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As we close out 2023, and turn to 2024, we reflect on the challenging operating environment for many mortgage originators, especially the small and mid-size Independent Mortgage Banks (IMBs) and optimistically look forward to more robust years. The following year end update will highlight the state of the economy, cover current events, liquidity concerns, and the changing regulatory landscape. For more information on the mortgage industry and the services performed, visit the Mortgage Center of Excellence.

State of the economy 

Throughout 2023, the Federal Reserve raised the Fed Funds rate four times for a total of 100 basis points (bps) from 4.50% to 5.50%. Simultaneously, a historically low number of homes for sale continued to place upward pressure on housing prices and limit borrowers’ ability to afford new houses. The increased financial requirements largely blocked out first time homebuyers. Existing homeowners were presented with a dilemma on whether to sell their existing homes with mortgages at potentially much lower rates, for new houses with mortgage rates at two-decade highs. The trifecta of higher interest rates, low inventory, and higher housing prices, slowed mortgage originations significantly when compared to the prior year from approximately $2.3 trillion to $1.6 trillion, impacting the bottom line of many IMBs. 

During the annual Mortgage Bankers Association (MBA) conference in Oct. 2023 and a subsequent article from the MBA, the MBA projected a decrease in gross domestic product (GDP) and consumer prices, with an increase in unemployment rate. While there have been various outlooks on the future economy with many economists forecasting a “soft landing,” the MBA, along with other trade groups and economists, have predicted recessionary conditions. These recessionary conditions are predicted to move the Federal Reserve Open Market Committee to cut the Federal Funds Rate starting in 2024, and continuing through 2025, in line with economic indicators. In addition to the anticipated recessionary conditions, other factors, such as the cost of debt on the federal budget and the potential impact of commercial real-estate loans maturing and requiring subsequent refinancing at higher rates, could impact the decision to cut rates. 

With potential rate cuts, many are projecting a considerably larger origination market starting in 2024 through 2026, which was noted by the MBA in their Oct 2023 article. For the week ending Dec. 21, 2023, the weekly average Freddie Mac 30-Year fixed rate mortgage fell to 6.67% from a high of 7.79% for the week ending Oct. 26, 2023. Similarly, the 10-year Treasury rate which mortgage rates generally track, fell below 4% from a high of approximately 5% during a comparable period. The decrease in rates is expected to spur home sales and bring potential homeowners who were sidelined back into the purchase market. Also, refinances are expected to increase for those who purchased and financed homes at higher rates. 

Current events 

With the completion of the second half of 2023, there were several headlines that could impact the mortgage origination space. Comerica and Fifth Third Bank decided to leave the warehouse lending market. The impacts of Basel III Endgame could further impact who decides to stay in the warehouse lending space. The enactment of Basel III, which is covered in greater detail later in the article, has a direct impact on mortgage lenders. These events could impact sources of cash and financing rates.  

During the second half of 2023, the National Association of Realtors was ordered to pay damages for excess selling fees. While this is a recent event and the litigation is still in process, there are different views on the impact of this event. One view is that by not requiring the seller’s agent to compensate the buyer’s agent, this could force buyers into having to compensate their agent, increasing the financial requirements for home ownership. Another view suggests that sellers might include the broker's commission in their home's overall cost, thereby inflating the home's sales price. Consequently, with reduced commission to pay, they may refrain from raising the sales price as much.  A third view is that the ruling could lead to fixed rate pricing ( agents charge a flat fee for their assistance), which could benefit both the seller and buyer. While this litigation is evolving and could bring significant changes, it is just another source of uncertainty for a challenged segment. 

In early 2023, we noted that organizations should prepare for the possibility of increased mortgage defaults. During the second quarter of 2023 through year end 2023, the industry discussed the increase in delinquencies, which will continue to pose a risk in 2024. While delinquencies were at comparably low levels, they have started to increase.  From a positive perspective, with the Federal Reserve holding rates flat and the expectation of lower rates in 2024, there is an expectation for increased mortgage demand. 

