This is an excellent question. I’ll answer it in detail, but fair warning: the answer is somewhat technical.
Before the economic effects of COVID-19 began to appear, the Federal Reserve announced that they were cutting the Federal Funds Rate by 50 basis points (.5%). They lowered it again by a full percentage point on March 15. The Fed lowers the FF rate to stimulate the economy or raise it to slow excessive economic growth, which would lead to excessive inflation.
The Federal Funds rate has nothing to do with mortgage rates. It is the rate banks charge to lend money overnight to other banks. When the Fed lowers the FF rate, the prime rate follows. That will directly affect HELOCs and often credit card rates—but not mortgages.
The money you get from a mortgage lender comes from a specialized line of credit called a warehouse line. You don’t care where the money came from, because you got the money you applied for at the terms you agreed to.
After funding, the lender sells your loan to an investor—Fannie Mae and Freddie Mac are the best-known, although there are many others—for a profit. This is the fundamental business model of the mortgage industry.
The investor pools the loans into a type of bond called a mortgage-backed security (MBS). Investors trade them on the open market like other types of securities.
When the price of MBS goes up, mortgage rates come down because lenders can get the profit margin they expect with a lower interest rate. If the price of MBS goes up 25 bps (0.25%), the rate of a 30-year fixed-rate mortgage typically goes down about 1/16%.
I should have prefaced the above with “in normal times.” The situation today is anything but normal. Here is what has changed.
When the lender agrees to lock your loan, they are promising to give you specific terms—both the rate and the discount points. One point is 1% of the loan amount. They will fund your loan at these terms regardless of the price the investor pays.
If the price of MBS goes down after the lender locks your rate, they will get a lower price for the loan, possibly less than the amount they gave you. To protect themselves against this, they will hedge the loan. The lender “shorts” MBS so that if prices go down, they’ll make money on the short position. Readers familiar with trading stock options will recognize this as a “put” or “short position.” The profit on the hedge offsets the loss from selling the funded loan at a lower price.
If MBS prices go up, however, they lose money on the short position (the hedge), but make more money when they sell your loan. The two cancel each other out. Lenders routinely hedge their pipelines to guard against the normal fluctuations in the market.
When rates drop rapidly, as they did following the week of February 24, many borrowers see an opportunity to lower the cost of their mortgage by refinancing. They may have done this even though they have had their loan for a short time. Residential mortgages no longer contain penalties for early payoff, but these early payoffs can cost the lender a great deal of money.
Even though the lender who funded your loan has sold it to an investor (Fannie or Freddie, for example), they may retain the servicing: issuing statements and collecting payments. The servicer typically receives a fee of .30% of the loan for doing this.
They purchase the rights to service the loan for about 1% of the loan amount, so it will take about three years for them to break even. Loan servicers may increase their servicing income by getting a loan, using the value of their servicing portfolio as collateral.
With the rapid drop in rates, borrowers have been refinancing and paying off their old loans far ahead of schedule. The loan servicer, who paid in advance for the rights to service the loan, may not have had that loan long enough to recover the fee they paid.
The lender typically earns additional profit from the higher volume of new loans, offsetting the servicing losses. But the COVID-19 crisis has brought much of the U.S. economy to a near-halt. Some borrowers can’t complete their transactions because their income has been interrupted or curtailed. The lender has had to pay hedging costs, but do not have the income from selling a funded loan to offset it.
Furthermore, the Federal Reserve, in its effort to stimulate a faltering economy, has launched quantitative easing for the fifth time in its history. They enter the market directly to purchase mortgage-backed securities and Treasury Bonds. They have announced that they will buy “unlimited” quantities of MBS, initially up to $50 billion each day.
Mortgage bond prices have soared as a result. Daily MBS activity ordinarily looks like this:
The green bars represent days where the MBS price closed higher. The size of the bar indicates the amount of change for the day.
Here is the activity for the past two weeks:
The scale of the two charts is approximately the same. The volatility is dramatically higher.
On days with very large green bars (higher MBS prices), lenders will take huge losses on their hedged positions. The broker-dealers issue margin calls to cover these losses. Lenders have to pay tens of millions of dollars to cover them. They must keep their rates higher to recover some of these losses.
Although the Federal Reserve’s intentions are laudable, their actions have the opposite from the desired effect. The rapid increase in MBS prices because of the Fed’s massive purchases is costing lenders millions of dollars in hedging losses. And with many loans not being able to close because of a borrower’s loss of income, lenders are not offsetting the hedging losses with additional income.
The Fed’s failure to communicate effectively—and communication is a critical responsibility–exacerbates the situation. When they executed two massive rate cuts in rapid succession, many borrowers with locked loans broke their locks, expecting better rates elsewhere. The first lender was left only with the hedging losses.
There will come a time when the effects of COVID-19 will subside. Lenders will clear their pipelines, and rates will return to normal. Borrowers with locked loans should do their best to meet all conditions to move through the process to funding. If rates improve later, there will always be an opportunity to refinance.
For now, we must minimize the health risks associated with COVID-19. Shelter in place, wash your hands and stay informed with reliable information. Memes and unattributed articles on social media are NOT reliable. The best places to start are the CDC website Coronavirus Disease 2019 (COVID-19), World Health Organization Coronavirus, and Johns Hopkins COVID-19 information
We’ll get through this. Stay well and be safe.