Mortgage Banking. October By Robert Stowe England

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1 Higher rates have led to lower origination volumes and a shift from refis to the purchase-money market. For Wells Fargo, the shift is boosting portfolio lending. Mortgage Banking October 2013 By Robert Stowe England A surge in mortgage rates since June is reshaping the contours of the residential origination market. The strength in demand for home-purchase mortgages is likely to determine the extent to which mortgage lenders can replace significant volume lost from the downturn in refinancing. At Des Moines, Iowa-based Wells Fargo Home Mortgage, there is a degree of optimism about the ability of a recovery in home sales to make up for a big chunk of the lost demand from refinancing. 1 / 18

2 With interest rates being higher, you will see a falloff in refinances. But the real estate market has really found its direction. It s stabilized tremendously, says Brad Blackwell, executive vice president and portfolio business manager with Wells Fargo Home Mortgage. We expect to see a strong real estate market in the near future. So, there s a lot of opportunity to service customers in that area, he adds. The strength of the housing market is broad-based, according to Blackwell. It s nice to see that much of the country has emerged from the funk it s been in for four or five years, he says. We re seeing particular strength in coastal markets. So, the California coastal markets are very, very strong. The problems [that do exist] are not what we ve seen a few years ago with the lack of buyers. Instead, there s a lack of inventory in many of those markets, he says. 2 / 18

3 Even Florida, which had been very, very challenged, is starting to show strength. And the same is true with the previously challenged markets of Arizona and Nevada, he adds. A second-quarter uptick in purchase volume In the second quarter, Wells Fargo originated $112 billion in residential mortgages, with 56 percent of those loans taken out to refinance existing mortgages and 44 percent for home purchases. By comparison, in the first quarter of 2013 home-purchase originations represented only 31 percent of total originations, while refis represented 69 percent. Origination data for the second quarter, however, does not capture the extent of the ongoing shift, because interest rates began to rise toward the end of the second quarter. The impact on origination volumes is not likely to be seen fully until the first quarter of 2014, acc ording to Guy Cecala, chief executive officer and publisher of Inside Mortgage Finance, Bethesda, Maryland. 3 / 18

4 Inside Mortgage Finance estimates that total originations for 2013, despite high refi volumes in the first half of the year, will fall 13 percent from the prior year. Overall volumes this year are likely to total $1.65 trillion--down from $1.9 trillion in If the housing recovery continues, home-purchase mortgages will keep growing, but they are not in a position to match what we saw in terms of refis, Cecala says. A powerful retail presence The management team at Wells Fargo sees its retail origination capacity as one of its fundamental strengths. We have invested in thousands and thousands of local home mortgage consultants that are in every market in the United States, for the most part, says Franklin Codel, executive vice president and head of mortgage production at Wells Fargo Home Mortgage. And the cost it takes to have the bricks and mortar, to have the local presence, the training, the tools that come with that, is primarily geared toward reaching out into the communities and partnering with Realtors and builders to seek and work with purchase-money customers, he adds. That s not to say that same consultants don t do refinance, which they do. 4 / 18

5 The company s investment in meeting the needs of the home-purchase market is part of an enterprisewide focus on two consumer market products--checking accounts and mortgages--as part of its long-term strategy to be a premier consumer bank, according to Codel. The idea was that if the bank did an outstanding job in meeting customer needs with those two products, we d have a fair shot at winning the rest of their business that goes with it--debit cards, savings accounts, brokerage accounts, etc., says Codel. Home-owning households represent a wonderful source of potential relationships for the rest of Wells Fargo, as well as for the mortgage lender, he adds. Correspondent channel The correspondent channel, even before the shift, was strong in home-purchase originations, according to Eric Stoddard, executive vice president and national manager, correspondent lending at Wells Fargo. 5 / 18

