It’s obvious that whoever pens the record books for financial stats is going to have a hand cramp after the past couple of weeks. The equity and commodities markets selling off extraordinary amounts, as well as the unprecedented moves in equities and bonds have us reeling from daily headlines screaming, “records broken again.”
Since February 19th, the yield on the 10-year treasury has dropped roughly .80% to an all-time low of ~.33, while 30-year mortgage rates are down almost .625%. Lender pipelines have grown by more than 50%, coupon spreads are lower than they’ve ever been, and as of this writing, there are no signs of rates backing up significantly anytime soon. This recent transformation of the interest rate market has sent the mortgage industry into another boom cycle. A housing market that looked like it was finally losing steam now has a new lease on life, and most notably, refinance applications are flooding through the door. Times are good, and everyone is busy! Thus, now is an excellent time to focus on adjusting to this new paradigm and to prepare for what’s to come.
No one knows where the market will go from here, but there are some predictions that are almost certainly going to come true, and some concepts on which we should be hyper focused. Below are some items to emphasize with the appropriate parties within your organization to ensure that anyone who needs to understand them, does. And furthermore, there are some areas where we can act quickly to ensure success and potentially increase revenue.Profit Margins Widen in a Rally
As with any product, when there is a heavy supply and sellers are motivated, buyers can pay less for that product. Borrowers (sellers) are desperate to close loans at extremely low interest rates, lenders (buyers and sellers) will very soon be looking to sell loans quickly so they can produce more loans, and investors (mostly buyers) stand ready to buy loans. Add to this operational and capital capacity concerns, and there is a case to be made that lenders and investors should widen, and in most cases already have widened, margins. All of this to say, investor pricing has softened and will probably soften a bit more before it firms up, and lenders should follow suit by widening margins.
Borrowers Watch the News
Renegotiations are a fact of life in the mortgage industry, especially when the market rallies sharply in a short period. Renegotiation policies and tendencies vary by lender, but in general, a lender should be prepared to renegotiate when a borrower initiates a request to do so. Renegotiating a rate obviously eats into loan-level profitability, but making a concession is often better than a loan not closing at all.
Also, early payoffs (EPO) are primed to spike in this market, so save some cash for the likelihood that many loans originated in the past 6 months will refi, triggering claims coming in from your investors.
Cash Flows Will be Far More Mismatched than Usual
For lenders that are hedging with TBAs, it is understood that as rates fall loans are sold for higher gains than expected, while TBA trades lose value, causing more cash to be wired to broker dealers a few times per month. The opposite is also true (i.e. as rates fall, loans sell for less and dealer wires are incoming). It is understood that these two transactions (trade settlement and loan purchases) often happen in two separate months (e.g. loans sell in March, but corresponding TBAs settle in April). In less volatile markets, this becomes a non-issue, but in volatile markets it’s important to remind those who need to know that this effect will be exacerbated to the extent of the market event.
So, in our case (as of March 6, 2020), locked loan pipeline values are up big, but obviously TBA positions are down. This glut of new production will make its way through the origination process over the next 20-50 days and in most cases, the trades that were used to hedge them will be assigned or closed out during that same period. The loans will be sold in March and April to investors for gains well above set profit margins, but trades will settle mostly in April and May with massive settlement amounts being paid to dealers. The key here is to plan ahead! Assume much of the extra gains you will see in GOS will need to be paid to dealers in a later month. Also, assign trades (AOT) to investors wherever possible. This will help smooth out some of these cash flow imbalances.
Broker/Dealer and Lender Capital Capacity is Being Stretched
Related to the dynamic in the previous section, as the market continues to rally, TBA trades are losing value. Broker/dealers often cover some or all these positions for lenders until trades settle and/or margin is called from the lender. For lenders and dealers alike, as volume continues to rise, more capital capacity is needed. Right now, dealers are covering a historically high dollar figure across all clients and lenders are making huge margin deposits to buffer MTM exposure. Some dealers have even stopped accepting new trades until some relief comes in the form of a bond market sell-off or when they receive settlement cash from clients. In any case, now is a great time to assess your current dealer coverage and limits with your hedge provider.
A Sell-off Could Happen at Any Time
As quickly as this rally ramped up, it could easily recede. Lenders should ensure they are not taking a risk position (i.e. don’t go uncovered) and should beware liquidity risk. Positions should remain neutral, as always, and lenders are wise to keep an eye on any production that falls into the lowest note rates available (e.g. 2.50% 30-year) and/or coupons that are not quite liquid. In a quick sell-off, some note rates may become illiquid, and some TBA securities may be difficult to close. Locking loans that fit this description via best-efforts is a prudent strategy to mitigate any liquidity risk, and cross-hedging may be necessary in some cases.
So, What Should I be Doing?
Manage capacity by widening margins, frequently review broker/dealer capacity, renegotiate when needed, assign trades to investors, look at cash flow on a long-term basis, hedge only liquid loans with liquid securities, and hang on!
As a proactive Hedge Analytics provider, the Optimal Blue team is already discussing all of this with clients! If you have additional questions related to this article, please do not hesitate to contact Optimal Blue.