It's fairly intuitive that lending money to rich people would be a better business than lending money to poor people.1 They have more money, for one thing, which makes it more likely that they'll be able to pay you back. Their collateral tends to be better too. Administrative costs are lower - your loans are in round lots and so forth. Also they're more likely to want to hire someone to, like, manage their kids' trust funds, and if they like the borrowing experience you provide maybe they'll look into your trust-fund management services. Cross-selling, it's a thing.
So you'd naïvely expect the rich to pay lower rates on their mortgages than the less rich and now, briefly, you'd be right. Er, right-ish. From a fascinating Bloomberg article today:
Wells Fargo & Co. and JPMorgan Chase & Co. lead banks that are offering jumbo mortgages, those too big for government programs, at rates at or below taxpayer-backed loans. On average, the extra cost of 30-year fixed jumbo loans reached a six-year low of 0.16 percentage point last month, according to data provider HSH.com. ... While rates for conventional mortgages surged last month by the most in two decades, financing costs for million-dollar homes are becoming a relative bargain. Deposit-rich banks needing to make loans are suppressing rates to compete for wealthier customers as home prices soar in expensive areas from Manhattan to San Francisco.
Of course normally jumbo (> $417-$730K, depending) mortgages have higher rates than conforming loans for the obvious reason that:
- somebody needs to take the credit risk on jumbo loans - either private jumbo-RMBS investors or (mostly, these days) the banks themselves, while
- Fannie/Freddie/the U.S. government will happily take the credit risk of a conforming loan off your hands in exchange for a small guarantee fee.
If your naïve view was that lending lots of money to rich people to buy fancy houses should be a better business than lending small chunks of money to less rich people to buy less fancy houses,2 then you might think those guarantees are wildly underpriced, and you might describe this state of affairs as "the government subsidizes conforming mortgages through Fannie and Freddie, but does not subsidize jumbo mortgages." And that's what everyone thinks. And now it subsidizes them less:
The gap between rates on traditional and jumbo loans has also narrowed after Fannie Mae and Freddie Mac increased how much they charge to insure bonds, according to Bank of the West’s Mayfield. Their regulator has been seeking to make private capital more competitive after taxpayers were forced to bail out the government-chartered companies in 2008. ... Fannie Mae charged 54.4 basis points for its new guarantees on single-family debt in the first quarter, up from 28.9 a year earlier, according to the Washington-based company.
That sounds a little like "the mortgage market, as mediated by Fannie/Freddie guarantee fees, is becoming more rational and market-driven and less blindly subsidized." But note that "also." The other big reason for the narrowing gap, per Bloomberg, is this:
Bigger loans are getting relatively cheaper because they’re mostly put on bank balance sheets instead of packaged into securities that get sold to investors, according to Paul Miller, an analyst with FBR Capital Markets in Arlington, Virginia and former examiner with the Federal Reserve Bank of Philadelphia.
So bank balance sheets are cheap, and getting cheaper? Say more?3
Bank appetite for jumbo mortgages contrasts with upheaval in the market for securities without government backing created out of the loans. Investors have been demanding higher yields as the Fed’s potential tapering raises concern that the debt will remain outstanding for longer than projected and prices on competing risky assets have plunged.
But that's equally true for banks, no?
“It would appear that banks have a different view on interest rates” than bond investors.
Umm. You should never feel entirely confident in an explanation of market segmentation that goes like "well some people think one thing and some other people think another thing."4
So how should you explain the segmentation whereby banks are now happier to hold long-dated interest rate and prepayment risk than investors are? I don't know, why don't you tell me? (In the comments, ha!) One possibility is that banks' cost of funding is just becoming relatively more attractive than non-bank investors' costs of funding over the past few weeks, which is an odd possibility given that the last few weeks have involved a lot of efforts to bludgeon banks with expensive capital requirements to make their funding more expensive and reduce the taxpayer subsidy provided to banking.5
Another possibility, which I'm lazily fond of, is that:
- when rates go up, mortgages prepay at lower than expected rates;
- this causes negative convexity spirals in fixed-rate RMBS, which lose value on a mark-to-market basis due to both rates going up and prepayment speeds declining;
- of course it causes the exact same result in banks' on-balance-sheet loans, economically;
- but not accounting-ly: those on-balance-sheet loans aren't marked to market, so who cares if their present value decreases?
If you're a bank and you own a mortgage and rates go up and prepayment speeds go down: you have positive revenue.6 (You keep collecting interest.) If you're an investor in RMBS securities: you have negative revenue (the securities lose value). Perhaps it's market segmentation by accounting segmentation?7
1.There's some limit beyond which this wraps back around. Like you probably shouldn't lend money to Donald Trump.
2.I guess even if that wasn't your view. Also I've done no research to determine if that view is correct; obviously there are overstretched jumbo borrowers and McMansions that have lost tons of value etc. etc.
3.I mean, one, sure, bank balance sheets are cheap. Also I guess it's intuitive that doing the work of gathering up loans and packaging them and so forth would add a little to the cost, though there's also an argument that tranching would reduce it (efficient risk slicing etc.). Anyway:
Redwood Trust Inc., the most-active issuer, sold top-rated bonds at yields over benchmark rates of 2.21 percentage points on June 11, compared with 1.75 percentage points in April and as low as 0.97 percentage point in January. Mortgage-bond pioneer Lewis Ranieri’s Shellpoint Partners LLC sold some similar top-rated bonds on June 27 at spreads of 3.3 percentage points and had to restructure parts of the deal to offer investors more protection against homeowner defaults.
Companies such as Redwood that rely on packaging jumbo mortgages into securities, known as aggregators or conduits, have been forced to increase their rates as debt investors demand wider spreads, according to Michael McMahon, a managing director at the Mill Valley, California-based firm.
4.That, as they say, is what makes a market. Not two markets!
[Update: Also of course a lot of RMBS buyers are banks too. Banks in their AFS portfolios. Which are now more mark-to-market for capital purposes. Which argues for an accounting-driven rather than differing-views driven of the move to on-balance-sheet mortgages.]
5.And here I was thinking that stricter capital requirements might shift risk from regulated banks' balance sheets to shadow-banky-things. In mortgages at least it seems to be the reverse.
6.I mean, NIM, whatever, your earnings go down. Though that looks primarily first-order (interest rates), not second-order (prepayment speeds); RMBS prices incorporate both. Also of course you can hedge that by just borrowing longer term. Or by, like, hedging.
7.Bloomberg ends with this:
“The banks are awash in liquidity, and they are looking for ways to make good loans,” said David Hilder, an analyst at Drexel Hamilton LLC in New York, who recommends buying Wells Fargo and JPMorgan stock. “One should not leap to the conclusion that this is uneconomic on the part of Wells Fargo and JPMorgan. In my experience they have very sharp pencils in terms of their cost of funds and their credit requirements.”
"One should not leap to the conclusion that this is uneconomic" is a funny thing to say.