May 25, 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.

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.

The Zero Sum Game Of Lower Interest Rates And Why Mortgage Rates Will Rise

The Federal Reserve has forced long term interest rates to historic lows in a desperate attempt to “stimulate” both the housing market and the economy in general.  The results have been mixed but the benefits of lower rates to borrowers are undeniable.  Lower rates reduce the cost of large debt burdens carried by many Americans and increases the spending power of those able to refinance.

Exactly how much lower the Fed intends to repress mortgage rates is anyone’s guess but as interest continue to decline, the overall benefits diminish.  Here’s three reasons why the Fed may wind up discovering that the economic benefits of further rate cuts will be muted at best, self defeating at worst.

1.  Lower rates are becoming a zero sum game for the economy as lower rates for borrowers translates into lower income for savers.  Every loan is also an asset of someone else and lower interest rates have merely been a mechanism for transferring wealth from savers to debtors.  Every retiree who prudently saved with the expectation of receiving interest income on their savings have been brutalized by the Fed’s financial repression. Even more infuriating to some savers is the fact that many debtors who took on irresponsible amounts of debt are now actually profiting from various government programs (see Foreclosure Settlement Q&A – A Victory For The Irresponsible).

A significant number of retirees that I know have been forced to drastically curtail their spending in order to make ends meet while others have been forced to draw down their savings.  The increased spending power of borrowers has been negated by the reduced spending power of savers.  This fact seems to elude Professor Bernanke who hasn’t been able to figure out why lower rates have not ignited the economy.

2.  Many consumer who would like to incur more debt are often turned down by the banks since their debt levels are already too high.  Those who can borrow often times chose to deleverage instead, considering the fragile state of the economy.  Anyone saving for a future financial goal (college tuition, home down payment, retirement, etc) is forced to reduce consumption and increase savings due to  near zero interest rates.  The Federal Reserve has destroyed Americans most powerful wealth building technique – the power of compound interest.  A 5% yield on savings will double your money in about 14.4 years while a 1% yield will double your money in 72 years – and that’s before taxes and inflation.

3.  As mortgage rates decline into uncharted territory, the mathematical benefit of lower rates diminishes.  As can be seen in the chart below the absolute dollar amount of monthly savings as well as the percentage decrease in the monthly payment diminish as rates race to zero.

Benefits of a refinance on a $200,000 mortgage diminish as rates decline

% Rate Mo Payment Mo Savings % Reduction Yearly Savings
6.00% $1,199.00
3.00%    $843.00 $356.00 29.70% $4,272.00
1.50%    $690.00 $153.00 18.10% $1,836.00
0.75%    $621.00  $69.00 10.00%    $828.00

Closing costs at lower rates also become problematic, making it impossible to recapture fees within a reasonable period of time.  With closing costs of $8,000 on a $200,000 mortgage refinance, it would take a decade to recoup closing costs.

Many astute analysts have made elaborate and compelling arguments that interest rates can only go lower.  From a contrary point of view, I believe that a future rise in interest rates is a high probability event.  This is the opposite of my prediction in March 2009 when I surmised that mortgage rates would decline to 3.5% – see 30 Year Fixed Rate of 3.5% Likely.

The Chart of the Day has a long term chart of the 10 year treasury and notes that the recent sharp decline in interest rates “has brought the 10-year Treasury bond yield right up against resistance of its 26-year downtrend channel.”

 

Why The Biggest Risk To The Economy Is A Strong Recovery

Concerns about the current economic mess turning into another Great Depression seem to have faded.  The consensus view of  government officials and private economists seems to be that the economy, although still fragile,  is well on its way to a robust recovery.  According to Bloomberg,

Companies in the U.S. expanded in December at the fastest pace in almost four years, signaling the economic recovery is gaining speed heading into 2010.

The Institute for Supply Management-Chicago Inc. said today its barometer rose to 60, exceeding the most optimistic estimate of economists surveyed byBloomberg News and the highest level since January 2006. The gauge, in which readings greater than 50 signal expansion, showed companies boosted production and employment as orders climbed.

Stimulus programs and discounting have propelled a rebound in global sales that is reducing stockpiles, which may spur manufacturers to further increase production in coming months.

