Realtors Beware: The Coronavirus Has Created a Mortgage Crisis

Mortgage lenders and their loan products are disappearing from the market at an alarming pace (seemingly faster than the Great Recession). Most of the nuances behind why this is happening are irrelevant, but it is vital every Realtor understands the basics and uses that knowledge to protect their clients during this mortgage crisis.

A Perfect Storm

What we are seeing behind the scenes in the mortgage markets today is truly a perfect storm. Interest rates have hit their all-time lows, and most lenders’ pipelines have reached their highest levels ever. Simultaneously, extreme interest rate volatility on a daily basis has resulted in margin calls and has left many mortgage lenders vulnerable and undercapitalized. 

Some of the actions taken by the Federal Reserve – like its buying of mortgage-backed securities – are accelerating the chaos and causing drastically more harm than good. Unfortunately, the situation is not getting any better and is unlikely to improve until the Federal Reserve ceases its purchases of mortgage-backed securities.

How the Mortgage Market Works

Most Realtors are educated on how the mortgage process works on the front end, and they possess more than enough knowledge to carefully guide their clients through it. Few however, understand how the mortgage market works after the loan closes. We call this the secondary market, and it’s this market that is experiencing extreme chaos at the moment. 

Let’s start from the beginning of the home-buying process. A client takes out a mortgage from a lender who has underwritten, approved, and funded the loan. The loan is then released into servicing, bundled with similar mortgage loans, and sold to mutual funds, insurance plans, and retirement accounts as a mortgage-backed security. 

The servicer of the mortgage typically does not own the loan; they simply manage it and make sure the monthly payments come in and the taxes and insurance are paid. Those monthly payments are ultimately passed on to whoever purchased the mortgage-backed security. 

The function the mortgage servicer fulfills is crucial. Without it, the mortgage and real estate industries dry up and cease to function properly.  

Typically, the servicer pays the lender about 1% of the loan amount to obtain the servicing rights for a loan. In return, the servicer earns roughly .3% of their investment per year. This results in a typical break-even period of three years; each year the loan stays with the servicer beyond that is profit. 

With interest rates hitting all-time lows, the industry is seeing massive waves of refinances. These refinances shorten the average lifespan of a loan below the three-year break-even point. The result of this rapid churning of loans is a drastically reduced value of the servicer’s loan portfolio. 

As the servicer’s asset value decreases, so does its ability to obtain financing and lines of credit needed to purchase new loans. This ultimately results in more margin calls and a massive liquidity crunch for the servicer.

It Gets Even Worse…

As loan servicers are experiencing a liquidity crunch due to all the refinance action, the coronavirus has created record unemployment numbers. This adds additional risk to the servicer because, even though they do not “own” the mortgage, the terms in the servicing agreement hold the servicer responsible to pay the investor who owns the mortgage-backed security, regardless of the receipt of the mortgage payment.

Typically, the servicer has plenty of capital to make its payment to the investor who purchased the mortgage, and there are no issues. However, thanks to today’s rapid refinancing numbers, the devaluation of their servicing portfolio, and a rising number of borrowers who are requesting payment forbearance, mortgage servicers find themselves dangerously short on liquidity.

This liquidity crunch in servicing has begun to impact borrowers and forced lenders to re-evaluate what loans they should approve. No longer is the consideration only going to be if the loan can get an Automated Underwriting approval – the mortgage industry now has to ask if the client getting the mortgage is likely to make the first payment. 

Lenders are going to be evaluating if the borrower has sufficient liquid reserves after closing and whether or not the industry the borrower works in is likely to be cutting its workforce. 

In summary, the liquidity crunch in the secondary market is beginning to have an impact on what loans will be approved or declined by mortgage lenders across the country.

Lenders Are Experiencing Liquidity Problems, As Well

The Federal Reserve was swift in its response to the coronavirus crisis by announcing virtually limitless amounts of stimulus. It has aggressively been buying Treasury Bonds and mortgage-backed securities in an attempt to reduce long-term interest rates. On the surface, this is a great play – lower interest rates should help stimulate the economy by increasing demand for housing.

However, there are significant and unintended consequences of the Federal Reserve’s buying of mortgage-backed securities. These consequences are now causing liquidity problems for lenders and ultimately making it harder for borrowers to obtain financing.

When a mortgage company locks a borrower’s interest rate, it is promising to reserve a block of money at that rate for a specified number of days. For example, let’s say your client locked in at a 3.5% interest rate for forty-five days, but between the lock date and closing date the interest rate market moved to 4.0%. In this scenario, the lender would need to buy down the interest rate because the market moved before the loan was able to close and be sold.

To protect themselves from scenarios like this, lenders hedge their locked loan pipeline. This hedge provides the lender protection against the interest rate market moving higher before the loan can close. Essentially, if a client has locked their loan and the interest rate market moves higher, the lender still has to buy the interest rate down, but they make up the difference by profiting from their hedge position. In a normal market, this is a low-risk strategy that allows lenders to lock loans without taking on excessive rate-movement risk.

Due to the Federal Reserve’s intense investment in the mortgage-backed security market, interest rates are at an all-time low. As rates moved lower the lender’s potential profit would increase on the locked loans, but put their hedge positions at significant losses. In the end, everything would even out because the two positions offset one another. 

Unfortunately, the financial institutions (called broker dealers) that provide the hedge position for lenders have very little patience; and when the lender’s hedge positions show deep losses, they enforce margin calls.

Lenders have seen intense margin calls resulting from upside-down hedge positions on their locked pipelines. We are talking numbers in the tens and, in the case of some of the bigger lenders, hundreds of millions of dollars. 

Many lenders will not be able to fund these margin calls, some have stopped taking or honoring rate-lock agreements with their clients, and some will disappear forever. 

How Should You Advise Your Clients During the Coronavirus Crisis? 

The mortgage and financial markets are under massive stress due to the coronavirus and the ensuing liquidity crunch in many areas of the economy. The result of this is going to be tighter underwriting guidelines in the mortgage market. There will be some clients who may have qualified for financing just days or weeks ago, but are no longer eligible today.

Clients with low credit scores, high debt-to-income ratios, minimal reserves, and unique circumstances are going to be the hardest hit by this new reality. If your clients are not picture-perfect for their financing, it is going to be increasingly difficult to obtain underwriting approval. Some potential buyers are going to need to sit on the sidelines for a few months while the market regulates and we get over the coronavirus caused crisis.

You should also be aware of potential underwriting delays and extended closing timelines for your clients. We are seeing some banks posting forty-five to ninety-day turn times for underwriting due to all the refinance volume moving through the markets. 

As always, use your most-trusted lenders. If things seem to be going off track, work on a backup solution quickly. Underwriting guidelines and loan programs are changing on a daily basis, and an increasingly chaotic loan process is likely to continue until we see unemployment numbers dropping and people going back to work. 

I am confident that we will get through this crisis, as a nation, one day at a time. If you have any questions about the mortgage market or have a current scenario you would like to discuss, please don’t hesitate to reach out.