The UK's Exit Will Take Several Years - Why Mortgages Aren't Tagging Along Yet

By rchrisman@robchrisman.com

There was a man in Bulgaria who drove a train for a living. He loved his job, driving a train had been his dream ever since he was a child, and he loved to make the train go as fast as possible.

Unfortunately, one day he was a little too reckless and caused a crash. He made it out, but a single person died. Well, needless to say, he went to court over this incident.

He was found guilty, and was sentenced to death by electrocution. When the day of the execution came, he requested a single banana as his last meal.

After eating the banana, he was strapped into the electric chair. The switch was flown, sparks flew and smoke filled the air- but nothing happened. The man was perfectly fine.

Well, at the time, there was an old Bulgarian law that said a failed execution was a sign of divine intervention, so the man was allowed to go free.

And somehow, he managed to get his old job back driving the train. Having not learned his lesson at all, he went right back to driving the train with reckless abandon.

Once again, he caused a train to crash, this time killing two people. The trial went much the same as the first, resulting in a sentence of execution.

For his final meal, the man requested two bananas.

After eating the bananas, he was strapped into the electric chair. The switch was thrown, sparks flew, smoke filled the room- and the man was once again unharmed.

Well, this of course meant that he was free to go.

And once again, he somehow manages to get his old job back. To what should have been the surprise of no one, he crashed yet another train and killed three people.

And so he once again found himself being sentenced to death.

On the day of his execution, he requested his final meal- three bananas. "You know what? No," said the executioner. "I've had it with you and your stupid bananas and walking out of here unharmed. I'm not giving you a thing to eat, we're strapping you in and doing this now."

Well, it was against protocol, but the man was strapped in to the electric chair without a last meal.

The switch was pulled, sparks flew, smoke filled the room- and the man was still unharmed.

The executioner was speechless.

The man looked at the executioner and said "Oh, the bananas had nothing to do with it. I'm just a bad conductor."

Is it too early for hurricane jokes? Ok, I'll just wait for everything to blow over. Fortunately, it has been 11 years since the U.S. was struck by a major (category 3 or higher) hurricane - Hurricane Wilma in 2005 in Southwest Florida. During the 2015 hurricane season, only 4 hurricanes hit (7 named storms did not materialize into hurricanes). The Census Bureau tells us that the total population of the 185 counties along the Atlantic Ocean is 59 million and that the collective land area (square miles) of the states stretching from Maine to Texas is 750,919. 143.6 million is the population of coastal states stretching from Maine to Texas - the areas most threatened by Atlantic hurricanes. An estimated 45% of the nation's population lives in these states.

"Rob, my clients keep asking me about why it is that Treasury rates - like the yield on the 10-year - keep dropping but mortgage rates don't seem to be along for the ride. Why not?" Early in the week the 10-year yield touched 1.38%, which was a record low on the 10 year. It looks like we are getting ready for another refi boom. Plenty of smarts folks are making the call that Brexit means slower growth and lower rates for the next couple of years. (Or more - see below.) But in this low rate environment pension funds and insurance companies, which need to earn 7% or more to keep up with liability growth, are already losing billions. 

 Yes, mortgage rates have lagged, and are still about 20 basis points higher than the record low set in late 2012. And mortgage-backed securities have lagged the move up in Treasuries. If you look at the 2012 period, one can see that the 10-year yield bottomed out in July, and started rising into the end of the year. Mortgage rates kept falling throughout the year, bottoming out in December. So, in 2012 mortgage rates didn't bottom out until 5 months after Treasuries did. 

 Sure enough, looking at this year, if you plot the difference between the two rates (basically a proxy for MBS spreads), you can see that the current difference is approaching a high again. If this is a truly mean-reverting series, you should expect that gap to close over time, and that will either happen through higher Treasury yields or lower mortgage rates - probably the latter. Which means we could have a good refi season into the end of the year. Which also means that any investor or servicer holding a 30-year fixed rate loan above 4% may see it pay off. And lenders have also used margins to regulate incoming locks - that should be a surprise to no one - especially with a lack of underwriters.

 That is good for LOs and lenders who are seeing locks continue to strain the system. It isn't good for any investor who paid a premium for MBS or servicing, only to see it run off - unless they have a portfolio retention group "defending" the loans likely to refinance.

 LOs also know recently originated loans are "stickier" - many borrowers don't want to go through the hassle again to save $50 a month. As one veteran broker wrote to me yesterday, "In the old days MLOs would move loans from lender to lender to the benefit of the borrower and themselves. These days, loans just go to the lender of least resistance. I don't recall a time in my near 30-yr career where I hear of MLOs so mentally exhausted to earn less."

 We can attribute this last move in rates to Brexit, the UK voting to leave the European Union. Yes, plenty can happen between now and a couple years from now when it actually occurs. Experts disagree on the impact it will have on our economy. For example, Goldman Sachs Group expects a limited impact from Brexit on the US economy and predicts a two-thirds probability of an interest-rate increase this year by the Federal Reserve. Brexit "is unlikely to stop the hiking cycle given the cyclical position of the US economy," according to a research note by Goldman strategist Rohan Khanna earlier this week.