Need for liquidity 

As some mortgage banks weathered the storm and utilized cash reserves during the recent period of interest rate hikes to offset the slower origination market, the need for sources of liquidity is still a priority until there is a stabilization of the origination market. Companies should forecast their cash needs for the foreseeable future and identify the sources of cash to meet these needs.  

For those companies that hold servicing, they should weigh the benefits from a sale of mortgage servicing rights (MSR), versus the longer-term lead source for future originations and the natural hedge against periods of origination activity downturns. Companies that hold servicing have a consistent relationship with these borrowers that lead to future refinance and purchase opportunities. However, MSR values are generally higher than they were in the past several years due to low mortgage refinancing demand and companies could benefit from a timely asset sale at these higher valuations. Another servicing strategy is for companies to evaluate the benefits of selling loans servicing released versus servicing retained for the additional servicing release premium on sale. Further, companies can enter into an excess servicing sale as well, where the excess servicing above the base servicing is sold, while the base servicing is retained. 
Entities that meet the minimum net worth and regulatory consent requirements can enter an MSR financing arrangement. They can also consider entering a servicing advance arrangement to generate additional liquidity from financing versus selling the servicing. If delinquencies increase, having financing in place for advance obligations, primarily Government National Mortgage Association (GNMA) principal and interest (P&I) advances, becomes a more tactical need. For more detail on the requirements of P&I advancing, see our article which discusses what happens in the servicing process when a loan becomes delinquent.  

IMBs should consider carrying more than one warehousing financing facility, to mitigate the risk that a line gets suspended or there is certain product that cannot be financed on one line but can be financed on the other line. Companies should also evaluate if they can repurchase loans on these lines, because agency repurchase requests could become cash intensive during an environment where liquidity is tight. Finally, in an environment with increased delinquencies, companies should prepare for an environment conducive of loan modifications in accordance with loss mitigation guidelines. 

While mortgage rates tend to track changes in the 10-Yr Treasury rate, financing facilities tend to be pegged to the Secured Overnight Financing Rate (SOFR) which track to changes in the Federal Funds rate.  This could lead to a situation where there is a disconnect or expectation difference between mortgage rates and financing rates, impacting net interest margin. IMBs should try to manage  this disconnection, optimizing financing strategies for better alignment with market dynamics and margin management.

For organizations that are concerned about passing their financial covenants, they should prepare a financial forecast and a financial plan and connect with their financing partners to see if a covenant waiver will be required. 

Diversification 

With margin down significantly off the 2020 highs and a significantly smaller origination market, many companies are turning to other products to generate revenue. While there are niche lenders that focus on these products, some lenders have re-entered the non-QM (nonqualified mortgage) space to originate loans to these qualifying borrowers. Some specialty finance companies are focused on buying and securitizing non-QM product and securitizing these.  

To account for the higher housing costs in today’s market, and for some borrowers who are priced out, some lenders started offering 40-Yr mortgages in addition to the 30-Yr mortgages to amortize the principal over a longer period. When interest rates were at historical lows following the COVID-19 pandemic, the amount of adjustable-rate mortgages were minimal.  However, at these higher rates, there has been an influx of ARMs which reset as the borrowing base index (index the ARM is pegged to) resets, with the expectations that interest rates will eventually decrease.  

With the rise in housing prices, many homeowners have a lot of equity in their homes. With increases in credit card balances, delinquencies, and with the need to pay off higher interest rate debt, many lenders are offering HELOCs and cash out refinances to provide borrowers with this needed liquidity. As we complete the holiday spending season, there could be an uptick in borrowers requiring the cash to meet buy now, pay later, or credit card balances. Some lenders are offering renovation loans for borrowers who are looking to make renovations versus buying new houses or utilizing other methods of higher rate financing for home improvements. 

While traditionally considered a higher risk loan, many lenders now offer manufactured housing loans for purchasers of manufactured housing. Some lenders are also offering buydown loans to lower the interest rate on the loan. They are buying down the initial rate to make the payments more affordable. The buydowns can be permanent or temporary for a period such as one or two years and in some cases longer. 

In the current origination market, it seems plausible that these products and others will continue to be offered to meet borrowers’ needs and attract new borrowers. 

