US mortgage rates have jumped to a two-decade high, with the average 30-year home loan now running above 7%. Of course, this makes sense. The Federal Reserve is raising benchmark interest rates and that's supposed to translate into a tightening of financial conditions, which includes housing credit. But the jump in mortgage rates far exceeds the increase in benchmarks, with the difference between average mortgage rates and the yield on equivalent US Treasuries at its highest on record. So what's going on? On this episode, we speak with Guillermo Roditi Dominguez, managing director at New River Investments, about what's happening deep in the market for mortgage-backed bonds to make rates surge this much. As he describes it, a sea change is helping to keep borrowing rates extra high. This transcript has been lightly edited for clarity.
Points of interest in the pod:
Why are mortgage rates so high? — 3:46
The average life of a mortgage — 5:36
Why MBS buyers get hit by high and low rates — 7:45
“No natural buyer” for mortgage bonds — 10:17
Bond outflows and mortgage bond demand — 16:09
Why aren’t banks buying mortgage debt? — 19:52
The role of US housing agencies — 22:22
A new normal of higher mortgage spreads? — 26:23
The supply chain of mortgage finance — 33:03
The impact of less mortgage money being ‘recycled’ — 37:32
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Tracy Alloway: (00:10)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:16)
You know, Joe, we've been talking a lot about what higher interest rates mean for the housing market, and we had that really good episode with Morgan Stanley's housing strategist, Jim Egan. He walked us through a lot of the technicalities of the impact of higher rates on house prices. But I think we could get even more detailed.
Joe: (00:36)
Well, absolutely, because we talked about what is the impact of higher rates on housing, but we didn't really talk about why have rates gone so much higher, and I know like, this is all I know about housing finance. I know the government backstops a lot of, implicitly or explicitly, actually, I'm not even sure anymore. But backstops a lot of it.
Tracy: (00:55)
It does. Even more.
Joe: (00:55)
It does. And so like you start with the sort of risk-free rate on like Treasuries because it's government [debt], and then you add some spread, and that's like the average more. And then I don't know anything beyond that.
Tracy: (01:09)
Well, that's a fair question though. Where does that spread come from? Why do people make additional money or why do they demand an additional premium for investing that's in something that has a guarantee from the US government?
Joe: (01:21)
Yeah, exactly. Right. This is the part I don't understand. Like, if the asset is backed by the US government, why don't we get mortgages the same rate as Treasuries? But it's not, because right now a 30-year Treasury is somewhere around 4% and a 30-year mortgage is around 7%. And that spread varies quite a bit from time to time. So even as recently as last spring, the gap between a mortgage and a Treasury had gotten down to less than 1%. Now it's around 3%. Where does that spread come from and why does it change over time, are two things I just don't know the answer to.
Tracy: (01:53)
Right. Well also that 3% spread is at the highest that it's been, I think, of all time. So something is happening in the market right now that is different to the way it used to work. And I think we need to dig into that. You know, we spoke a little bit with Jim about it, but we really need an expert. And I’ve got to say I was sort of baited by, there was a tweet recently. It started with, “I'm not about to go on a podcast to explain why, but this year has likely broken the market for mortgage-backed securities.”
Joe: (02:21)
That was a dare to us. Yeah. It was like, I'm not going to go on a podcast. It's like, all right, try us. Let's see.
Tracy: (02:28)
Let’s see if you can resist. Okay, well here is the podcast to explain why the MBS market seems to be broken. We are going to be speaking with really the perfect guest. We have Guillermo Roditi Dominguez, He is the managing director at New River Investments, and he is going to explain all of this to us in detail.
Joe: (02:45)
One of our super fans, I think.
Tracy (02:46):
Oh really?
Joe (02:48):
I think so. He's one of the first to tweet them often, so. And we've known him a long time, so very excited about this conversation.
Tracy: (02:53)
So maybe it wasn't a dare, maybe it was, you know, ‘please pick me for the podcast.’ Guillermo, we are delighted to have you on and really looking forward to the conversation.
Guillermo: (03:01)
I am very, very, very happy to be on. This is a bucket list item for me. And you know, I do stay up until very late at night so I can listen to Odd Lots, and tweet out my notes before anybody else wakes up.
