August 13, 2022

Mortgage Investors Pay Big Price for a Small Yield

Investors trying to eke out a small return on their savings are finding out that buying mortgage-backed securities (MBS) can yield big losses when rates increase.  It is doubtful that most investors in MBS appreciated the risk involved in buying long duration assets, regardless of the collateral behind it.

The zero-rate policy of the Federal Reserve has resulted in yield hunt by conservative investors looking for a yield higher than the near zero rates offered by banks and money market funds.

Investors buying MBS were probably seduced by the fact that they are guaranteed by various U.S. government agencies such as Fannie Mae, Freddie Mac and Ginnie Mae.  The government agencies guarantee payment of interest and principal but unfortunately, the value of MBS can and will fluctuate in value depending on changes in interest rates.  For example, a popular Vanguard MBS ETF has an average duration of almost 6 years.  Duration measures interest rate risk and in this case, a 1% increase in interest rates with result in a 6% decline in the value of the ETF.

A MBS ETF as part of a laddered bond portfolio makes sense but could turn out to be a disaster if increase rates continue to increase, especially if the investor has to liquidate a position.  Since the high reached in August 2021, the Vanguard MBS ETF has decline in value by over 10%, a really big loss for someone who thought they were investing in a relatively safe security. With the ETF currently paying a yield of 1.83% if would take almost six years to recoup losses if interest rates remain stable.

The biggest loser of all in the MBS market may turn out to be the U.S. taxpayer since the Federal Reserve currently holds almost $2 trillion of mortgage-backed assets.  The Fed has been furiously purchasing MBS in an effort to keep interest rates low in the mortgage market.

With inflation continuing to accelerate, MBS along with other long dated debt securities will continue to drop in value.

 

Why Won’t My Loan Officer Answer the Phone?

Anyone trying to refinance or get a mortgage to buy a house may wonder why it is so hard to reach their loan officer.  Numerous emails and voicemails ignored and cell phone numbers not in service are annoying to any customer but at least the missing loan officer probably has a really good excuse – he just got fired!

The mortgage industry has always been a boom and bust business but the current environment is more brutal than anything ever seen.  According to the Mortgage Bankers Association (MBA), both purchase and refinance mortgage activity have seen a stunning decline from a year ago.

The Refinance Index decreased 8 percent from the previous week and was 68 percent lower than the same week one year ago. The seasonally adjusted Purchase Index decreased 3 percent from one week earlier. The unadjusted Purchase Index decreased 2 percent compared with the previous week and was 14 percent lower than the same week one year ago.

For the average loan officer working strictly on a commission basis and doing mostly refinances, driving to the office costs more in gas than what he gets paid.  The response from the nonbank mortgage companies has been swift and brutal.

Why you shouldn't close your business to carry out a stocktake | Stocktaking.ie

Better.com, a major mortgage banker, which clumsily fired 900 people in December via a Zoom meeting and a further 3,000 employees in March, announced that another round of cuts will eliminate an undisclosed further number of employees.

Will things get better soon?  Not soon enough for those loan officers who were abruptly fired and even the MBA which usually spins optimism, seems to have a bleak outlook going forward.

The 30-year rate has increased 70 basis points over the past month and is 2 full percentage points higher than a year ago. The recent surge in mortgage rates has shut most borrowers out of rate/term refinances, causing the refinance index to fall for the sixth consecutive week. In a housing market facing affordability challenges and low inventory, higher rates are causing a pullback or delay in home purchase demand as well. Home purchase activity has been volatile in recent weeks and has yet to see the typical pick up for this time of the year.

Many mortgage companies facing a drastic drop in revenue from their only source of revenue face a serious risk of having to close their doors.  It may be time to approach your local FDIC insured bank for a mortgage going forward instead of a nonbank mortgage lender.  Banks are strictly regulated in terms of capital requirements whereas the regulations on “nonbank mortgage” companies are much more lenient.

Home Equity Line of Credit (HELOC) is a Better Option than a Mortgage Refinance

Savings – A Lost American Virtue

In an uncertain world it is important that everyone has at least six months’ worth of savings available.  It might not be possible to save this much for the average person.  The best option to establish a readily available and reasonably priced source of funds is to take out a home equity line of credit (HELOC).

Here are some of the basic things to know about a HELOC.

A home equity line of credit (HELOC) can provide emergency funds at a fraction of the cost of a credit card advance or personal loan and there are no monthly fees.

A HELOC is a mortgage on your home which means that you are using the collateral in your home as security for the loan.  If the borrower already has a first mortgage, then the HELOC would be a second mortgage lien.