Regulatory 

In 2020, during the pandemic and in a historically low interest rate environment, the Federal Housing Finance Agency (FHFA) and the Government National Mortgage Association (GNMA) collaboratively worked to formalize new servicer eligibility and capital requirements. As part of the new requirements, FHFA and GNMA aligned many of their requirements. In August 2022, both announced their rollout and timeline for the new requirements per the FHFA and GNMA joint release.

To summarize their updates, the following updates went effective Sept. 30, 2023:

  • GNMA’s adjusted net worth now subtracts valuation adjustment of certain assets.
  • FHFA and GNMA aligned their minimum net worth requirement, with a base of $2.5 million, plus 25 basis points (bps) on FNMA and FHLMC servicing (enterprise servicing), plus 35 bps on GNMA servicing, plus 25 bps on private label (PLS) and other servicing.
  • FHFA and GNMA aligned their liquidity requirements, which includes the following aggregate of enterprise servicing, GNMA, and PLS/Other:
  • Enterprise liquidity allocation includes:
  • Scheduled / Scheduled (scheduled interest and principal payment basis) of 7 bps times the outstanding UPB.
  • Scheduled / Actual (scheduled interest and actual principal payment basis) of 7 bps times the outstanding UPB.
  • Actual / Actual (actual interest and principal basis) of 3.5 bps times the outstanding UPB.
  • GNMA 10 bps times outstanding UPB.
  • PLS and Other 3.5 bps times outstanding UPB.
  • For large nondepository institutions, which are defined as $50 billion or more in single family loans, FHFA now requires a liquidity buffer of an additional 2 bps on enterprise servicing and an additional 3 bps on GNMA servicing. 

The following updates went effective Dec. 31, 2023: 

  • FHFA and GNMA implemented an origination liquidity requirement, based on 50 bps times loans held for sale, plus pipeline loans with interest rate lock commitments, adjusted for fallout. Small sellers are excluded from the origination liquidity requirement if mortgage originations over the prior four quarters are less than $1 billion in aggregate. 
  • FHFA set the following requirements for third-party ratings: 
  • When there is greater than or equal to $50 billion in servicing, FHFA requires one primary servicer or master servicer rating, as applicable. 
  • When there is greater than or equal to $100 billion in servicing, FHFA requires one primary servicer or master servicer rating as applicable and one third party unsecured debt rating or corporate rating. 
  • When there is greater than or equal to $150 billion in servicing, FHFA requires one primary servicer or master as required, and two third party unsecured debt rating or corporate ratings. 

The following updates are effective March 31, 2024: 

  • Annually, FHFA requires a capital and liquidity plan, including an MSR stress test. 

The following updates are effective Dec. 31, 2024: 

  • GNMA is implementing a risk weighted capital model, whereas FHFA is not implementing one per an Oct. 2022 GNMA press release.  
  • Originally required for December 31, 2023, GNMA deferred the effective date until December 31, 2024.  
  • Under the model, adjusted net worth, less excess MSRs divided by risk weighted assets needs to be greater than or equal to 6%.  
  • Excess MSRs are defined as MSRs greater than adjusted net worth. 

The Federal Deposit Insurance Company (FDIC), the Federal Reserve, and the Office of the Controller of the Currency (OCC) collaborated to issue new capital rules, known as Basel III Endgame on July 27, 2023. The rules go into effect in July 2025, and are implemented over a three-year period. The new guidelines propose more stringent guidelines for banks with over $100 billion in assets. The new requirements have raised concerns for the banks that are impacted and the mortgage industry.

Some of the potential impacts to the mortgage industry include:

  • With banks above $100 billion in total assets now being required to have more capital, this could force banks to reduce their overall mortgage platform as they allocate their capital.
  • Basel III proposes a loan to value (LTV) risk weighted approach to hold loans on the balance sheet. The proposed LTV approach increases the capital required to hold loans. Some banks could reduce the amount of mortgages that they originate, which could create more origination flow for the IMBs, but overall could decrease the amount of mortgage originations when combining traditional banks and IMBs.
  • More capital is required to hold MSRs, which could create less demand for MSRs and could impact MSR values, and MSR liquidity. This could also impact the amount of MSR financing that lenders are willing to provide.
  • This could create less liquidity in the correspondent channel with a decrease in MSR values.
  • As noted under current events, a couple of warehouse lenders have already left the space. The capital requirement change could impact how much resources are allocated to warehouse lending and or increase the cost of debt for the facilities.
  • Special interest groups are concerned about how this will impact the overall mortgage origination market, already in a currently challenged environment. With a push to provide affordable housing options, many feel that this would continue to compound the space.