6 Correspondent lenders have tended to be very focused on the purchase-money market. Most are new to the servicing business or they don t service at all, he says. While they certainly participated in the refi business, particularly some of the [Home Affordable Refinance Program, or HARP], they stayed focused primarily by and large on purchase money opportunities, he adds. They have been quite adept at originating FHA [Federal Housing Administration] loans. Thus, the falloff in originations for Wells correspondent channel has not been as dramatic as it has for some of the large servicers, who were more focused on refis, according to Stoddard. Mortgage bankers and other independent non-financials, large and small, represent a growing share of the correspondent origination business for Wells Fargo. The market has been very good and very robust, says Stoddard. The last couple of years have seen considerable profitability in the business, and many of our clients and customers have grown appreciably. The origination capacity of correspondents has improved with an increase in the availability of warehousing lending, according to Stoddard. 6 / 18

7 There was a time when warehouse lending was very, very constrained. That has opened up considerably, he says. Stoddard adds that Wells Fargo has made a strong commitment to warehouse lending, which he says is the lifeblood of the mortgage banking industry. Portfolio lending Demand for home-purchase loans is likely to boost portfolio lending at Wells Fargo and at other lenders. On the non-conforming side, which Wells Fargo is putting on its balance sheet, our originations have skewed more toward the purchase segment, says Blackwell. This continues a pattern during the refinance boom, when Wells focused on portfolio lending for home purchases. For this reason, originations for portfolio lending have not declined as much as they have for refinance lending, he adds. Confounding the industry, interest rates borrowers have to pay on mortgages purchased by Fannie Mae and Freddie Mac are higher than the rates being charged on jumbo loans. 7 / 18

8 We re in an interesting time right now, where non-conforming interest rates are lower than conforming interest rates, Blackwell adds. I haven t seen a time like this in my 30-year career in the business. Mortgage interest rates have historically moved in tandem, with conforming rates lower than jumbo non-conforming rates. While the spread might widen or narrow jumbo rates were always higher. Now, however, factors driving the underlying costs of the two streams of pricing have changed and reversed the relationship between jumbos and conforming loans. The rates on conforming mortgages are tied to pricing trends on Treasury bonds, Cecala points out. Treasuries of various durations began to rise in June after Federal Reserve Board Chairman Ben Bernanke indicated in late May that the Fed would consider curtailing its monthly $85 billion in purchases of Treasuries and mortgage-backed securities (MBS) conducted under its quantitative easing program. The financial markets immediately began to push up interest rates. Both agency mortgage rates and non-conforming jumbo mortgage rates rose in response to expectations that the Fed would taper its bond purchases. However, the agency mortgage rates rose more than the non-conforming jumbo rates, leaving the non-conforming mortgage interest rates lower than the agency mortgage interest rates, according to Cecala. The pricing of mortgages by portfolio lenders, who are the funders of the vast majority of 8 / 18

9 non-conforming loans, is based on a different set of cost factors than the conforming market. For one thing, portfolio mortgages are funded from deposits. Both large and small portfolio lenders are paying only 0.3 percent to 0.5 percent for deposits, according to Cecala. And those costs have not risen. There s a lot of margin to play with and make money on it, Cecala explains. With jumbo loans at 4.5 percent in mid-september, mortgage lenders could easily push those rates down even further because of their low cost of funding, he contends. A number of factors have come together to make it possible for Wells Fargo to expand its portfolio lending. The first one is that Wells Fargo and most major financial institutions have a lot of excess deposits that we re interested in lending out. So, there s a tremendous amount of liquidity in the marketplace, Blackwell says. And as market interest rates have risen in the bond markets, our internal cost of funds have hardly moved, he adds. So, we re able to offer a very attractive rate and we have a lot of appetite for loans we would put on our balance sheet. (sh) Higher guarantee fees raise conforming rates above jumbos 9 / 18