The world’s largest economy expanded at a 2.2 percent pace from July through September after a yearlong contraction that was the worst since the 1930s, figures from the Commerce Department showed last week. Economists surveyed byBloomberg forecast growth to pick up to a 3 percent pace in the fourth quarter and average 2.6 percent for all of 2010.

Predictions for a strong economic recovery seem to grow by the hour.   Recent articles in the press lead one to believe that  –  unemployment has bottomed, the growth of  foreign economies will result in greater demand for U.S. goods and services, inflation will remain subdued, the dollar has stabilized, a recovery in the housing market has started, mortgage rates will remain low, the bailed out banks are in full recovery mode, the Fed will gradually remove excess liquidity from the system, the politicians will get the deficit under control and the stock market will continue to post impressive gains.

Is the bullish consensus getting out of hand or will there be a few surprises on the path to a booming economy?  One scenario that could shatter the dreams of the bulls is if private individuals and businesses are crowded out of the debt markets by a U.S. government that needs to borrow seemingly endless trillions of dollars.  The latest data on private and governmental borrowing from the St Louis Federal Reserve show that crowding out could slam the brakes on an economic recovery.  Businesses and individuals may be unable to borrow in strained capital markets or face much higher borrowing costs as they compete with the government for capital.

Lending by large commercial banks has plunged, a combination of tougher lending standards and reduced loan demand.  Any economic recovery would result in increased loan demand by the private sector which strained capital markets may not be able to supply.   Competition for funds could lead to a spike in interest rates.

comm-lending-wk-change

As lending to the private sector has collapsed, government borrowing has exploded.

fedgov-debt-explodes

With no end in sight to new trillion dollar programs being passed by Congress, the financing needs of the U.S. Government are not likely to be reduced any time soon.  The recovery of the U.S. economy that many foresee may come to a grinding halt if private sector borrowers are crowded out of the capital markets.

Federal Reserve Super Low Rate Policy Crushes Savers And The Elderly

Fed Sees Solution In Zero Rates

The Federal Reserve recently vowed to keep interest rates “exceptionally low”  for the foreseeable future in an attempt to revive the economy.   Since mid 2006 the Fed has brought the Fed Funds Rate down from 5% to virtually zero in an attempt to reduce the debt service burden on over leveraged borrowers.

fredgraph

A world of ultra low interest rates may continue for much longer than many expect.

Fed To Keep Rates Low  (WSJ) –  Fed officials voted unanimously to maintain their target for the key federal-funds interest rate — at which banks lend to each other overnight — near zero and said they expect to keep it there for an “extended period,” which suggested increases are at least several months off.

While consumers are spending, the Fed noted they were “constrained by ongoing job losses, sluggish income growth, lower housing wealth and tight credit.” Meanwhile, “businesses are still cutting back on fixed investment and staffing, though at a slower pace.”

A low interest rate policy has worked in the past to stimulate the economy and the Fed is applying the same prescription to the current economic downturn.   At this point, it is too early to tell if the same policies of super low rates and easy money will work as it has in the past.  Japan stands out as the premier example of a post bubble economy still failing to recover despite twenty years of super easy fiscal and monetary policies.  The Fed prescription of attempting to revive an overly indebted economy with more lending may very well produce the same results as in Japan – slow economic growth, lower incomes and crushing public debt burdens.

Individuals who were prudent enough to save and avoid debt are now left to  wonder if they will ever see a return on their savings.  Short term CD’s are below 1%, money market funds pay a ridiculously low rate barely above zero and short term treasuries have a negative yield.   Those who are retired and depend on interest income for living expenses must now deplete their savings or take on more risk by investing in higher yielding bond funds subject to substantial market fluctuations.

The Fed’s low interest rate policy effectively represents a massive wealth transfer from savers to debtors.   FDIC insured deposits of bank savings and CDs currently total $4.8 trillion and there is approximately $5 trillion in money market funds for a total of $10 trillion that is earning at best 1% compared to 5% in 2006.  The drop in interest rates from 5% to 1% represents an annual income loss to savers of $400 billion dollars per year.