In an Oct. 2023 announcement, the FHFA aligned the treatment of active mortgages for borrowers who elected a Covid-19 forbearance for its representation and warranties policies. Under the alignment, FHFA will treat FNMA and FHLMC backed mortgages under a Covid-19 elected forbearance similar to a natural disaster forbearance for representation and warrant relief based on the borrower’s payment history for the first 36 months from origination, allowing lenders to factor this into its sunset guidelines.

With the robust amount of new guidelines becoming effective, originators should understand the implications that these guidelines will have on their organization. Originators should consult with their subject matter experts to fully address the impact of adoption.

Cybersecurity center stage 

In addition to managing operating performance and meeting the new regulatory requirements, there has been an increase in the amount of cybersecurity threats. Given the vast amount of borrower data, wire activities through the origination process and payment activities through the servicing process, the mortgage industry is highly susceptible to cyber incidents. Notable cyber breaches that have impacted the industry, with costly consequences in terms of loss mitigation and resolution expenses, and reputational issues impacting consumer trust. 

To effectively mitigate the risks stemming from cyber incidents, companies require buy-in from all employees of the organization and the board and not just from the CTO or CISO. With the appropriate buy-in, mortgage and servicing entities should: 

  • Set the required governance structure to enforce the appropriate oversight of the mortgage ecosystem exposed to cyber. 
  • Establish policies and procedures to mitigate cybersecurity risks and escalate incidents. 
  • Develop a robust risk assessment to ensure that there are no gaps in the policies and procedures and ensure that the appropriate controls and precautions are in place. 
  • Implement the appropriate technology to support the mitigation activities, including firewalls, scanning technology, multi-factor authentication, penetration testing, among others. 
  • Develop the appropriate reporting to monitor the mortgage ecosystem and to timely escalate and respond to incidents. 
  • Continue to train and educate employees on the risks of cyber to reduce future incidents. 
  • Evaluate the need to obtain cybersecurity insurance to protect the organization against incidents. 

With the adoption of innovative technologies and the significant flow of funds tied to the mortgage space, there is minimal expectations for a decrease in inappropriate cyber activity, and companies should be prepared to mitigate the risks from bad actors. 

Looking forward 

With the MBA forecasting more origination volume in years 2024 through 2026 per the MBA Dec 2023 forecast, and with decreases in mortgage rates and increases in applications, there is some new optimism that has not been prevalent in more than a year. However, we believe that it is critical to manage expectations until baseline production metrics are met and continue to stay focused on the following over the next several months: 

  • Deriving a realistic budget in terms of volume and margins for the next year. 
  • Knowing what is required to breakeven and be profitable at different levels and mix of production. 
  • Forecasting the cash needs and identifying the sources of cash. 
  • Having a plan to sell servicing or hold and finance servicing and be prepared to recapture loans. 
  • Focusing on good margin product and continuing expense management. 
  • Understanding and measuring the implications of the new regulatory requirements. 

This article aims to help you better understand year-end events and regulatory requirements that are impacting the mortgage and servicing industry.  Companies and interested parties should monitor these developments and contact their accountants, consultants, and industry specialists prior to taking instruction from this article.  Baker Tilly professionals are available to discuss your questions and individual needs through our Mortgage Center of Excellence. 

Co-author Matt Petrick, CPA is a senior finance and accounting executive specializing in the financial services industry, with a focus on mortgage and servicing entities. Matt has experience with REITs, financial institutions, business development companies and other funds. The discussions throughout the article should not be implied to represent the position, processes, or procedures of professional affiliations, current or former employers, or employer relationships.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought.

Chuck Kronmiller
Director
global tax | Abstract data and graph lines
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