Tracy: (03:15)
Oh, I love that. That makes me happy. Okay, so why don't we start out with, here's a very simple premise, is the current moment in the mortgage market -- and you know, when I say the mortgage market, I'm kind of talking about mortgage-backed securities, aka MBS. A lot of people will think back to, you know, pre-2008 times and think of them in that context. But is this particular moment in the mortgage market different or remarkable in some way? Can you give us some historical context around what we're seeing right now?
Guillermo: (03:46)
Yes. So this moment is special because it's not happening because people are afraid people are not going to pay their mortgages. It's not because people are afraid house prices is going to go down. It's a combination of the fact that mortgage-backed securities went from being effectively short-lived assets because we went through a pretty epic refinancing boom in 2020 and 2021 to all of a sudden rates going up very, very, very quickly -- faster than anybody expected. Prepayments going effectively to zero and a huge strain on mutual funds from tax payments that were due for gains from calendar year 2021. That's, you know, give or take one and a quarter trillion dollars. That's probably the highest compared to GDP that we've ever had. This kind of conspired to leave holders of MBS holding securities that have a much longer expected life than than they originally expected when they purchased them. And you know, the discount rate on that longer life going up, which has been pretty disastrous to the prices of this product.
Joe: (05:01)
This gets to an important nuance or an important thing. A person buys a house and takes out a 30-year fixed mortgage. Let's start really simple. They get a 30-year fixed mortgage. Someone owns that asset, but their expectation is not that they're going to hold that for 30-years. They're not thinking like, ‘okay, I'm going to wait 30-years.’ What is the typical length via which that asset exists? How frequently, in normal times, would it either get refinanced by the homeowner or sold because the homeowner sells the house and the loan gets paid back automatically?
Guillermo: (05:36)
On a baseline scenario, you, you would assume that you have a 30-year mortgage which has a weighted average life of the cash flows, because it's an amortizing loan, of about, you know, 15 years. And we have some expectation of turnover. You know, people move. People sell their houses or prepay their loans for many different reasons. All sorts of life events. And you know, that shortens the effective life to, you know, about half of that, about seven years. And usually we're assuming anywhere between 6% and 8% of loans on an annual basis transition -- not because they are refinanced to there being a rate incentive, but from any other number of reasons. During 2020 and 2021 we saw about 36% of loan balances being extinguished each year. That's a lot. You know, usually, we're expecting about half of that.
2016, you'll recall in the first three quarters of the year we had pretty low rates and we got up to 20% and that was pretty high. And you know, in 2019, which was a more normal year, we were at about 17%. So, you know, this fueled a lot of extinguishing of those balances and you know, you bought what you thought was a seven-year asset and you know, it turned out that it was a five-year asset and then you know, 2022 happens and all of a sudden you're holding a 10-year asset.
Tracy: (07:00)
Right. So can we dig into this just a little bit more? Because I seem to remember during the era of low interest rates, so you know, after 2008 when rates were just grinding lower and lower and lower, the big investors in MBS, the big buyers, and we should probably talk about who those actually are at some point, they didn't want MBS to be prepaid because it basically meant that they would get a bunch of money that they then had to invest at even lower interest rates. Now we're in an environment of higher rates and it feels like MBS is not desirable because suddenly it leaves you with an asset that has much longer duration than you expected and much more exposure to interest rate volatility. Is that right?
Guillermo: (07:45)
Yep, that's correct. I think one way to look at it is a mortgage-backed security is essentially similar to a covered call in equity terms. And that means that you have all of the downside and you know, very, very little of the upside and you trade that in for a little bit of extra coupon. And when rates were going down, everybody was upset about it because Treasury bonds were going up in price. People were making money there. If you held MBS, you got your money back and then when you went to buy new bonds, you bought them at a lower yield. And right now what we’re seeing is all of a sudden bond prices are going down, yields are going up and you’re not getting any cash flows so you don’t get to reinvest that money.
Joe: (08:28)
This is sort of a key thing and I just want to make it clear. You know, everybody knows that a homeowner can always refinance their home. People talk about like homeowners on a 30-year fixed has like a quote ‘free’ option to refinance their home if rates go down after that. But essentially that free option for the homeowner is a theoretical source of risk for the holder of the MBS. So there's two ways for the MBS holder to lose. It sounds like one is okay, rates go up a lot and then you're not getting much payment on those bonds, or rates go down and then you have to, you know, eat that repayment.
