Back in August, before Donald Trump crushed Kamala Harris in the presidential election and the Fed decided to slow the pace of interest rate cuts, lenders were starting to see a surge in loan production. This rising tide of activity carried over into stocks and bonds. The results are visible in hyperbolic headlines of “record earnings” in Q4 2024 for banks.
But if we normalize the uptick in revenue for new lending, underwriting commissions and principal transactions, banks are continuing to see funding costs rise faster than asset returns. The net margin of Bank of America, for example, was flat at 1.97% versus 2023, in part because of the huge portfolio of low-coupon mortgage securities owned by the $2 trillion asset bank. The whole US banking industry is still making less than 1% return on assets.
The Mortgage Bankers Association reported a 30% increase in lending volumes in Q3 2024 to $1.3 trillion vs Q1 of last year, when the industry did about $1 trillion in new loans. Bank America, for example, did $6.6 billion in new first liens and $2.3 billion in HELOCs in Q4, but the bank’s portfolio actually declined due to net runoff. Risk-free collateral is scarce and many banks are buying loans and MBS to maintain asset levels.
“Independent mortgage banks and mortgage subsidiaries of banks reported a pre-tax net profit of $701 on each loan they originated in the third quarter of 2024,” the MBA said. “[That’s] an increase from the reported net profit of $693 per loan in the second quarter of 2024.
Better managed firms are able to earn a profit at these levels, but utilization levels in the industry are still depressed compared to 2022. With many IMBs selling new conventional production into 6.5% coupons for February, the outlook is for lower volumes, suggesting that the MBA and others may be dropping production estimates again for 2025.
With the Fed continuing to run off its balance sheet, both in terms of securities investments and reverse repurchase agreements, which are essentially T-bills issued by the Fed, demand for risk-free collateral is rising even as production volumes fall. The market demand for existing MBS to be restructured as collateralized mortgage obligations is brisk.
“Over the past two weeks, primary rates have jumped back up to the 7.00%-7.25% range at many lenders, which has effectively pushed 98% of borrowers outside of the 50bp refi elbow,” writes Scott Buchta at Brean.
“While the market has been focused primarily on the drop in the refi indices, we believe that this recent move higher in rates has also had a huge impact on the ‘lock-in’ effect as well. Moving primary rates up from 6.00% to 7.00% has pushed 35% of borrowers back into the 300bp “lock-in’ window,” he continues.
Higher rates in 2025 are likely going to drive further consolidation in the industry, particularly among IMBs. Firms such as Bayview, Freedom, Mr. Cooper and Rithm Capital have built substantial portfolios of mortgage servicing rights. These walled silos of mortgages mean less and less of the mortgage market is available for refinance, in the event that interest rates eventually fall.
Given the limited volumes of mostly expensive purchase loans available for lenders, the last thing anybody wants to discuss is privatization of the GSEs, Fannie Mae and Freddie Mac. As we noted in an earlier blog post in The Institutional Risk Analyst, releasing the GSEs without new legislation basically means that conventional loans will become a private label and bank loan market. That is a disaster.
Last week, President Donald Trump nominated PulteGroup scion Bill Pulte to lead the Federal Housing Finance Agency. Wells Fargo strategists Mario Ichaso and Jonathan Carroll called Pulte “far from a policy wonk or free-market ideologue, signaling low importance” for privatizing Fannie and Freddie, Bloomberg reports.
While the chances of an actual release from conservatorship seem to be falling, the hedge funds pursuing the “GSE trade” are reported to be looking at profits of over 1,000% on the two best performing financial stocks in the US over the past 18 months. But the reality is that without Treasury backing for conventional MBS, the liquidity in the conventional loan market will disappear.
Even if releasing the GSEs is not likely to be a top priority for the Trump Administration, there is plenty for the new FHFA Director to do. Abandoning the ill-advised progressive idea of using two credit scores to underwrite a loan is probably a top priority. Let the lenders, and not the providers of credit files and scores like Experian and FICO, decide which score to use. That’s competition.
Encouraging new capital to enter the MSR market should be another priority for Bill Pulte, both in terms of conventionals and also government loans. Pulte should take the lead on coming up with a single capital rule for all IMBs covering the GSEs and Ginnie Mae. Also, as the bank regulators eventually return to Basel III, FHFA should push for a lower capital risk weight for MSRs for banks and IMBs.
As the Trump Administration reviews all of the federal financial regulatory agencies, banks and IMBs have a golden opportunity to reset the erroneous view of risk in the mortgage space. Hopefully Bill Pulte will use his knowledge of the homebuilding sector to fix some serious mistakes.
First, IMBs are not a systemic risk to the US economy in a high-interest rate environment. The growth of the top-ten IMBs in terms of MSR portfolios and profitability since the Fed began increasing interest rates refutes the alarmist view of Treasury Secretary Janet Yellen and the Financial Stability Oversight Council that IMBs are a problem. Mortgage firms are islands of liquidity that are, of note, increasingly using the bond market for capital finance.
Second, the notion that MSRs are a risk to IMBs or banks is flat wrong. Why is JPMorgan the largest residential mortgage servicer in the US? Because the profits and cash flows generated by that $1 trillion MSR portfolio of large prime loans are very attractive. But this begs another question: Why do Basel III and the FHFA and Ginnie Mae capital rules assign a 250% capital risk weight to MSRs?
Contrary to the Basel framework, there is no credit risk in an MSR. The chief risk is operational. As IMBs have improved their systems and controls since 2008, the benefit of MSRs in terms of cash flows is clearly demonstrated. Bill Pulte and the new Fed vice chairman for bank supervision should break with the Europeans and lowering the punitive risk weight on MSRs to say 100%? Same as corporate credit exposures. That works.
If, as seems likely, mortgage rates are going to remain higher for longer than many expected even a few months ago, then we need to make some rational adjustments in how federal regulators manage risk. Fewer, larger IMBs with bigger MSR portfolios seem to be the most likely outcome in 2025 and beyond. Developing rational capital rules for IMBs that encourage these firms to build assets and internal sources of cash flow seems like a good idea, especially before that housing market reset in 2028.
