobs because of the Coronavirus shutdown, they have granted forbearance of mortgage payments for affected individuals. This presents an enormous obstacle for Servicers who are obligated to forward the mortgage payment to the investor, even though they have not yet received it. Fortunately, there is a new facility set up to help Mortgage Servicers bridge the gap to the investor. However, it is unclear as to how long it will take for Servicers to access this facility.

But what has not been yet contemplated is the fact that a borrower who does not make their very first mortgage payment causes that loan to be ineligible to be sold to an investor. This means that the Servicer must hold onto the asset itself, which ties up their available credit. And with so many new loans being originated of late, the amount of transactions that will not qualify for sale is significant. This restricts the Lender’s ability to clear their pipeline and get reimbursed with cash so they can now fund new transactions.

Mark To Market

This week – Due to accelerated prepayments and the uncertainty of repayment, the value of servicing was slashed in half from 1% to 0.5%. This drastic decrease in value prompted margin calls for the many Servicers who financed their acquisition of servicing. Additionally, the decreased value of a Lender’s servicing portfolio reduces the Lender’s overall net worth. Since the amount a lender can lend is based on a multiple of their net worth, the decrease in value of their servicing portfolio asset, along with the cash paid for margin calls, reduces their capacity to lend.

Unintended Consequences

The Fed’s desire to bring mortgage rates down isn’t just damaging servicing portfolios because of prepayments, it’s also wreaking chaos in Lenders’ ability to hedge their risk. Let’s look at what happens when a borrower locks in their mortgage rate with a Mortgage Lender. Mortgage rates are based on the trading of Mortgage Backed Securities (MBS). As Mortgage Backed Securities rise in price, interest rates improve and move lower. A locked rate on a mortgage is nothing more than a Lender promising to hold an interest rate, for a period of time, or until the transaction closes. The Lender is at risk for any MBS price changes in the marketplace between the time they agreed to grant the lock and the time that the loan closes.