Guillermo: (09:06)
Yeah, and I mean I would say that it's not a free option, it's an expensive option, not always, but right now it is. We're talking about why are mortgages at, you know, 7%+ when Treasuries are at 4%. You know, just a year ago Treasuries were 250 basis points lower, but mortgages were 400 basis points lower.
Tracy: (09:34)
Maybe this is a good moment to sort of step back and talk about who the big buyers of mortgage-backed securities actually are. And one thing I would be curious to hear is have they changed from pre-2008 to now? Because of course, I mean the big change has been the Federal Reserve when it started quantitative easing, it bought a whole bunch of different types of bonds, but one of those was MBS. Now that they're in quantitative tightening mode, they've sort of stepped back from the market. So could you maybe talk a little bit about the ecosystem of who actually purchases these securities and the kind of considerations that they're thinking about as they decide whether or not to buy more or less MBS?
Guillermo: (10:17)
The answer that nobody wants to tell you is that right now there's no natural buyer. You know, and that's the problem. And when you see these spreads go really wide, the problem is that who is the buyer right now? Right now there is no natural buyer. Post-2008 you had, you know, banks that had expanding deposits and you know, there was little to no loan growth. And so banks kind of filled in that gap with MBS. Bond funds had pretty sizable inflows. And when you think about bond funds, you know, you're thinking about like Pimco’s Total Return Fund or you know, Doubleline’s Total Return Fund. These are funds that engage in, you know, marginal risk taking and illiquid securities in order to boost the yield of their fund. And you know, as long as you keep that illiquid portion to a small percentage of the fund assets, you can enhance the yield for the whole fund.
Ever since the start of the year, you know, bond funds have been seeing weekly outflows, so there are certainly not buyers there. You know, the Federal Reserve is not a buyer. Banks have demand for loans and managers at banks, you know, thought that they were ready for the risk that extension of MBS would entail. And it turns out that, you know, maybe they don't like it so much. So they're not buyers of the product.
We used to have a pretty healthy demand for some of the cash flows, particularly the more longer-dated cash flows there you would get into, you know, tranching. But you'd have some demand for that stuff from buyers in Asia and they’re nowhere to be seen. And because of this prepayment risk, it's a very poor fit for people that are in the business of matching assets and liabilities because if you're in the business of matching assets and liabilities, you don't want your asset to get called because your liability’s not getting called. So you know, it's a non-starter for them. There's very, very few people who want this product.
Joe: (12:31)
Can we just go back on prepayment risk specifically, and you made a good point that this option that homeowners have to refinance, it's not a free option. They pay for it in the spread and that spread is wide. So just, you know, 7% mortgages, 4% Treasuries, you're actually paying a significant amount to borrow that money. Is part of what investors are concerned about, or is part of why that option is so expensive right now simply because there's concern that like, okay, there's this spike in rates due to the [Fed’s] fight [against] inflation, but that's kind of temporary and that rates might, you know, reset lower significantly in a couple years and that we get this huge wave of like everyone who can refinances then. So it's like if I'm buying a home right now at 7%, I'm probably thinking, well I really hope this inflation fight ends in a couple years and that I can like refinance in 2025 or something.
Guillermo: (13:23)
That's exactly right. Nobody wants to take their money at this point, you know, if you've had cash up until now, you've done very well versus the losses that you know, everything else has taken. So if you're going to put money to work now, why are you going to put it into an asset that, you know, that may have capped upside? For most people it either doesn't make sense or it's just not something that they're willing to consider. You know, if rates go down and you buy Treasuries, you're going to make a boatload of money. If rates go down and you buy MBS, you might not make any money.
Tracy: (13:59)
Can you talk about whether or not there are forced buyers or buyers who have to buy MBS and I'm thinking specifically of, you know, situations where you might have a bond fund that's benchmarked to a benchmark index, something like the Bloomberg Barclays Agg or something like that. And I seem to recall there was some discussion -- again in the mid 2000s -- that it was unfair that the Barclays Index still included a bunch of MBS when there wasn't actually that much MBS in the market because the Fed was buying it and MBS was a source of duration for a lot of the funds. And if they couldn't, you know, buy MBS then they couldn't be as exposed to duration as the benchmark index. And so you had people like PIMCO actually complaining that there wasn't enough MBS in the market. So it's kind of ironic that fast forward, you know, seven years or something and a lot of these big buyers don't want to touch MBS with a 10-foot pole after complaining that, you know, they, they couldn't get enough of it.
