I hope everyone is doing well in light of the recent events. I was recently asked: “Did the Federal Reserve trigger a housing market crash?” What happened? The Coronavirus struck, the fed had to act swiftly to mitigate the damage, but by flooding the market with cheap money, did Federal Reserve just accidentally push mortgage bankers to the brink of bankruptcy and the housing market into a recession? What does this mean for the mortgage market?
How does the real estate mortgage market work?
The United States mortgage market is very complex and work differently for residential and commercial loans but both follow a similar concept in that the person who makes the loan does not typically hold the loan.
Residential: Residential originators can have a couple different models of lending. First, a flow agreement, this is where the originator immediately sells to Fannie or Freddie, the two government sponsored entities (GSEs) that buy mortgages. Second, the aggregator, has a warehouse line where they buy and hold mortgages for a period of time to create a “pool” and either sell this pool of loans to wall street or to one of the GSEs. During this hold period, hedges are taken out to insulate against swings in value of the mortgage. For example if a mortgage was made at 3%, the aggregator would take out a hedge if rates increased to 3.5% to ensure that their value was protected.
Commercial: Commercial is similar to residential, but the end buyer is typically a security on wall street or a bank portfolio (or insurance fund, hedge fund, etc…). Just as in residential there are flow agreements and aggregators that take on more risk, but also can reap far greater rewards as their cost of capital is cheaper.
Hard Money lenders: Many private lenders/ Hard money lenders will fund loans with a warehouse line of credit, bulk up the number of loans, and then sell to Wall street or get included in a larger securitization. This model has led to the vast majority of larger hard money lenders suddenly out of business as the model “broke”. *** Fortunately at Fairview we are unique in that we both make and hold our loans; we are considerably smaller than a major billion dollar bank and focusing on small balance commercial and residential loans that we can fund ourselves and hold in cash.***
How did the federal reserve’s recent moves impact the market?
Shortly after the Coronavirus hit, the federal reserve flooded the market with cheap money driving treasuries to basically zero. This abrupt move also changed the dynamics of the mortgage market by increasing volatility, mortgage rates initially plunged then suddenly rebounded as the end buyer were nervous about the low rates and risk involved.
At issue are the Fed’s unprecedented $183 billion of purchases last week of mortgage-backed securities. The purchases were meant to drive down rates, and they did. But together with the storm that gripped financial markets from the coronavirus, they also effectively blew up a widespread hedge that mortgage bankers use to protect themselves against rate increases. The hedge pays them if the prevailing rate in the market is higher than the mortgage rate they locked in with the customer.
The system works well unless mortgage rates are highly volatile. It is generally considered to be a safe trade: the hedge simply protects the lender against higher rates until the mortgage closes. But compounding the problem, many customers couldn’t close on their loans because of quarantines, leaving the mortgage lenders with only the cost of the hedge and no off-setting loan.
The huge volatility in mortgage bonds created massive margin calls from the broker-dealers, who wrote the hedges, to their mortgage bankers. Some of these mortgage bankers are now facing margin calls of tens of millions of dollars that could drive them out of business, according to Barry Habib, founder of MBS Highway, a leading industry advisor who was among the first to publicly sound the alarm bell last week.
Hardest hit are independent mortgage bankers who wrote about 55% of the $2.1 trillion mortgages created last year and can have higher leverage. Furthermore, many brokers and hard money lenders who utilize warehouse lines of credit are also facing a cash crunch as the warehouse line is meant to be temporary. With a volatile market and large swings in rates, many of these loans may not have a buyer so loans are basically “stuck” in the warehouse line.
What does this mean for the mortgage market today?
Currently the mortgage market is “barely” functioning. The Federal reserve was forced to act and in March stepped in to buy 32.5 billion in securities from the GSEs. Unfortunately this only solved part of the problem. If a banker had loans and could sell them to the GSE’s they might have taken a hit, but likely not catastrophic. There are still billions hanging around that will be catastrophic for the industry.
Let’s look at two examples. First, on the commercial side, let’s say you were a mortgage banker had made a loan to a class A restaurant in a great ski town market like Vail that was in a great location. The borrowers were A+ borrowers with plenty of assets and strong balance sheets. You funded the loan and put in your warehouse line. To protect yourself, you took out a hedge to protect against swings in rates until you could sell on the secondary market or bulk up with other loans. Then the virus hit, the value of the loan declined substantially. The real estate value is fine, but the ability of the borrowers to pay is questionable. You could sell the loan now for a huge loss or sit with it in your warehouse line if your bank allows to wait out the market; neither of which are good options. On the residential side, a similar story could play out. Let’s say you made a jumbo loan or a non-qualified mortgage (non QM) as the market’s risk appetite has changed so quickly, the value of these loans is questionable at best.
What is happening today happened to me in the last crisis when we funded with lines. Overnight our lines were frozen and we had a major cash flow problem. We were very fortunate to have made it through, but after experiencing the pain from that event, we decided to change the model to fund in cash to insulate us from the downside risk.
What does this mean for the mortgage market long term?
Large scale events have profound consequences on small businesses. We are seeing this throughout the economy as companies like Walmart or Amazon are able to scale up for the crisis and absorb some short-term bumps along the way. On the flip side, many small businesses do not have the balance sheets or cash flow to absorb the losses. For example, if Wendys had to close a location, they would likely be fine as they have thousands of other locations, if a small owner had to close a location, they could be out of business as this is their only location. The same currents are playing out in the mortgage market as banks have the balance sheets and cash flow to hold loans until the market rebounds. The vast majority of mortgage bankers and aggregators do not and will perish as a result of the pandemic. Long term, the mortgage market will emulate the general economy and further consolidate with large Wall street firms along with regional and national banks and eliminate many of the smaller players within the industry. Many independent mortgage brokers will leave the business and larger firms like Quicken, Wells Fargo, Insurance funds, etc… will take much larger market shares.
The federal reserve didn’t intentionally trigger the housing market crash. They had no choice but to lower rates to ensure liquidity for the market. Unfortunately, if one lever is pushed there can be unintended consequences far down the line like the mortgage market.
During good times the mortgage model works great as loans seamlessly flow from origination into the warehouse line and then to a buyer. Unfortunately, when there is uncertainty in the market, this model breaks. Although the cause of the 2008 crisis is different, the result in the mortgage meltdown is eerily similar today.
We are still Lending as we fund in Cash!
I need your help!
Don’t worry, I’m not asking you to wire money to your long-lost cousin that is going to give you a million dollars if you just send them your bank account! I do need your help though, please like and share our articles on linkedin, twitter, facebook, and other social media. I would greatly appreciate it.
Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, Illinois, and Florida. They are recognized in the industry as the leader in hard money lending with no upfront fees or any other games. Learn more about Hard Money Lending through our free Hard Money Guide. To get started on a loan all we need is our simple one page application (no upfront fees or other games).