An Explanation

As I re-read my last post (on the Annaly secondary), it occurred to me that people may be wondering how the current mortgage yield can be as low as 3.60% while the current mortgage rate is so much higher at 4.57%.

There are three things at work that make up the difference.  First is that Freddie and Fannie (and Ginnie) charge guarantee fees.  Second is servicing costs.  Third is up-front costs the lender/originator takes on.

Until the meltdown, the guarantee was a very good business, taking a few basis points from every mortgage and paying the principal losses on those that fail.  Since Fannie and Freddie were mandated to limit their guarantees to loans with 20% down payments (and mortgage insurance to cover shortfall on the 10% down loans), the losses were not too bad, and foreclosures were pretty rare.

Prior to the collapse of housing prices, most borrowers who couldn’t afford the monthly payment due to personal circumstances were able to sell their homes and recoup some of their down payment, so the first mortgage loans didn’t take a loss.

A nationwide decline (of any size) had never been seen in single-family detached housing, so the statistics from which the fees were calculated basically could not have covered the event we have now experienced.

Today, the Agencies are playing “catch up” on their guarantee fees for new mortgages.  These fees have been raised several times over the past two years, and there is still some doubt that they are charging enough.  No doubt, at some point when the housing market finishes bottoming, the new borrowers will be paying “too much” for the guarantee for a few years, because the recovery in house prices and conservative loan underwriting will combine to make losses from those borrowers almost nonexistent.

The second element that takes some of the cash flow is servicing.  That part of the picture had been costing less and less as automation and economies of scale took hold.

The mortgage servicers were basically able to let their computers handle everything, except for the human staffing needed to handle payoff amounts and the like, along with the occasional call from a borrower.  Still, each member of the staff of an efficient operation could literally handle thousands of loans, if not tens of thousands.

I recall hearing the head of Countrywide’s servicing operation tell me that they had gotten the cost of servicing prime loans down to 6 basis points per annum in 2006 or 2007.

That all changed when the flood of problems hit the housing market.  People were being encouraged to call their servicer by Public Service Announcements, and literally a quarter or more of all the loans outstanding in America had issues that warranted questions, if not a series of complicated calls.

Certainly going through a loan modification, workout, short sale or foreclosure takes many times the human hours that a simple loan payoff takes.  On top of that, every national servicer faces a patchwork of laws that vary by state and even city.  They have to constantly update their compliance rules (usually in “intelligent” computer programs), and maintain the systems so they don’t fall afoul of some county, state or city laws and get hit with enormous legal liabilities.  Unless and until the Feds institute a truly national standard that replaces local standards, any rules at the Federal level will only add to the burden of staying compliant.

Even though today’s new loans may not turn out to be as expensive to service as the existing loan portfolio, any company will charge new customers more once it finds out that the old customers are money-losers because of rising costs.

You may recall from the HousingWire article that the average mortgage from the Freddie Mac weekly survey includes 0.7% of origination points paid by the borrower.  That doesn’t cover today’s up-front costs to originate a loan.

Loan officers, staff appraisal reviewers, computer systems professionals, and “sales” professionals who deal with thousands of small mortgage bankers all are part of the cost of originating a loan.

Today, a borrower is likely to be nervous enough to apply with four or five lenders, rather than one or two as they did in the past.  For that reason, while half the loan offers lenders made used to be completed, the hit rate is probably less than 25% today.  That means the loan officers will have to be paid for four rate and term quotes for every one that turns into a loan.

Additionally, the new rules require independent third party appraisals to avoid the conflict of interest that helped exacerbate the bubble lending.  That’s another few hundred dollars of additional expense for every loan.

Taken together, these costs are well over 1%, and more likely around 2% of the loans that actually close.

How do they make up for the shortfall from the 0.7% that the average borrower is paying at the closing table?

The way to do that is to carve off an additional stream of interest payments — maybe 25 or more basis points per annum, and holding or selling that “strip” of interest payments.  In the business we call that “excess servicing,”, and it gets capitalized if held, or monetized if sold.

So there you have it.  The borrower pays nearly 100 basis points more on their loan than the investor gets in yield.

When you hear that the average mortgage rate is 4.57% and that the repo rate is 0.57%, there is nothing even close to the 400 basis points of gross profit you might think there is.

I hope this helps you make sense of the seemingly wide gap between the mortgage rate you hear in Freddie’s Thursday reports, and the yield the amREITs report in their quarterly earnings calls.

Now, having written over half of this for a second time (and not the same, of course), I’m going to hope that the computer gods have taken all the sacrifices they need, and the post appears on the blog.



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