Guillermo: (15:00)
Anybody that tracks an index is not going to be necessarily a force buyer because the funds that track an index don't necessarily replicate it down to every single line item. That's, you know, incredibly difficult to do in fixed income where you're talking about tens of thousands or hundreds of thousands of different bonds and especially in MBS where you don't have a fungible product. You know, there's thousands of pools that are packaged in different ways and dealers will often sell, you know, the entirety of an issuance to a single buyer. And so there's no chance for anybody to really replicate it. It's impossible to replicate an index. And so, you know, you have some leeway around that and sure there's, you know, there are flows going into index trackers that are going to replicate that, but there's also a lot of funds leaving, you know, a lot of flows out of different products that are more heavily exposed to MBS. And I wouldn't be thinking about forced buyers, I'm thinking about forced sellers.
Tracy: (16:03)
Sorry, can you expand on that point a little bit more? Like what would trigger a forced sale of MBS?
Guillermo: (16:09)
Let's say, you know, you have a total return fund at a large manager, you know, a well known, large manager and you're participating in the MBS market because that way you can get some extra spread for your clients and you can get them, you know, a little bit of a higher return and all of a sudden starting this year, you start getting massive outflows and maybe you keep, I don't know, five or 10% of your assets in super liquid securities and that's going to be bills and one-year Treasuries or, you know, two-year notes. And all of a sudden outflows keep coming, you run through your bills, you run through your one-year notes, you know, you run through your two-year notes and all of a sudden, you know, your prepayments, which were coming in every month, and you were cash flowing a lot from those prepayments on your MBS, all of a sudden they totally stop. So you have outflows, you have no cash flow coming in. Well you're going to have to sell something and you know, unfortunately for many managers, we've been seeing it since about March, you know, kind of a relentless number of, we call them BWICs -- which stands for ‘bids wanted in competition.’ It's essentially when you auction off your bonds to the highest bidder and you know, we've seen that a lot of these auctions bring few or no participants.
Joe: (17:30)
We have this period of high inflation. So of course there's a lot of second guessing about all kinds of policies that were going on in 2020, 2021, etc., fiscal, monetary, etc. And one of the criticisms of why was the Fed still buying, you know, mortgage-backed securities up until relatively recently in your view, can we quantify the degree to which that Fed buying depresses spreads? Or to put it another way, okay we have, you know, this 3% spread between mortgages and Treasuries. Can we decompose how much of that can just be explained via the Fed switching from being a buyer to a seller of these assets?
Guillermo: (18:12)
I can give you my best estimate. And so that would be for, when you're talking about calendar year 2021, I would say about 25 to 30 basis points was from, you know, QE continuing maybe later than we needed to. We don't have a counterfactual of no QE to look at. And if we look at before the Great Financial Crisis for that counterfactual, well the market was a lot, there was a lot more private label MBS. The implicit guarantees were maybe a little bit less implicit and there was less market share dominated by Ginnie Mae, which is obviously an explicit guarantee. But I would say that if you wanted to compare to, you know, the Fed not intervening at all, I think 50 basis points is not a bad guess, but, you know, versus a 2019 scenario, I would say about 25 to 30 basis points, that's how much they depressed the spread.
Tracy: (19:10)
Can you talk a little bit more about what's going on with the banks? So they're a big buyer of MBS as you mentioned, and I've seen some discussion, you know, for instance, JPMorgan had a note a couple weeks ago talking about how leverage and risk capital requirements for the big banks basically makes it much more difficult for them to hold onto these assets, to hold onto MBS. And so they haven't been buying as much of them and that's one reason why that spread between benchmark rates, i.e. Treasuries and mortgage rates has been going up. Is that a valid analysis or is this another excuse for big banks to complain about various regulatory requirements?
Guillermo: (19:52)
I think it's a valid criticism. I think it was just last week on Friday that Jamie Dimon said that, you know, they don't want any part of the conforming mortgage space, that they're not participating in that at all. Currently the capital requirements, they don't make it prohibitive for banks to participate. It just means that if they have demand for loans, well that's more attractive to them. And so they're not going to participate in something that is relatively less attractive. You know, if they can originate a lot of personal loans or non-conforming loans or credit to their corporate borrowers, they're probably going to focus on those activities instead of, you know, buying MBS. The other part of it is that everybody kind of assumed a certain base level of prepayments that in retrospect was not sustainable. I don't want to say sustainable, but you know, everybody kind of assumed that there would be a full, like that even if rates went up, prepayments wouldn't decline past a certain point and they did.