Congress and the Fed have attempted to bailout out every imprudent debtor  with super low interest rates – homeowners who borrowed too much, bankers who lent foolishly, and hundreds of poorly run, over indebted companies from GM to AIG.   Someone always pays in the end and in this case, the victims are the savers.

More On This Topic

Near-Zero Rates Are Hurting The Economy

Artificial Mortgage Rates Drop To 4.75%

Fed Manipulation Of Mortgage Rates Continues

Mortgage rates continue their downward trend with the perfect borrower now able to obtain a rate of 4.75% with a two point buy-down on a 30 year fixed rate mortgage.  As expected, with mortgage rates now back in the 4% range, mortgage applications have increased.   The latest stats from the The Mortgage Bankers Association show large increases in mortgage activity, with refinances accounting for almost 60% of total mortgage applications.

The Market Composite Index, a measure of mortgage loan application volume, increased 17.0 percent on a seasonally adjusted basis from one week earlier.  On an unadjusted basis, the Index increased 15.8 percent compared with the previous week and 64.5 percent compared with the same week one year earlier.

While fluctuations in mortgage rates are historically based on many factors, the biggest factor affecting mortgage rates today are the manipulations by the Federal Reserve.   With the mortgage market dominated by the government, it is difficult to determine where rates would be in a free market but indications are that rates would be much higher.  For example, non agency lenders who do not sell mortgage loans to the government agencies but portfolio them instead, are currently quoting 30 year fixed rates at around 6 to 6.5% depending on credit and loan to value (obviously, the non agency lenders are not doing much conforming loan business).

Fed Price Fixing Efforts With Mortgages Will Fail

So what’s the problem with having low mortgage rates?  The  government manipulations in the mortgage market allow homeowners to refinance and buy at low rates.   If mortgage rates drop low enough, perhaps the government will succeed in its objective of re-inflating housing prices.  There just might be a few problems with the government’s manic quest to keep mortgage rates low.

  • How long will investors continue to buy securities backed by mortgages on which payments are guaranteed by the government?  Perhaps forever, but perceptions of the value of a “government guarantee” may diminish as the financial condition of the US Government continues to erode.  At some point, rational buyers will give little credence to the guarantee of a government that needs to borrow 40% of its year outlays while running multi trillion dollar yearly deficits.
  • How long can the Federal Reserve continue to purchase mortgage backed securities and treasury debt with printed money?  It may not seem to be causing a problem in this country (yet) but some of the USA’s largest foreign creditors are getting very nervous – See China Alarmed By US Money Printing.

Banks Load Up On Mortgages

Theoretically, the Federal Reserve can buy every mortgage backed security in existence but at what point does the bond market react with higher rates based on the risk that the Fed is going to monetize debt on a colossal scale?  Fed purchases of mortgage backed securities are fast approaching the announced goal of $1.25 trillion.

Courtesy wsj

Courtesy wsj

As it turns out, the Fed has a willing and able partner in the purchase of mortgage backed securities.  With the banking industry facing massive losses on defaulting mortgages, how is this for irony? – Banks Load Up On Mortgages.

As of June 30, the roughly 8,500 federally insured banks and thrifts were holding $113.5 billion of Ginnie securities, compared with just $41 billion a year earlier, according to a Wall Street Journal analysis of bank financial disclosures. It is the largest amount that banks have reported holding since at least 1994.

Banks, sometimes with the blessing of federal regulators, have been loading up on Ginnie securities for one main reason: They make their balance sheets look healthier. Since the securities are guaranteed by the government, federal banking regulators have deemed them risk-free, meaning that adding them to a bank’s investment portfolio, or replacing assets deemed riskier, lowers the overall risk of the portfolio in the eyes of regulators.

Some banks have used government cash infusions under the Troubled Asset Relief Program to buy Ginnie Mae bonds.

Holding Ginnie bonds help banks look better because federal bank-capital guidelines give the Ginnie securities a “risk weighting” of 0%. That means banks don’t have to hold any cash in reserve to protect against losses.

At the same time that the banks are choking on defaulted mortgages and reluctant to lend, they are purchasing vast quantities of government guaranteed mortgages to shore up their capital ratios, sometimes using TARP funds.

