Rising Interest Rates And The Changing Mortgage Market

Climbing interest rates are taking their toll on the number of consumers in the market for new home mortgages. Mortgage applications for new homes are down 25 percent year over year.

They’re also taking their toll on the non-bank mortgage lenders that proliferated in the good old days of zero or near-zero interest rates, compliments of the Federal Reserve.

The Supply Side of the Story

The Mortgage Bankers Association (MBA) reports that new home mortgage originations are at their lowest levels in years. Sales of used homes are a bit of a bright spot, and even perked up a bit in October after a sluggish September. That said, originations are also down 5 percent year on year.

High interest rates are the culprit. Interest rates on 30-year fixed-rate mortgages dropped in the third week of November, down 13 basis points to 4.81 percent, according to Freddie Mac – the biggest weekly decline since January 2015. But a year ago, that interest hovered near 3.99 percent.

The Incredible Shrinking Non-Bank Mortgage Lending Market

According to the Conference of State Bank Supervisors, non-bank mortgage lenders saw their number decline by about 3.5 percent between the end of 2017 and the middle of 2018, while the ranks of mortgage loan originators at those firms declined by 7 percent, or by about 11,000 workers.

And it is a decline likely to be felt, as non-bank lenders now represent the majority of mortgage underwriting done in the U.S. Of the $1.26 trillion in mortgage originations that happened in the first nine months of 2018, roughly 52 percent came care of non-bank lenders.

“Rising rates are headwinds to us,” said Dan Gilbert, chairman of Quicken Loans, the largest non-bank lender and one of the largest mortgage providers in the U.S., according to industry rankings. “When rates go low, those are tailwinds. But either way, the plane has to fly.”

And while large players like Quicken may continue to fly, smaller non-bank lenders may struggle to keep the wind beneath their wings in the new environment. Unlike banks, these lenders have neither deposits to fund themselves nor (in most cases) other lines of business to buoy them through a slow housing market. Instead, they often rely on short-term bank loans – now also at a more expensive rate.

Market watchers also note that many non-bank mortgage lenders appeared in the market after the 2008 crisis, and an environment of rising interest and cooling home sales is unfamiliar territory. Some even believe this will mean disaster, particularly if banks decide to stop serving as their lenders.

Others, like Jeffrey Levine, a Houlihan Lokey senior banker who advises mortgage lenders, notes that what is happening isn’t so much a crisis as a natural process by which an over-saturated market is set to consolidate to appropriate levels.

“Consolidation is a natural part of the cycle, and right now there’s too much capacity in the business,” he said.

There is also, he noted, too much reliance on refinancing, which was a highly popular product when interest rates were low. But interest rates are climbing – and, according to the MBA, refinancing volume in 2018 is expected to be less than half of what it was in 2016.

The New Refinancing Landscape

Last week, Americans submitted the fewest applications for home loan refinancing in nearly 18 years, according to the MBA – 5 percent from the previous week and officially at its lowest level since December 2000. New mortgages also declined on the week, but by a much smaller .1 percent.

Again, increasing interest rates are the culprit: The average rate on a 30-year fixed rate mortgage refinance was 5.16 percent last week, down slightly from the previous week’s 5.17 percent, but notably higher than the 4.88 percent average of nine weeks prior.

But while refinancing has mostly taken a beating in 2018 – and is projected to continue to do so, since the Fed is expected to raise the rate again when it meets in December – there is at least one area of refinancing that is growing strong: so-called cash-out refinances. In a cash-out refinance, a homeowner essentially takes on a new mortgage with a higher principal balance than their old mortgage, allowing them to pay off the previous loan and pocket the remaining cash.

Of all those who refinanced during Q3, a full 80 percent chose the cash-out option, according to The Wall Street Journal. That adds up to about $14.6 billion in equity being pulled out of homes, per Freddie Mac – the highest share of cash-out refis since 2007.

“Home equity is the big pot of gold,” said Sam Khater, the chief economist at Freddie Mac.

A pot of gold that makes some market watchers nervous – particularly in light of the role they played in the housing crisis a decade ago. Many homeowners sought to take the cash out of their homes right before the market crashed, leaving them underwater on those loans post-crash and for several years after.

This time around, however, things look a bit different, according to The Journal, simply because homeowners are at present pulling a lot less money out of their houses than they were right before the crash. In 2006, for example, there were three straight quarters during which borrowers withdrew more than $80 billion from their homes.

But others are concerned that those figures could start to rise quickly – particularly if consumers who don’t really understand all the consequences of a cash-out refi are pressured to pursue them by underwriters trying to keep their volume up.

“There are issuers that really want to make their profitability targets,” said Michael Bright, chief operating officer of government-owned mortgage corporation Ginnie Mae. “The only way to do it is to convince borrowers to take cash out of their house.”

Bright noted that to prevent that sort of pressure from existing in the market, Ginnie Mae is “preparing to take additional steps” to ensure “that borrowers aren’t being solicited for refinancings that don’t make sense.”

But for some borrowers, such refis do at least appear to make sense. Mandy Whitworth of Dallas pursued a cash-out refi that left her with $75,000 for a home addition and funds to pay off credit card debt.

“For me, I don’t have that much cash on hand,” she said. “It allowed me to pull out equity from the home to reinvest in the repairs and addition.”

It also left her with a more expensive mortgage – one with a 5.75 percent rate instead of a 3.625 percent rate, a difference of tens of thousands of dollars’ worth of interest payments over the life of the loan.

But with rates set to rise again in the next few weeks, and on pace to keep rising in 2019, it seems likely that cash-out refis will continue to make up the majority of mortgage refinancing in the U.S.

Will those be enough to keep the non-bank lenders in the market in the face of falling purchase mortgages and interest rate refinances? According to the experts, maybe for some – but probably not for most.

We’ll keep you posted on which firms survive and which don’t.