The application process with a bank is very easy and usually there are no upfront costs. The borrower may be responsible for paying the fees associated with setting up the HELOC if the line of credit is cancelled within five years. Keep in mind that the bank must incur costs for underwriting, credit report fees, processing, title search, appraisal and closing costs. A HELOC is a much lower cost option for obtaining cash than doing a fee laden cash out refinance of a first mortgage.

The application process is similar but less stringent than applying for a first mortgage. The borrower’s income is verified, and the credit score must meet the bank’s standards. Most banks will lend up to 80% or more of the home’s value minus any first mortgage balance.  At the time of application, the borrower puts in a request for a specified loan amount.

Once the HELOC is approved, the borrower is given a check book to access the approved credit line.  There is no requirement to borrow any funds.  The money is quickly available when needed which can be a lifeline in the case of job loss or unexpected expenses.

The interest rate of a HELOC is variable and is typically based on the prime rate or other short-term index plus a specified margin.  The rate and payment on any advances will therefore change monthly. Interest rates on personal loans and credit cards can easily be more than triple the rate on a HELOC.

The monthly payment on a HELOC is interest only which keeps the payment low. Borrowers have the option of paying more than the minimum payment due and can pay off the loan in full at any time.  The interest on a HELOC is tax deductible which lowers the cost of the loan.

The biggest risk of a HELOC is that if a default occurs, the bank may initiate a foreclosure proceeding.  If you are comfortable with the concept of using your home equity as collateral, a HELOC is the lowest cost and most flexible option for borrowing money.

The Pros and Cons of an Adjustable-Rate Mortgages (ARM)

A mortgage payment is usually the biggest monthly expense for most people.  Since an adjustable-rate mortgage (ARM) will always start off with a lower rate than a fixed rate mortgage, it is useful to understand the pros and cons of an ARM.  Depending on the trends of future interest rates, an ARM can be a money saver or a money pit.

The interest rate on an ARM can change over the life of the loan at various time intervals depending on the type of mortgage product you select.  An ARM product is more challenging to understand than a fixed rate mortgage so dealing with a knowledgeable mortgage loan officer is essential.  The rate on an ARM is the sum of an index rate plus a fixed margin.  The index rate will vary but the fixed margin will not.  Most banks use a short-term index rate such as the yield on a one year Treasury bill.  The index rate plus the margin is called the fully indexed rate.  The ARM will never have a rate less than the fixed margin.  For example, if the fixed margin is 3% and the yield on the one year treasury is 0%, the ARM will have a rate of 3%.

The typical ARM rate will change yearly. The date of the first-rate change on an ARM depends on the type of ARM that the borrower initially selected. The four most common ARMs are the 3/1 ARM, the 5/1 ARM, the 7/1 ARM, and the 10/1 ARM.  These ARM products are called hybrid ARMS since they have a fixed rate for the time specified and afterwards convert to an adjustable rate which can change once a year.  For example, the 3/1 ARM will have a fixed rate for three years and the rate might change starting in year four.  The starting rate on loans with a longer initial fixed interest rate will start off higher.  For example, the rate on a 5/1 ARM might start off one percentage point lower than the start rate on a 10/1 ARM.

ARM products have lifetime and yearly rate caps.  Although the rate change on an ARM can be substantial over the life of the loan, lenders have a cap on the yearly rate increase to avoid payment shock to borrowers, but the lifetime rate increase can result in much higher payments.  Most ARMs cannot increase by more than 2 percent after the initial fixed rate period and the lifetime rate is usually capped at 5 percent above the start rate.  For example, in a worst case basis a borrower with a 5/1 ARM at a 2.75% start rate might see an increase to 4.75% in year six, 6.75% in year seven, and reach the lifetime cap of 7.75% in year eight.

The risk involved with an ARM should be carefully considered.  An initial interest rate that is lower than a 30-year fixed rate is a bet that future interest rates will not dramatically increase.  This has been the case for the past 14 years and the ARM borrower automatically shifted to a lower rate without the large expenses involved in a refinance.  However, even if rates do increase in the future, savings from a low start rate could more than offset higher rates in later years.

No one can predict future interest rates but in a declining or stable interest rate environment, ARM borrowers will save money over time compared to a fixed rate mortgage which almost always has a higher rate than the start rate of an ARM.

An ARM will make sense for a borrower who expects to sell his home within 10 years which is the average number of years a person lives in his home before selling it.

Mortgage Rates At 10% a Real Possibility If Inflation Can’t Be Reduced

Mortgage Rates Explode to 12 Year High

This year has seen one of the most explosive mortgage rates increases in history.  In a matter of a few short months the 30-year fixed rate mortgage has almost doubled from the high 2’s to over 5%. There have been previous periods of time during which rates rose substantially but 2022 has been a vertical move up that is rarely seen.