And maybe you bought a bond and you thought, ‘well, worst case scenario rates go up and then, you know, the duration of it, you know, goes from three years to five years and you know, it turns out that now you're looking at six and you know, you thought you would be comfortable with five, but it turns out that you don't feel so comfortable with five and now you have six on top of it, you know. And so there's just a general lack of appetite for this and, you know, you see this a lot. I mean, managers at banks are just normal people and they have the same biases and reactions as all of us and, you know, you get burnt by something, you don't want to do it again. And they just got burnt by the extension risk of MBS
Joe: (21:44)
Since you mentioned the difference between conforming and nonconforming loans, and in the intro I was like, ‘wait, do like Fannie and Freddie still exist?’ Because I kind of forgot about them and Tracy like gave me like a really like mean look like ‘what an idiot.’ [Editor’s note: I absolutely did not give a mean look]. She was surprised that her co-host could say something so stupid like do Fannie and Freddie [still exist?]. But I actually don't know what's going on with them because I just, they're like penny stocks now and I don't really know what happened. So could you talk a little bit about like what they do now? Like what is their role, how big is the difference between the conforming versus non-conforming? Like where do things stand with the GSEs?
Guillermo: (22:22)
Well, they're a huge part of the market. I can't tell you the exact percentage right now. I actually don't have the number in front of me. Ginnie Mae has been growing their share over the last decade. But you know, Fannie and Freddie are still huge players and you know, their role is that they buy loans from originators and then they, you know, they package them into MBS and sell them at the market. And they're not in the business of, you know, speculating on rates spread. You know, they basically just facilitate moving those loans from loan originators to the private buyers in the market. And as part of that, they guarantee the credit of the loans. And that's about 55 basis points, effectively. There's, you know, there's going to be some variation there because some borrowers are more creditworthy than other borrowers, and certain types of loans are penalized.
But a role that I think people don't really consider is that, you know, they do have certain policy. They act to an actual sort of like policy, right? You know, earlier this year, at the end of January, I believe Fannie Mae came out and said, ‘Hey, we're going to restrict credit and increase the price of credit for borrowers that are borrowing for an investment property or a vacation home.’ And especially if, you know, if that vacation, if you're trying to refinance that vacation home, and especially so if you're trying to take cash out, you know, on that refinance and especially so if the loan to value ratio is high, they kind of saw that there was a little bit of froth going on, you know, with people trying to build many real estate empires and buy a bunch of properties to Airbnb them, and they said, ‘Hey, no, no, no, this is, this is not what these institutions are for.’
We don't want to encourage this, so we’re going to actually restrict how much money, you know, we're going to give you and we're going to make that money more expensive. But they can't just change the price from like one day to another. They have to give, you know, a certain amount of notice, and there's customs in this market. And so they said, you know, any loan that is delivered to us after a certain date, we're going to pay less for it if it has any of these characteristics. And you know, what happened was that originators talked to their prospective borrowers and said, ‘Hey, you know, let's get these loans done right now because they're going to shut this faucet off.’ And sure enough, as we saw, you know, in in April numbers, we saw loan origination down substantially.
Tracy: (25:37)
So the Fed’s out of the market because it's winding down its balance sheet and we probably wouldn't expect it to start buying up MBS anytime soon. Probably the banks are out of the market for the various reasons that you described. Duration risk, interest rate volatility, a lot of them are in the process of rebuilding up their capital levels, especially potentially ahead of a recession and some loan losses going up. What's the trigger for the big buyers to come back and start buying MBS again, and maybe start to bring that spread down? Or is that just not going to happen anytime soon and we're going to be stuck with a new normal of higher mortgage rates?
Guillermo: (26:23)
So let me just fill in this one buyer that we haven't talked about yet, and that is going to be your highly leveraged balance sheets and this is essentially hedge funds and mortgage REITs and I guess what, you know, we could call shadow banks. I hate using that term because it's kind of become associated with… it has connotations that I don't particularly agree with. But, you know, these are institutions or you know, operators that want to behave like banks in terms of participating in having a maturity mismatch and a liquidity mismatch and earning that spread and using a lot of leverage to achieve it. But they also don't want the regulation that comes with, you know, being a bank and the costs associated with being a bank. I think the one that is most visible in the market is mortgage Reits, right?
