A Deeper Look: GSEs Lend a Hand to Independent Mortgage Bankers
What’s not clear from yesterday’s announcement is whether or not Fannie and Freddie are acting strategically or at the behest of Treasury or FHFA. Strategically this makes a lot of sense since the GSE’s have long supported a diverse market of loan sellers: credit unions, community banks, no profits, etc. – to avoid the operational risks and margin compression that come from fewer, larger clients. Try as I might, I struggle with what public policy motives or purpose is served by throwing independent mortgage bankers a life line. The best I can come up with is the motive to ensure more capacity and competition, and to increase the ability to respond to market demands.
The GSEs have long had a love/hate relationship with large lenders. Love them for the volume commitments and deliveries – hate them when it comes time to negotiate on programs, variances, and guarantee fees. For example, how do you think Fannie and Freddie got into Alt-A and Subprime in the first place? Why weren’t the risk premiums in like with the true risk of the transaction? Smaller lenders on the other hand do not negotiate as vigorously as large lenders – they’re usually happy just to get someone from either GSE on the phone!
The problems the GSEs are attempting to solve with this initiative are not unique, they are more complex and protracted than ever before. Historically, the end of every mortgage cycle claims wholesale lenders first, and then correspondent lenders. This event is usually driven by large lenders that were the suppliers of financial products squeezing out middle men to meet production demands and salvage their shrinking margins. Death does not come as a result of starvation, i.e. eliminating the supply. Rather, death comes as a result of competitive annihilation by large lenders (suppliers) that ratchet up their pricing to wholesale/correspondent channels that renders them uncompetitive compared to the retail channels of large lenders. In today’s market the correction is of epic proportions and is being accelerated by 1) the onerous capital requirements put on warehouse lenders and their customers, mortgage bankers, and 2) the lack of a competitive and robust market for MSRs (mortgage servicing rights).
Since the GSEs only buy loans and not servicing rights, a healthy MSR market is required for lenders to deliver to the GSEs and for the GSEs to remain competitive business partner s for lenders. Without a buyer for MSRs, bankers need to service the loans and tie their economic returns to the servicing strip (make money over time), which requires a very well capitalized and diversified business model to run and be competitively priced. The banker’s second option is to sell both the servicing rights and the whole loan to an “aggregator,” i.e. large lender. The aggregators buy up as much production as they can from third parties originators (TPOs) and then disaggregate the pools and sell them to the GSEs or FHA/GNMA.
In the end, the GSEs need to ensure a large diverse market for originations, and they need to ensure a liquid and competitive market for MSRs. MSRs are critical to the GSEs because most of the economic value and premium associated with selling a mortgage rests with the MSR. For example, a GSE might pay a lender 100bps for a loan, but the MSR could be worth 175bps to a servicing buyer. Therefore, most of the price competitiveness of GSE’s “bid” is driven by a market it doesn’t control. On the other hand, aggregators can buy the servicing rights and the loan at the same time, capitalize the “expected” value of the servicing rights (usually far higher than market price) and sell just the loan to a GSE for a premium well north of what the independent banker would get.
An important precedent in all of this comes in the form of data integrity checks applied before a loan is closed and sold. Beyond the benefits of quality, which are substantial, comes the often unintended benefits of risk management initiatives – efficiency. The efficiencies from standardizing workflows, automating processing, and electronic ordering and auditing of settlement services are substantial.
The GSEs appear to be attempting to prop up the origination side of the equation with this announcement. They are also working hard to solve the other half of the equation – competitive and liquid market for MSRs. Stay tuned. The accountants and business people have some tricks up their sleeves and aim to fix that problem in the near future.
At the end of the day, the GSEs are incentivized to create market conditions that preserve their negotiating power and margins – and that doesn’t happen with less clients – it happens with a diverse, robust market of loan sellers.
Requiring pre-funding quality assurance checks is a reasonable short term solution to weak representations and unredeemable warranties made by too many lenders. I think this is a positive step on a number of fronts.