30-year fixed mortgage

Why rates have risen so quickly is no mystery.  After months of Federal Reserve talk of “transitory inflation” it has become clear that inflation is here to stay and likely to get worse before it gets better. The Fed must increase rates significantly to have any chance of reducing the inflation rate since current rates are far below the rate of inflation.

This from the WSJ:

During the 1980s, when Paul Volcker’s Fed was desperate to avoid a repeat of the inflation of the 1970s, interest rates were on average more than 4 percentage points higher than inflation. Leave aside the fact that at the moment the Fed Funds target rate is an extraordinary 7 percentage points below inflation; markets aren’t bracing for the Fed to be truly hawkish in the long run. Investors still think there’s no need, since in the long run inflation pressures will abate.

This is probably a mistake. The inflationary pressures from Covid and war will surely go away eventually. But self-fulfilling consumer and business expectations of inflation are rising, and a bunch of longer-term inflationary pressures are on the way. These include the retreat of globalization, massive spending to shift away from fossil fuels, more military spending, governments willing to run loose fiscal policy, and a starting point of an overheated economy and supercheap money.

If interest rates continue to rise, we may be looking at another housing bust similar to what we saw in 2018.

Mortgage Rates at 5% Could be the Low for 2022

A few short months ago at the end of 2021, 30-year mortgage rates hit their lowest level in history in the low 3.25% range.  Since that time rates have skyrocketed by 50% to a shade below 5%.  Increased rates have occurred as the Federal Reserve was forced to raise rates due to a rapidly increasing rate of inflation resulting in double digit price increases for many products and services.

Any one expecting rates to decline from here is likely to be disappointed.  Both wage and price inflation have become embedded in the economy as shortages of workers and products relentlessly drive prices higher.  Trying to tame inflation while at the same time keeping the economy running at full speed is the biggest challenge the Fed has faced in the past thirty years when short term rates approached 20%. 

None of this has been on the boom/bust mortgage industry as thousands of workers have been laid off as mortgage refinances plunge and purchases slow down. 

According to the Mortgage Bankers Association, refinance volume has plunged 60% below levels one year ago.

… The Refinance Index decreased 15 percent from the previous week and was 60 percent lower than the same week one year ago. The seasonally adjusted Purchase Index increased 1 percent from one week earlier. The unadjusted Purchase Index increased 1 percent compared with the previous week and was 10 percent lower than the same week one year ago.

“Mortgage rates jumped to their highest level in more than three years last week, as investors continue to price in the impact of a more restrictive monetary policy from the Federal Reserve. Not surprisingly, refinance application volume declined further, as fewer borrowers have an incentive to apply at rates that are significantly higher than a year ago. Refinance application volume is now 60 percent below last year’s levels, in line with MBA’s forecast for 2022,” said Mike Fratantoni, MBA Senior Vice President and Chief Economist…

The average interest rate for a conforming 30-year fixed rate conforming loan with a 20% down payment in now at about 4.8%. Although the mania in the purchase market continues, it’s only a matter of time until activity declines due to higher rates and dramatically increased home prices.  Potential purchasers are being squeezed as wages lag far behind the increases in the cost of living and housing.   

If the Fed engages in multiple half point rate hikes as they are suggesting, expect mortgage rates to steadily increase.

FHA Mortgages and Student Loans Are a Risky Combination

First time home buyers have traditionally faced a variety of obstacles including the high cost of housing, stagnant wages, and the difficulty involved in saving for a down payment.

 

If that wasn’t bad enough, recent changes by the Federal Housing Administration (FHA) now raise another potential barrier to home ownership due to the manner in which student loan debt must be evaluated.

 

For a variety of reasons many potential home buyers with a large load of student debt are able to obtain payment deferments of various durations.   Since there was no formal payment due under the payment deferments, some of which can last for years, the FHA had for the most part simply ignored the looming certainty of future monthly payments.  By not factoring in an estimated loan payment for deferred student loans, borrowers were able to lower their debt ratios for purposes of loan eligibility.

With the new FHA requirement to account for future payments on deferred student loans, many applicants may wind up with a back end debt ratio in excess of the 43 per cent currently allowed under FHA regulations.  Potential home buyers who were close to the maximum for monthly debt payments may now find themselves ineligible for any type of mortgage loan.

Are the new FHA regulations fair to first time home buyers?