10 Meanwhile, higher guarantee fees charged by Fannie Mae and Freddie Mac have raised the cost of funding conforming loans. You see quite a bit of increase in G-fees [guarantee fees] on loans that the agencies are buying. That s driven up Fannie Mae and Freddie Mac pricing quite a bit over the course of the last couple of years. So, jumbo pricing relative to agency pricing is better as a result of that, says Blackwell. As of mid-september, interest rates on non-conforming 30-year fixed-rate jumbo loans were 25 basis points lower than the rates for conforming loans originated for sale to Fannie and Freddie, according to Blackwell. There s been a gradual increase in guarantee fees at Fannie and Freddie over the last few years. The Federal Housing Finance Agency (FHFA), the conservator and regulator for the government-sponsored enterprises (GSEs), has been leaning on them to raise the fees, says Cecala. The higher guarantee fees are expected to reduce the government-related share of originations from the very high share of the market they have controlled for several years. During the second quarter of 2013, for example, the government share of the market--fannie, Freddie, FHA, Department of Veterans Affairs (VA) and the U.S. Department of Agriculture--stood at 89 percent, according to Inside Mortgage Finance. 10 / 18

11 GSE guarantee fees have gone from an average of 25 basis points to an average of 50 basis points, says Cecala. Those fees, in turn, have pushed up the interest rate on the conforming 30-year fixed-rate mortgage (FRM). Better portfolio ARM rates There is also a pricing advantage for jumbo and other non-agency adjustable-rate mortgages (ARMs). Our ARM pricing is quite a bit lower, says Blackwell-- as much as ¾ of a percent lower than the agency ARMs. The pricing advantage for portfolio ARMs relative to agency ARMs is also based on a shift in the underlying funding costs for each of these two segments of the market. The interest rates offered on agency ARMs are tied to pricing in the secondary market, while portfolio ARMs are priced to internal hurdles, explains Greg LaVallee, mortgage trading manager at Wells Fargo. The recent volatility in the secondary markets has investors shying away from agency ARMs, so the pricing of those loans reflects that worsening trend, he explains. The portfolio is not as sensitive to the day-to-day market volatility, therefore the pricing on the portfolio ARM loans has remained the same or improved, he adds. 11 / 18

12 Higher interest rates have often led more borrowers to choose adjustable-rate loans over fixed-rate loans. But so far that has not happened at Wells Fargo, according to Blackwell. Consumers are largely gravitating to the 30-year fixed-rate product and the 15-year fixed-rate product, Blackwell says. Typically the jumbo borrowers are very sophisticated and oftentimes more willing to take risk. So, you would expect to see more adjustable-rate mortgages, he says. But we haven t seen that yet. If they do choose an ARM, jumbo borrowers more like to choose a 7/1 and 10/1 ARM rather than a 5/1 ARM, he adds. Wells Fargo and other mortgage lenders also see potential gains in portfolio lending in yet another segment of the mortgage market. That s the segment with mortgages with principal balances higher than $417,000 but below $625,500--the so-called conforming jumbo market. For most real estate markets in the United States, the conforming loan limit is $417,000. However, in high-cost markets, such as those in Los Angeles, San Francisco and New York, the limit stands at $625,500. Soon there will be yet another reason for portfolio lenders to target this segment of the market. By late November, Fannie and Freddie are expected to announce new loan limits for A key justification for expected lower limits is that home prices are a lot lower than they were when the loan limit was raised to $417,000 for single-family homes in / 18

13 The Wall Street Journal reported September 8 that the FHFA plans lower loan limits, citing a statement by the agency that gradual reduction in loan limits is an appropriate and effective approach to reducing taxpayers' mortgage-risk exposure and expanding the role of private capital in mortgage finance. If the loan limit comes back to the $400,000 range, you re going to see additional growth in the jumbo mortgage market and probably less inclination for lenders to have to cut their rate because they are going to get somewhat of an immediate windfall by just the lowering of that limit, Cecala says. Loan limits in high-cost markets are also expected to fall. After Jan. 1, 2014, lenders targeting what was once the conforming jumbo segment of the market will be able to be both aggressive in pricing and still be very profitable, according to Cecala. Ever since the emergency high loan limits went into place [in 2009], lenders have routinely been pricing the loans between $417,000 and $625,500 a quarter of a percent higher than on the others, Cecala says. Some portfolio lenders, like Wells Fargo, are not waiting for loan limits to fall. They are already targeting the conforming jumbo sector. We are competing in that space. So, a lot of consumers that might have taken a high-balance 13 / 18

