Today, Federal Reserve chair Janet Yellen held a press conference, indicating that the Fed would proceed “cautiously” regarding interest rates.
These aren’t mortgage interest rates, but the overnight cost of money. However, what happens to the Fed’s interest rate has repercussions for housing.
The Fed is still deeply engaged in trying to run-proof the banking system. Dodd-Frank gave the Fed essentially unlimited authority to re-regulate banks after the credit bubble blew in 2008, but the Fed has wisely taken its time. (Better to screw down risk one turn at a time than all at once, give banks and markets time to adapt, and take time to evaluate the consequences of each new turn.)
The first steps were obvious:
- Stop with the stupid stuff.
- Raise more capital by selling stock, so that you have more skin in the game and can afford to lose bigger strips of your hide before you need a bailout.
- Set maximum exposures to other institutions.
- Keep a liquidity reserve so you can cover surprises without a fire-sale of other assets, which would undercut assets held by others.
All good.
‘Bank runs,’ deposit insurance and ‘liquidity risk’
In the 1930s, everybody knew what a “bank run” was. Grown-ups lined up around the block, hoping to get in the bank to take their money out before the bank closed. Today known as a “retail run,” this was stopped in the ’30s by deposit insurance — really a government guarantee that your money is safe, and there’s no reason to run to get it.
Beginning quietly in July 2007, the great credit crisis was a “wholesale run” — giant banks running on each other. As calls came for withdrawals, they sold collateral held against loans to raise the cash. Then, the horror of all: in September 2008, the collateral wasn’t worth anything — it was, but with everyone a seller and no one a buyer, who could tell?
That risk has always been known as “liquidity risk.” I hold an IOU; I’m a good borrower and make my payments on time. But if I need to sell the IOU to raise cash, can I liquidate it?
On this issue, the Fed is running into ultimate trouble: If I try hard enough to run-proof the system, there may not be enough credit to run the economy.
ABS-MBS ‘illiquid’ — and jumbos scarce
My Okie parents were fond of country-isms. Don’t throw the baby out with the bathwater (who throws out bathwater?). Don’t bother to close the barn door when the critters are already gone.
CoreLogic this week gave the first of two good examples.
During the inflation of the credit bubble, really bad mortgage ideas were securitized into asset-backed securities — “ABS” in the Fed’s accounting to this day. At pre-bubble beginning, ABS-MBS was $400 billion or so; at bubble peak, ABS-MBS hit $2.2 trillion, today written back down to $600 billion, most bad stuff foreclosed out.
The good stuff, very much deserving of securitization: jumbos and other high-quality but non-Fannie loans.
CoreLogic said that in 2007, there were 125 outfits collecting loans and issuing securities. Half of those deserved to go out of business, but as of last year, only 10 were left, and their volume undetectable.
Why? The Fed says those securities are “illiquid” and require many times more capital to support them on a bank balance sheet than a Fannie MBS. Hence, today’s very cramped supply of jumbos. VERY.
And with Fannie limits capped by Congress, missing jumbos will become more painful.
Loan servicing contracts also not liquid; non-bank entities joining game
The second example: “loan servicing.” As many have figured out, when a new loan is created, we also create a contractual right to service each loan, which has a separate market value.
To “service:” collect the payments, manage tax and insurance escrows and stand ready to foreclose if necessary. Selling the servicing right is the main way that mortgage lenders get paid (the loan goes off to securitization with very little compensation to the originating company).
Big banks, especially Wells, vacuumed up the servicing rights and made good money “cross-selling” other products to the borrowers whose loans they serviced — they didn’t own the loans, but did service them.
These servicing rights have substantial market value, about 1.75 percent of the loan amount, because the actual owner of the loans pays a fat annual fee to have the loans serviced.
But loan servicing contracts are not liquid. (Here we go again.) They suddenly became expensive for a big bank to hold.
Big banks have been my primary competitor for the last 30 years. No love lost between me and thee. However, now they are forced to unload servicing contracts — even Wells — and the buyers are non-bank corporate entities of questionable competence. These non-banks will never have to be bailed out, never cause or contribute to a run, but they give much weaker service than the big banks.
And it’s not over. The Fed will continue its run-proofing until they (and we) discover the limits — which may be that an occasional bailout is not so bad, especially considering that we-the-taxpayer do the bailing but ourselves are bailed.
Lou Barnes is a mortgage broker based in Boulder, Colorado. He can be reached at lbarnes@pmglending.com.