One could make the argument that the new rules make sense since at some point the borrower is going to be required to start making payments on the student loan debt and if the payment is large enough it could cause enough financial stress to put the borrower at risk of defaulting on the mortgage.   According to a HUD spokesman,  “Will that borrower actually be able to afford their loan and the student loan payment? It’s a legitimate issue to consider.  Deferred student debt is debt all the same and really must be considered when determining a borrower’s ability to sustain both student debt payments and a mortgage long term.  Our primary interest is to make certain that a first-time home buyer is put on a path of sustainable home ownership rather than being placed into a financial situation they can no longer tolerate once their student debt deferment expires.”

It’s difficult to dispute the logic of HUD’s position but it seems to fail to take into account the prospect of a borrower’s future income increasing enough to compensate for the additional student debt payment.

The problem with considering future income, however, is that incomes have been increasing at a very slow pace in the post financial crisis period.  The prospects of higher incomes for the average worker remains speculative while the certainty of having to make payments on a student loan at some point are not.  Nonetheless, the increase in the amount of student loans being handed out have been increasing at a staggering rate as students furiously borrow on the dubious prospect of obtaining a job after college that pays enough to buy a house and car, raise a family, and payoff student loans.

Those expecting an increase in the rate of home ownership are likely to be disappointed as more and more young people remain at home with their parents unable to take on the financial responsibilities of home ownership.

The excessively easy lending of a decade ago temporarily raised the rate of home ownership as totally unqualified borrowers bought houses on the theory that home values could only continue to skyrocket.  The subsequent default of these weak and unqualified borrowers resulted in millions of foreclosures which burst the housing and mortgage lending bubble which resulted in the rate of home ownership falling right back to the long term historical average of about 65 per cent.

What Dow Stock Is Up the Most in 2013 With a 74% Gain?

The Dow Jones Industrial Average is up a stunning 18.8% this year as of Friday’s closing price of 15,570.28.

While an investor in the Dow 30 stocks has done quite well this year, the S&P 500 has outperformed the Dow Jones this year by about 5%.  After closely tracking the returns of the Dow for most of 2013, the S&P has broken out to new highs while the Dow has basically been churning in a trading range between 15,000 and 15,500.

Is there any significance to the sudden under performance of the Dow Jones to the S&P or is it impractical to compare the prices of a small sample of 30 stocks to 500 stocks?

Courtesy: Yahoo Finance

Had it not been for the unbelievable gain in Boeing this year, the S&P and Dow Jones would have had an even larger divergence.

Despite the ongoing problems with the 787 Dreamliner, Boeing’s stock price has gained steadily throughout the year and is currently the best performing Dow stock of 2013 with a 74% return.

Courtesy Yahoo Finance

Trailing Boeing for second place in the Dow’s biggest gainers is Nike with a return of 46.7% to date.    Nike is a newcomer to the Dow Jones, having been added in September of this year.

Courtesy: Yahoo Finance

Disclosure: No holdings in either Boeing or Nike.

An Economic Puzzle – Consumer Confidence Hits Six Year High While Majority of Americans Say U.S. Still in Recession

courtesy: forbes.com

If everyone from the Fed Chairman on down to the average man in the street seems confused about how the economy is doing, well, it’s because they are. The economy is still in a recession, a depression or an emerging boom depending on who you listen to. Two recent news articles published days apart highlight the divergence of opinion on the state of economic affairs.

Consumer Confidence Revisits High Set in 2007

Americans are more confident about the economy than at any time since July 2007, a survey found, suggesting consumers will spend more and accelerate growth in the months ahead.

The University of Michigan said on Friday that its final reading of consumer sentiment in July was 85.1. That’s up one point from June and nearly 13 points higher than a year ago.

Rising home prices and steady job gains are bolstering household wealth and income. The proportion of Americans who expect their inflation-adjusted incomes to rise in the coming year is greater than at any time since late 2007, the survey found. And the percentage of Americans who say their home values have risen is also at a six-year high.

Majority of Americans Say U.S Still in Recession

The economy may be sputtering along. But it hasn’t been in recession for more than four years. More than half of Americans think it still is.

A majority of people — 54% — in a new McClatchy-Marist poll think the country is in an economic downturn, according to the survey conducted last week and released Tuesday.

The McClatchy-Marist poll found that Americans who earn less are more likely to think the economy is in a recession. Of those earning less than $50,000 a year, nearly two-thirds say the downturn is still underway. For those earning more than that, only 47% think so.

Is it any wonder that Bernanke swings from tapering to easing in the same week? The Federal Reserve, packed with PhD economists, seems as equally confused about the state of the economy as the average consumer.

After considering the divergent opinions, two general conclusions regarding the economy are possible here.

-Predicting the future is a fool’s game, and
-Consumers who have well-paying jobs, money in the bank and rising incomes are far more likely to be optimistic about the future than someone with no job and no money.