14 conforming loan are actually getting a non-conforming mortgage from Wells Fargo, says Blackwell. Wells Fargo is not making non-conforming loans below $417,000, according to Blackwell. More competitive underwriting and lower down payments While borrowers have complained about the very strict underwriting standards that have prevailed in recent years, lenders are now beginning to adjust their underwriting guidelines to be more competitive. You re seeing more flexibility and somewhat [of a] rolling back of underwriting overlays that have dominated the landscape... for the past three to four years, Cecala says. One of the ways we ve seen increased competitiveness is an increased willingness of lenders, including Wells Fargo, to offer lower-down-payment mortgages, according to Cecala. 14 / 18

15 Right after the credit crisis, everyone was sort of defaulting to 20 percent down-payment mortgages because they knew they were lower-risk. They didn t have to hassle with mortgage insurance, and Fannie and Freddie pretty much preferred those, he says. As the mortgage insurance industry has come back, as the industry has become more comfortable with the underwriting of new Fannie and Freddie loans, they ve been willing to say, OK, we ll do 10-percent-down loans, says Cecala. He notes that in late August, Fannie Mae announced it was not going to do 3 percent down-payment mortgages anymore. And that wasn t because they were doing many of them. It was the fact that they were worried that lenders, now that they were interested in doing lower-down-payment loans, would start it. So, they just nipped that in the bud and said, OK, we re not going to do 3 percent, we re going to have a minimum of 5 percent down, he says. We re also seeing [efforts to be more competitive through changes in underwriting standards] in the FHA market, says Cecala, who reports that one major mortgage lender--not Wells Fargo--has begun to offer FHA-insured mortgages to borrowers with credit scores as low as 580, with a 10 percent down payment. Nobody before would touch that group of borrowers even though you could technically qualify them for an FHA mortgage [under FHA s underwriting rules], says Cecala. Wells has separate underwriting group for portfolio loans 15 / 18

16 Wells Fargo has set up a completely separate underwriting group to manage its portfolio originations, according to Blackwell. We re using a different set of guidelines, he says. We re teaching our underwriters to use judgment on the quality of loans that we are putting in portfolio as opposed to the much more prescriptive approaches that you would use when you re selling a mortgage, he explains. We think that provides us with a competitive advantage and a nimbleness in being able to serve customers that might not otherwise be served by a more rigid standard. In some markets, Wells Fargo is offering jumbo mortgages with less than a 20 percent down payment. We re gaining more confidence in the strength of the real estate market. One example of that is that we recently this summer rolled out an 85 percent loan-to-value [LTV ratio] jumbo loan, says Blackwell. We re more confident that real estate values have firmed up, and we re willing to go a little bit higher on loan-to-value than we had been through much of the recession. 16 / 18

17 The separate underwriting group is dispersed across the nation, with three locations in California; one in Minneapolis; one in Chicago; one in Charlotte, North Carolina; and one in Des Moines. These underwriters do not get involved with agency and non-portfolio loans, so they do not have to switch back and forth from one set of guidelines to another, Blackwell explains. I want to stress that these are very high-quality originations, says Blackwell. But a lot of the complex financials of our customers mean they don t fit into the traditional boxes with the traditional approach, he says. So, we ve trained and hired very experienced underwriters and then trained them to be able to understand those customers finances. Mortgage executives at Wells Fargo say they are well positioned to maintain strong origination volumes despite rising interest rates. They plan to continue to innovate to meet the needs of borrowers in an improved real estate purchase market. It s good to see that the economy is improving and most of the country is out of the doldrums, says Blackwell. MB Robert Stowe England is a freelance writer based in Milton, Delaware, and author of Black Box 17 / 18

18 Casino: How Wall Street s Risky Shadow Banking Crashed Global Finance, published by Praeger and available at Amazon.com. He can be reached at rengland@us.net. 18 / 18