And they basically borrow a bunch of money, buy a bunch of MBS, do some hedging. They can't be completely unhedged and then whatever the spread is, you know, they take a big fee for themselves and then they pay the rest as a dividend. And these instruments are, you know, pretty popular with current yield focused investors and income focused investors, and they've been a sizeable participant, right? And so as long as repo is reasonably easy to get and it's not too expensive and there's a decent spread between where you borrow and the yield you get, they're out there, you know, they're participating in this market, buying those bonds. Some of these REITs are, you know, effectively captive to loan originators. I'm not going to name names because I don't want to make anybody mad, but you know, a lot of these originators are in the business of originating these loans and immediately selling them to a REIT that is associated with the same management.
And as long as, you know, the book value was underneath the share price, they were very active in issuing new shares, thereby raising more capital and thereby, you know, being able to increase how many bonds they bought. And that trade is broken now. There's not enough yield left. Repo is is harder to get and it's one of the reasons that things are very difficult for this product, is because using MBS as collateral for a loan is a lot harder and more expensive than using investment grade credit, you know, let alone Treasuries.
Tracy: (28:52)
I was going to ask just on this point, I mean, why can't you do what every major financial player seems to do when it comes to illiquid bonds and just put it in, like, an ETF wrapper and improve margins on it that way?
Guillermo: (29:04)
That is the question that I was hoping you would ask. ETFs need to track a reference basket and as we mentioned, you know, we talked about earlier, this is a market that is full of individual securities that are not fungible and they're not liquid. A lot of times a particular bond will only have one owner for its entire life. That makes it particularly unsuited for wrapping it in an ETF. The other part of it is that, you know, we do have some ETFs that folks, some mortgage-backed securities, they don't really get a lot of flows. Whoever the end user is of ETFs seems to want either investment grade credit or government bonds. There's really very little appetite for MBS wrapped in an ETF product. I can't speak as to why, but you know, I do monitor the flows pretty closely and, and we just don't see that.
Joe: (30:08)
So I just have one last question and, you know, one of the things that's going on right now, or that we talked about on our last housing episode is there's been this big affordability shock. And so, you know, no one wants to buy homes at these levels. Probably not a lot of people want to sell. The expectation is that you just have this very frozen dormant market, the monthly payments at these prices and these mortgage rates are just like way too high. Do you see finance innovating beyond here? Like, could we see a 50-year mortgage, could we see a hundred-year mortgage or other things? Or maybe the return of, you know, non-fixed rate mortgages that come back in popularity after a long time being dormant
Tracy: (30:50)
We can have Option Armageddon headlines again.
Joe: (30:53)
Yeah, like in 2030 we'll be talking about it, or 2035. Are we going to seethe return of like finance finding ways to lower that monthly cost for prospective home buyers?
Guillermo: (31:01)
Unfortunately not. An adjustable rate product works when you have a steep yield curve, but you know, right now we have a pretty flat yield curve and so, you know, if you're paying a rate based on the short rate, that's not going to be great. The market might be a little bit reduced because people are, you know, less worried about the duration, but it's not going to help that much past 30 years. Increasing the amortization time doesn't really reduce the monthly payment. We've had attempts at, you know, doing 40 years pretty recently and it just doesn't help lower the monthly payment. The thing that helps lower the monthly payment is bringing the spread down and, you know, having rates at a lower level. And I just want to clarify, when I talk about the MBS spread, you know, I'm talking about the spread between a generic mortgage-backed security and by generic, I know I just said that this product is not fungible, but you know, we're talking about a products that's called TBA, which stands for ‘to be announced.’
It's essentially product that hasn't been delivered to the market yet. You can think of it as like futures for MBS and that is, you know, at the highest level in probably about 12 years, you know, if we use last week's rates, it was about 1.75%. It's about the same today, that's really, really high. A year ago that rate would've been, you know, about 80 basis points. And so we've seen about, you know, 1% added to a borrower's page just from that spread. But apart from that spread, you know, we also have the spread that is captured by the GSEs and that's increased not much, but it's increased by about five basis points. And there's also originators, right? Originators have to make money and part of, you know, what they make is the difference between what borrowers pay and at what level they sell the loan to Fannie or Freddie.
