What the End of Easy Money Means for Originators and Servicers
It’s coming. We don’t know when, but sooner or later, it will happen. The taps will be closed, the well will run dry – the Fed’s current policy of easy money will come to an end. Regardless of when – or even how – the taper occurs, the outcome will be higher interest rates for capital market participants and the effects on the mortgage business will be far reaching.
Let’s start by looking at the impacts to origination activity. Real estate prices have enjoyed a bit of a renaissance lately, with many markets taking large bounces off of recent lows. These higher home prices coupled with the rise in interest rates will negatively impact first-time homebuyers’ ability to purchase. Additionally, the volume of refinancings will sharply drop, as they are a purely rate-driven activity. We’ve already seen anticipatory moves in benchmark interest rates (rising from 1.62% to 2.55% on the 10-year Treasury since May) which has driven the expected drop refinancing activity and substantial layoffs in the mortgage industry (mortgage originations have fallen 14.6% by volume from March to July of this year, per data from Lender Processing Services); we’ll have to wait to see just how much greater the impact will be when Fed tapering actually begins.
We’re likely to see a few residual trends emerge as a result of these changes. First, the drop in volume would see a quick decline in headcount at mortgage brokers and originators, a reduction that would take a long time to recover when business finally improves. To stem the origination decline, the marketing of ARMs might need to resume in earnest, although credit departments would be concerned about originating these loans as defaults on other floating rate debt increased. Third, we’ve seen correspondent lenders (who derive a significant portion of their revenues from originations) acquiring small banks with physical branches in an attempt to diversify away from refinancings and to capture a larger piece of the origination pie (such as loandepot.com merging with imortgage.com). This sort of anticipatory move could soften the blow of any eventual rate hikes on refinancing activity.
Mortgage servicing is a slightly different animal from origination, with the impacts of rising rates a lot less cut and dry. Servicing has gone from cash cow to anchor due to political scrutiny and legal liability stemming from negligence and fraud. Even with fee income for servicers rising with defaults, eventually the decline in outstanding loans and rising cost of capital will catch up, forcing a reduced workforce headcount. Interestingly, all of these negatives are counterbalanced – and possibly even outweighed – by the increase in the value of the servicing rights held. Servicing is like an annuity – the longer a given mortgage is on the books of a servicer, the longer the servicer collects fees for servicing the loan, and accordingly the value goes up – servicing rights are one of the few financial assets that would seriously benefit from higher interest rates. The value of these servicing rights has historically increased faster than defaults rise, which provides a nice cushion in times of economic weakness. Also, with housing prices rising recently and the overall improvement in the US economy, we’re likely to see a lower rate of defaults than during the financial crisis, which would further bolster the value of these servicing rights.
The balance sheets of mortgage market players would take multiple hits as well. As interest rates increase, the market value of the mortgages held on balance sheets would decline. Overall assets would decline from a combination of the decline in originations and defaults on floating rate debt, and mortgage portfolios would need to be rebalanced for the now-longer duration mortgages on the books. Capitalization ratios would be pinched in a number of ways as well: increased default risk increases Risk-Weighted Assets, and common equity would decline due to write-offs from defaults on mortgage assets, the decline in origination and servicing fee income, and unrealized losses on securities held for sale (marks to market on mortgage securities held on-balance sheet, such as conduit loans awaiting securitization).
It’s clear that the Fed’s tapering will reverberate through the halls of mortgage institutions throughout the US. Many of the leading lenders are already reducing expenses and developing new strategies to cope when the Fed begins in earnest to reduce economic stimulus. But what other impacts might there be? Are there other niches that might be impacted differently in a rising interest rate environment? And what other ways can mortgage market players adjust to avoid the worst of what’s to come, to protect their hard-earned capital and live to lend another day?