Unintended Consequences

The Fed’s desire to bring mortgage rates down isn’t just damaging servicing portfolios because of prepayments, it’s also wreaking chaos in Lenders’ ability to hedge their risk. Let’s look at what happens when a borrower locks in their mortgage rate with a Mortgage Lender. Mortgage rates are based on the trading of Mortgage Backed Securities (MBS). As Mortgage Backed Securities rise in price, interest rates improve and move lower. A locked rate on a mortgage is nothing more than a Lender promising to hold an interest rate, for a period of time, or until the transaction closes. The Lender is at risk for any MBS price changes in the marketplace between the time they agreed to grant the lock and the time that the loan closes.

If rates were to rise because MBS prices declined, the Lender would be obligated to buy down the borrower’s mortgage rate to the level they were promised. And since the Lender doesn’t want to be in a position of gambling, they hedge their locked loans by shorting Mortgage Backed Securities. Therefore, should MBS drop in price, causing rates to rise, the Lender’s cost to buy down the borrower’s rate is offset by the Lender’s gains of their short positions in MBS.

Now think about what happens when MBS prices rise or improve, causing mortgage rates to decline. On paper, the Lender should be able to close the mortgage loan at a better price than promised to the borrower, giving the Lender additional profits. However, the Lender’s losses on their short position negate any additional profits from the improvement in MBS pricing. This hedging system works well to deliver the borrower what was promised, while removing market risk from the Lender.

But in an effort to reduce mortgage rates, the Fed has been purchasing an incredible amount of Mortgage Backed Securities, causing their price to rise dramatically and swiftly. This, in turn, causes the Lenders’ hedged short positions of MBS to show huge losses. These losses appear to be offset, on paper, by the potential market gains on the loans that the lender hopes to close in the future. But the Broker Dealer will not wait on the possibility of future loans closing and demands an immediate margin call. The recent amount that these Lenders are paying in margin calls is staggering. They run in the tens of millions of dollars. All this on top of the aforementioned stresses that Lenders are having to endure. So, while the Fed believes they are stimulating lending, their actions are resulting in the exact opposite. The market for Government Loans, Jumbo Loans, and loans that don’t fit ideal parameters, have all but dried up. And many Lenders have no choice but to slow their intake of transactions by throttling mortgage rates higher and by reducing the term that they are willing to guarantee a rate lock.

Furthering the Fed’s unintended consequences was the announcement to cut interest rates on the Fed Funds Rate by 1% to virtually zero. Because the Fed’s communication failed to educate the general public that the Fed Funds Rate is very different than mortgage rates, it prompted borrowers in process to break their locks and try to jump ship to a lower rate. This dramatically increased hedging losses from loans that didn’t end up closing.