And you know, we've seen that go up, you know, depending on the week, it's pretty volatile, but between 15 to 20 basis points there, which brings you to something that I think you guys will find interesting, and I don't think enough people are paying attention to. Originators make money based on how many dollars of volume they put through, right? So their costs are tied to the number of loans that they process. Loan originators, their main costs outside of like, you know, office space and whatever it is that they have, you know, these loan officers and their assistants, you know, chase borrowers, making sure that they have all the paperwork, making sure that they're getting everything in before the deadlines. It's a very call center type of job, making sure that, you know, everything is according to the rules and those costs are kind of like on a per loan basis, but the money that they make really is based on how much dollar volume they do.
And so, you know, bigger loans mean more profits. And last year and the year before that they were, you know, they were doing many, many loans, but they were also doing bigger loans, right? And because they have this incentive to write you a bigger loan so they can make more money, they would remind you, ‘hey, you know, you're doing a refinance, I see that, you know, you're dropping the rate that you're paying from, you know, 3.5 to 2.75, you know, at your new lower payment, your debt to income drops and you know, would you like to borrow against your existing home equity?’ And a lot of people said yeah. And we had an incredible amount of equity withdrawn from housing, you know, we had about a trillion dollars last year. We had a decent size chunk this year.
That's also, you know, when you think about like, why is inflation so high? You know, where's all this money coming from? Well, a trillion came out from that way, and so they were employing a lot of people doing this, right? And now, you know, we've had the amount of dollars that flow through these originators decline by more than half. You know, we were seeing in some months $250 billion being originated and now we're closer to $100 billion. And well, there's just not that much work to do. And you want to keep people around because like, well what if the business comes back, right? You want to be able to ramp up. But, you know, one of the things that we are likely to see is this is a commission-based business. And so as the flow dries up and the commissions dry up, there's going to be some attrition, in staffing.
And then what you're going to see is something similar to what we saw in 2020 where in the second half of 2020 when everybody was rushing to refinance their mortgage originators said, ‘you know, we don't have enough people to handle this loan pipeline.’ So they did what anybody else in that situation does and they raised their prices and they, you know, they kept a larger amount of the coupon that borrowers paid. And so as we go through this slow down in lending, we're likely to see attrition to this quote/unquote ‘supply chain’ of lenders. And if Treasury rates were to come down again, that doesn't necessarily mean that, you know, the rates available to borrowers are going to come down because in that case, originators are going to have enough pricing power to defend their unit economics and keep a larger portion of that coupon.
Tracy: (36:46)
You know, I love it when guests come on the show and talk about incentives because there are a bunch of incentives at play here. There's the incentives of banks choosing exactly what to put in their portfolio or big investors making the choice between Treasuries versus MBS, but the loan originators as well.
Joe: (37:00)
Well, I was just going to say this is a supply chain episode. Seriously, because what you're describing or what you described is the physical -- literally not even a financial -- but the physical capacity to process all this paperwork. And I remember when it was really constrained in early 2020 because rates collapsed, and there was just this flood and so there was like this sort of like physical constraint, like a supply chain. Anyway, I think that's a fascinating point -- that now, as you say, is going to ripple and we're going to have like hollowed out supply chains that will keep mortgage rates even higher if rates come down.
Guillermo: (37:32)
And it doesn't just happen in originators. Everybody loved complaining about prepayments, but prepayments kept this industry alive. It kept massive amounts of flow going through the system. It kept originators employed, it kept appraisers employed, it kept people on the sell-side employed. It meant that if you were on the buy side and, you know, you were buying all of these billions of dollars worth of product and it was like rapidly prepaying and you had to kind of recycle that money. It kept those traders employed. Generally more flow is good. There's more to do. People in this business love to be big accounts. It helped with that. You know, when you were saying, ‘Hey, you know, I'm doing like X amount of business with you’ and that X was like a very big number that kept you in the good graces of the sell side, kept your coverage happy, you know, salesmen for bonds, especially on the primary market where, you know, they always had lots of product and there was always buyers for that product.
