When we all look at surging forward projections for home price appreciation (HPA) in 2013 and 2014, the change in the Fed’s monetary policy posture and the related impact on job creation both seem to be important factors. Michelle Meyer at Bank America, for example, sees household formation topping 1 million annually for the next several years, with new housing starts and construction related jobs following close behind.
It is interesting to note that rising expectations for HPA are coming at a time when the Fed is shifting monetary policy toward a more restrictive posture after years of zero interest rates. More, Buy Side investors seem to be rotating out of bonds and into equity in growing numbers. What is the prospective home buyer, consumer advocate or economist to do?
The New York Times featured a comment on January 19th, “Rushing Into a Mortgage Can Prove Costly,” which talked about consumers being inattentive to the up-front fees charged by lenders in getting a home mortgage. http://www.nytimes.com/2013/01/19/your-money/mortgages/rushing-into-a-mortgage-can-be-costly.html?pagewanted=all
The article tells how someone named Wilbur is faced with between $6,900 and $9,700 in up-front fees on a $300,000 mortgage. And the point made by the NYT author, Paul Sullivan, is well-taken. But nowhere in the article does it mention the yield-spread premium on the mortgage, which is an amount of money that the bank will earn selling the loan. This amount could be equal to the up-front fees on the loan. Indeed, the spread could be used by the borrower to offset all of the up-front costs – if you are smart enough to ask.
Now reading the paragraph above, you probably feel the way I did years ago when my teachers reminded me about the blessings of a premium market in residential mortgage backed securities. Most home owners are completely unaware that the lender earns a hefty gain on sale when the mortgage is sold into a private securitization or, more likely, to an end investor. This money belongs to the borrower in the same way that the proceeds of a corporate bond issuance, less fees, is the property of the obligor.
If a new loan is going into a private mortgage security and similar bonds are trading at, say, a five point premium above par, then a good rule of thumb is that the yield spread premium is at least half of the market spread. Loans going into the agency market – FHA, GNMA, FNMA command much smaller spreads in the 25bp to half point range.
But if you are getting, say, a $5 million jumbo mortgage to buy a home in Manhattan, tony CT or CA, then odds are pretty good that the yield spread is measured in points. And the end investor who will ultimately take that loan will split the up-front premium with the originating bank.
In a comment by Bloomberg News, “Biggest Banks Back to Black in Fed-Fueled Recovery: Mortgages,” Heather Perlberg and Dakin Campbell talk about how the banks have used the Fed’s purchase of RMBS and the hefty market premiums that result, to enhance earnings.
But sadly, few consumer advocates understand that the by-product of the Fed’s QE is to hand the biggest lenders supra-normal spreads on all mortgage originations. While originations for the agency market are a volume game – figure half a point premium max, the non-conforming loan market is particularly rich since all collateral ultimate prices off of the agency curve.
The Bloomberg News article notes, for example, that Wells Fargo booked $2.8 billion in gains on new originations in Q4 2012 and almost $12 billion in mortgage banking income for the full year. http://www.bloomberg.com/news/2013-01-22/biggest-banks-back-to-black-in-fed-fueled-recovery-mortgages.html
If you are buying a home, one question you must ask the lender before the close is to quote the yield spread premium for the transaction. If you are considering a non-conforming or jumbo loan, the premium on the loan could be several points – cash that can offset some or all of your upfront closing costs. But you must ask. Neither the lender, nor the broker nor the end-investor will volunteer to share this windfall with the borrower.
And once the FOMC stops buying RMBS and allows premiums on agency securities to gradually disappear, a good bit of the incentive for banks to lend will also fade from the mortgage market. And with this change in mortgage market dynamics, we will see a deceleration of large bank revenues and earnings.
Thus the real question is this: Can a bull market in US equities exist, side-by-side, with an economic rebound and a bullish outlook on HPA? Especially if a change in zero interest rates maintained by the Fed is the main driver in the bullish equity rotation out of bonds?
A: In a word: “No.”