Mortgage applications are primarily interest-rate driven. Applications typically increase as rates fall because home owners take advantage of the drop in rates to refinance. Conversely, they fall as rates rise. They also exhibit a seasonal pattern, correlating with purchase activity during the Summer selling season. This year, we are seeing strong origination volume growth, even as we see prepayment burnout. Prepayment burnout happens when interest rates oscillate in a narrow range for an extended period of time; each time rates return to a lower range, the number of prepayments (or refinances) drops. The mix of purchase activity versus refinance activity is tilting more towards purchases as the economy improves and refinance activity slows. This favors mortgage bankers who have a strong retail branching system and works against lenders who go direct to the consumer.
The bond market sell-off continues
The MBA Mortgage Application index fell another 9% to close at 721.4 after falling nearly 10% the week before. In April, we saw a big decline in interest rates as the March jobs report disappointed and the Bank of Japan launched its own version of quantitative easing (QE). Investors feared that the sequester would crimp second quarter growth. So far, there has been a small effect, but nothing dramatic. However, that trend reversed on the April jobs report which showed a better than expected rise in payrolls. Combined with generally good earnings, the bond market has suffered from the “risk on” trade, which means investors are selling “riskless” assets, like Treasuries, to buy risky assets, like stocks. The final nail in the coffin was Bernake’s testimony before Congress where he refused to rule out tapering quantitative easing by Labor Day. The 30-year fixed rate mortgage rose another 9 basis points to 3.75% last week after bottoming at 3.4% in the first week of May.
Mortgage bankers had an extremely profitable 2012 as rates fell and real estate prices bottomed. Much of the activity over the past five years has been the “serial refinancer,” or someone who has equity in their home and has taken advantage of refinance opportunities as rates have fallen. These borrowers are highly price-sensitive and tend to go with consumer direct lenders who offer low rates and reduced application fees. These consumer direct lenders will struggle in a purchase environment, and have been laying off staff in anticipation of a drop in volume.
The purchase market is much more relationship-driven. This market requires a branch system of local professionals who have a large network of realtors, real estate attorneys, etc. These bankers compete on the basis of price and service. It also means that there is competition for independent brokers and bankers. A mortgage banker can grow very quickly through M&A activity.
Big opportunities ahead for mortgage REITs that focus on origination
The mortgage market is undergoing a massive transformation as the private label mortgage market returns. The House Financial Services Committee had a hearing this morning discussing how to revive the private label market. Ever since the bubble burst, mortgage origination has been almost exclusively government-driven. 50% of the credit risk of the entire U.S. mortgage market is borne by the U.S. government. Originators typically do not hold their mortgages. They either sell them to the big banks or securitize them. Since the securitization market was dead, they had no outlet for non-agency mortgages. Redwood Trust (RWT) has been the only issuer of private label (securities backed by mortgages that are not government guaranteed) mortgage backed securities, and they have focused exclusively on high quality jumbo loans. Pennymac (PMT) noted on their conference call that they recently launched a jumbo product and are targeting a first securitization in Q3.
In the beginning of the year, we saw a wave of private label deals, but subsequently spreads have widened and the deal flow has slowed. Whether this is a temporary “buyers strike” or something more remains to be seen. The vast majority of the deals were extremely high quality loans with significant over-collateralization, so they look nothing like the private label deals done at the end of the bubble. The sense is that more deal flow will happen once the government settles on how it wants to regulate private label securitizations. Finally, increases in origination will help servicers, like Nationstar (NSM) and Ocwen (OCN).
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