 Attorneys at Seyfarth Shaw have written an overview, "BRACING for BREXIT - after the shock, what now?" - sent to me by Ivan Alexander. The piece, written by Robert Hanley, Ming Henderson, Amy S. Levin, Gordon Peery, Julia K. Sutherland, Peter Talibart, and Deirdre M. Murphy, spells the situation out pretty well.

 "...despite the political and market upheaval, the UK's membership of the European Union will continue until it has been formally withdrawn, and that is likely to take several years. In the immediate future, the legal landscape will remain substantially unchanged in many respects.

"The formal first step to exit is the UK notifying the EU of its intention to leave in accordance with Article 50 of the Treaty on European Union. (The article is down about ¼ of the way.) Once served, the remaining countries of the EU are then obliged to negotiate with the UK the terms on which the UK will withdraw. The withdrawal agreement will cover not only the terms of the UK's exit but also the nature of the UK's future relationship with the EU.

"Under Article 50 the EU treaties will cease to bind the UK after two years from the date the UK serves notice of its intention to leave the EU (although this two-year period could be extended by agreement between the European Commission and the UK Government).  The UK Prime Minister David Cameron has indicated that he does not intend to serve an Article 50 notice and that doing so will be for his successor. Accordingly, the two-year timetable for exit may not commence until October this year when the new Prime Minister has taken over. This leaves a period of several months for informal talks between the UK Government and the European Commission and other EU member states.

"Once the Article 50 notice has been served, the formal negotiation process is very likely to take at least two years owing to the complexity of the issues and the range of issues to be accommodated. The Government's view (in the lead up to the BREXIT referendum) was that the negotiations could take up to 10 years whereas the successful 'Leave' campaign has indicated its desire that negotiations are concluded before the next UK general election in May 2020, just under four years from now. 

"In any event, once negotiations are concluded the withdrawal agreement will need to be ratified by the UK and the EU and, in the latter case, this means ratification by all 27 remaining member states which is unlikely to happen quickly.

 "The nature of the UK's ongoing relationship with the EU will directly affect the way in which the UK's legal framework will change when the UK does eventually exit the EU.  There are several alternative models the UK could choose according to how close (or not) the UK wishes to remain to the EU...Regardless of which BREXIT route is selected by the UK and ultimately agreed with the EU, it is important to remember that major changes to the UK legal landscape will not occur immediately and, instead, may take several years."

 Speaking of "big picture" changes, "Attacks on America's financial system and institutions by the administration, activists, and politicians from both the left and right have undermined the economy," according to U.S. Chamber of Commerce President and CEO Thomas J. Donohue. Donohue said it was time to put the focus on where it belongs-creating robust capital markets that can finance America's growth and provide jobs and opportunities for American consumers. "Those attacking our capital markets don't have a reform agenda, they have a big government agenda," said Donohue. "They aren't looking out for consumers or the 'little guy.' They are looking to gather more power for themselves so they can run the entire economy from Washington, D.C. Their proposals would trap us in this anemic economy and strangle small businesses and Main Street."

 In his remarks, Donohue explained that our financial services industry isn't a problem to be solved, limited, and controlled-it's a key ingredient to boosting the economy. But the current regulatory approach is restrictive, punitive, duplicative, and overlapping. It is focused on the impossible task of eliminating all risk from the system at the cost of economic growth. Donohue outlined an agenda to create robust and smartly regulated markets that could produce higher rates of growth and solve major financial challenges, such as unsustainable entitlement programs.

 Much closer to us are changes in loan applications for borrowers. Yes, 1003 changes are in the works, hopefully well before the 1/1/18 implementation date, and Jeff Reeves with Box Home Loans writes, "I first learned of it at the MBA Tech Conference this spring in LA where Fannie and Freddie gave a sneak preview of the new form. Afterward I asked the presenters - since they were stylizing the new 1003 with some of the same elements as the LE and CD - if they were going to align two critical sections of the two documents: the Details of Transaction (1003) and Cash To Close (LE/CD). Right now the two documents have different ways of expressing closing costs and prepaid items, and it just confuses borrowers.

 "I was pleased to learn that while the Details of Transaction on the new form will continue to NOT be expressed like the LE/CD's Cash to Close section that at least the borrower version of the new 1003 will NOT include the Details of Transaction. The Details of Transaction will come on subsequent pages after the borrower's signature, and will not need to be provided to the borrower, but instead just to lending partners, such as investors. That's a good change, and one reason I'm looking forward to the new form."

 Eventually everyone will be using a new 1003, whether it is a Qualified Mortgage or not. On the topic of non-QM origination trends from out in California Krista Donecker with Angel Oak Mortgage Solutions writes, "I have a few thoughts on why non QM has not exploded as expected. As an Account Executive for Angel Oak, I have witnessed the brokers get excited about alternative lending yet not make much of an effort to solicit and spread the news. Brokers usually call me on files that have fallen out of agency guidelines. I believe the hesitation comes from a false belief that Non QM loans are difficult to close.

 "Additionally, the broker is contending with a Non QM borrower who continually hears about 3.50% rates instead of risk based pricing. When I speak on behalf of the broker to the real estate community, the agents are very excited about non-agency lending because they realize it expands their selling opportunities. Again, the programs went away years ago, yet the borrowers did not. As the news spreads about Non QM loans, we will see more borrowers calling brokers asking for non-traditional loans." Thank you Krista.