The Great Unwind

The Fed fostered the bubble in the housing market with easy money, leaving us with collapsed housing prices and oceans of defaulted mortgage debt.  The Fed is now inviting a similar disaster in the mortgage market, again with super easy monetary policies.

The massive purchases by the Fed and the banks of mortgage backed securities is artificially inflating the prices of mortgage backed securities, consequently curtailing purchases by private investors.  This leaves the Fed and the banks as the only (irrational) buyers.

At some point mortgage rates will rise regardless of the Fed’s manipulations.  The taxpayers will be stuck with massive losses on the Fed’s mortgage backed securities as yields climb and prices plunge.  Banks, as always, will be heavily invested in the wrong asset at the wrong time.  Due to the magic of FASB accounting rules, the banks won’t have to take losses if they do not sell their mortgage backed securities; but neither will they be able to increase lending with capital frozen in underwater mortgages.

The government’s obsession with housing has resulted in the misallocation of untold trillions of dollars.   Meanwhile, urgent human and infrastructure needs of the country are left unfunded.   With the mortgage markets now completely dominated by the government, we can look forward to a continuation of the same failed policies.

Loan Sharks “Salvation” For Many At 2,437% Interest Rates

Loan Sharks: The New Subprime Lenders With A Twist – They Expect To Get Repaid – And Why A Loan At 2,437% Interest Makes Sense

For every loser, there is a winner.  Since the demise of the subprime lending industry, loan sharks have been reaping profits by lending to the same foolish crowd that used to be the target of subprime lenders.

In this country, the new subprime lenders are called payday lenders, who operate legally.  In Britain, the new subprime lenders simply call themselves, well, loan sharks and operate without the courtesy of government sanction.  The Wall Street Journal had an interesting article on loan sharking in the UK that should have been titled – “Why The Foolish Can’t Be Protected From Themselves”.

In a recent report, the U.K. think tank New Local Government Network said it expects the number of people with debts to loan sharks to jump to more than 200,000 in Britain this year, from an estimated 165,000 in 2006. A confluence of indebtedness, poverty and the diminished availability of regulated subprime credit are creating the conditions in which many are borrowing “from nefarious sources,” the report says.

But perhaps no country in the world was more addicted to debt than the U.K. By the end of 2008, the average British household had a debt-to-income ratio of 180% compared with 140% for the average U.S. family, according to the Organization for Economic Cooperation and Development.

That is coming back to haunt the U.K. The number of individual insolvencies rose by almost 30% year-to-year to 33,073 in England and Wales in the second quarter of 2009, the highest level since records began in 1960.

New Lending Lessons For British Borrowers

Apparently, over leveraged U.K. borrowers took every nickel they could from lenders foolish enough to lend to them, oblivious to rate or terms.  The actions of these borrowers could almost be viewed as rational since the money they borrowed and spent that they couldn’t pay back is now being absolved in bankruptcy courts with little repercussions from now defunct lenders.   U.K. borrowers who now have to deal with unlicensed loan sharks are shocked to learn that the loan sharks actually expect to be paid back – or else.

Some consumers are going to loan sharks to fund purchases for items including new televisions, overseas vacations or expensive clothing.

In mid-2007, Donna Ockerby, a 45-year-old auxiliary nurse in Manchester in northern England, turned to a local loan shark after her hours were cut at work. She borrowed £700 from Johnny “Boy” Kiely to help pay for a wedding dress.

Mr. Kiely, who charged interest rates of up to 2,437%, was jailed earlier this summer for five years for offenses including blackmail and illegal money lending. Ms. Ockerby now lives in a one-bedroom apartment on government benefits. She was moved out of her childhood home by police to protect her. Ms. Ockerby, who says she is on antidepressants, says the decisions to borrow from a loan shark ruined her life.

I’m sorry Ms. Ockerby but you are a financial idiot who deserved to pay the market rate of 2,437% interest.  Did you ever hear of “if you can’t afford it don’t buy it”?  What was the problem with buying or renting a used wedding dress for a fraction of the cost?  Johnny “Boy” Kiely risked his capital, is now in jail and out his £700.  Johnny “Boy” did not ruin your life – you did.