So everybody got fed by this refinancing and prepayment flow and that disappeared. You guys reported, well, Bloomberg reported recently that, you know, BMO cut 20% of their staff and Wells Fargo has been cutting the people that they have associated with this. And I can tell you from talking to people that I've known for 10 or 15 years, it's tough out there. People used to have a steady source of clients, you know, that were pretty reliable buyers of new issuance every month and suddenly they're just not there. They're not present. There's more supply in the secondary market from, you know, these fund outflows that we talked about and from levered balance sheets that have to reduce their leverage because higher interest rates and less favorable borrowing conditions have made it uneconomic for them to hold this paper. It's not good for anybody. And so we're going to see attrition in the origination space, but we're also going to see attrition on the sell side, you know, whether that involves sales or structuring or trading. You know, by structuring I mean the tranching of these securities into different risk profiles.
Tracy: (39:52)
All right, Guillermo, we teased this episode by saying we were going to go into detail on what's going on with the MBS market and you definitely delivered on that promise. So thank you so much. Really appreciate you coming on Odd Lots. Even though you said on Twitter that you would never do a podcast. You weren't going to go on a podcast.
Guillermo: (40:08)
I meant that. I meant that. But then you DMed me and you know, I talked to Connor Sen and I was like, ‘I don't really love doing media.’ And he's like, ‘But it's Odd Lots. You can't say no.’ And I said, I know I can't, I can't say no.
Joe: (40:25)
We’ve got to leave this part in. No one should say no. That was so good. Rhat was so helpful. Now I actually understand your tweets.
Tracy: (40:32)
All right, thank you Guillermo.
Joe: (40:35)
Take care Guillermo.
Guillermo: (40:35)
Yeah, thank you guys.
Tracy: (40:50)
So Joe, well first of all, I would never give you a mean look. I roll my eyes with love. Only with love.
Joe: (40:57)
Okay, thank you. That makes me feel better. I was feeling pretty down for the first few minutes.
Tracy: (41:01)
Oh sorry. But I thought that was a really interesting conversation. And so first of all, you know, it doesn't happen that often that someone comes on and says a market is essentially broken. Or it used to happen a lot more when the Fed was in various markets and everyone would go and say, ‘Oh, it's broken or distorted,’ but then the Fed left and now people don't seem to be talking about that as much.
Joe: (41:22)
It was so good. That answered so many questions. I mean, just like I, you know, I did not always understand like why if we have Fannie and Freddie or Ginnie Mae backing mortgages. Like, why can't we just get mortgages at 4% like the Treasury if it has the government guarantee? So that was just really helpful understanding like why now in particular the spread is so high in part, but there are obviously many reasons because of sort of the cost of that option going up. Because of course everyone wants to refinance. The questions you asked about the natural buyer. So much good stuff there.
Tracy: (41:55)
Well, the other thing I would say, I know everyone's interested in the mortgage market because it's housing and people are interested in housing. But the other reason I find this so interesting is it's sort of a microcosm of some of the more structural critiques that you're starting to hear about who's going to be the natural buyer for all types of bonds. So not just MBS but also things like Treasuries, other government bonds. I mean we just had a massive kerfuffle with gilts in the UK. And so if you think that because of all these changes, because we're in this new era of higher interest rates, higher interest rate volatility that's going to lead to structurally higher spreads, then that basically means that's kind of a drag on growth and a drag on returns potentially.
Joe: (42:41)
Got it. I was looking while we were talking, I was like looking at some mortgage REITs on the terminal, just the price…
Tracy: (42:48)
Don't do it.
Joe: (42:49)
So brutal. Also, I love that last point and I remember that from like early 2020, rates collapsed. And so if you have a house, you're like, ‘Yeah, I wanna refi, right?’ But everyone's doing it so then, you know, they lack the capacity and so then they charge more because they're like, ‘well if you want to get through, if you want to have our workers do the paperwork, you're going to have to pay more.’ And then they hire a bunch of people and then it's like, okay, then you're out late 2021 when the spread collapses because they have no pricing power anymore. So it really like this idea that there is this a finance supply chain…
Tracy: (43:23)
I was going to say we managed to turn a highly technical financial markets episode into basically a supply chain.
Joe: (43:29)
I love it. A quintessential Odd Lots episode.
Tracy: (43:31)
All right. Shall we leave it there?
Joe: (43:33)
Let's leave it there.
You can follow Guillermo on Twitter at @NewRiverInvest.