Don Layton, the current Senior Industry Fellow at the Joint Center for Housing Studies at Harvard University—and former CEO of Freddie Mac—released a new column on the policymaking implications of record-high mortgage origination profits during the pandemic he authored after the release of the Mortgage Bankers Association (MBA) Annual Mortgage Bankers Performance Report.
Citing the MBA’s report, the “net production income” of mortgage lending firms—a key measure of those firm’s profits—was a record 1.57% in 2020 and 0.82% in 2021. However, this compares to an average, since reporting began in 2008, of just 0.60%.
Putting this another way, mortgage lending profit margins were 262% of the historic average and are still 133% of average in 2021. “That’s an extraordinary increase during the dislocations of the pandemic,” Layton commented.
“This pattern of profitability is evidence of an unintended flaw in the country’s system of funding new mortgages, created by how the origination process is layered between the primary market (several thousand lenders who make loans directly to homeowners) and the secondary market (which consists almost entirely of three government agencies) that provide permanent financing,” Layton said in his article. “These two markets are tightly connected because significantly more than half of the loans originated in the primary market are held by its lenders for only a short period, and then sold to a permanent funding source via the secondary market.”
“Thus, primary market firms will earn as revenue the difference in the interest rate charged to borrowers versus the lower rate paid to the secondary market funder when the loans are sold,” Layton continued. “Given the mechanics of the market, this interest rate differential is reflected in primary market lenders selling loans to the secondary market for an amount larger than actually advanced to borrowers, producing what is called the ‘gain on sale margin.’ (Unlike the MBA’s net production income measure, it does not consider expenses or other sources of revenue.)”
Layton goes on to say the gain on sale margin confirms a pattern of “dramatically increased profitability” during the pandemic and cited Rocket Mortgage as an example of this—Rocket Mortgage had a gain-on-sale margin of 3.19% before the pandemic which rose to 4.46% in 2020, and decreased to 3.13% in 2021.
He cited a second example of another large non-bank mortgage originator, Loan Depot, which saw a similar rise and fall of profits during the pandemic. Their gain on sale was 2.18% in 2019, 4.13% in 2020, and 2.61% in 2021.
“The unusual primary versus secondary market structure was designed to ensure that the primary market can keep lending even in the most stressful economic or financial market periods, which it largely does,” Layton said. “Regrettably, however, it also means that the economic benefit of federal policymaking actions cannot be assumed to be fully and promptly transmitted to the homeowners who were its intended beneficiaries; instead, some portion can be diverted to the middlemen primary market lenders, which is exactly what happened during the stress of the pandemic.”
In the early of the pandemic, the Federal Reserve aggressively intervened to reduce interest meaning the two Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac, along with Ginnie Mae, were able to offer to finance mortgages at much lower interest rates that they were just months earlier. However, primary market lenders were not required to pass through those lower rates to borrowers.
While the market typically moderates its own prices through competition, this was decidedly not the case during the pandemic as a tsunami of refinances came down on primary lenders by those taking advantage of record-low rates.
As a result, the market largely decided to not pass those savings onto borrowers competitively, and instead decided to raise their margins to equilibrate supply with the massively increased demand by raising interest rates to homeowners in an amount measurably less that if the much-lowered secondary market interest rates had been fully passed through to homeowners.
What resulted were record profits in 2020 when the supply/demand imbalance was it its peak then returning to normal in 2020 as supply and demand came more into balance.
“Interestingly, the increase in profit margins could have been even more pronounced,” Layton said. “In October 2020, at the direction of the government, the GSEs announced that they would (with some exceptions) add a 0.50 percent up-front ‘adverse market fee’ on their refinances. It was justified by the elevated credit losses expected to occur because of the pandemic, and took effect on December 1.”
“Naturally, the mortgage industry complained strongly about the fee. It was eliminated on August 1, 2021 when it became apparent to the government that the anticipated losses were not being incurred,” Layton continued. “However, in retrospect, we can see that the fee kept the industry’s 2020-21 profits from increasing even more than they did (with the fee’s impact largely felt in 2021). As a result, a portion of the primary market profit margin increase benefited the GSEs instead of going exclusively to shareholders of the lenders. And as the GSEs are effectively owned by the taxpayer, this means the taxpayer captured a portion of those enhanced profits, which only seems fair since it was government policymaking that produced the conditions for the record profits in the first place.”
This primary versus secondary market friction in policymaking can also be found elsewhere, including the requirement that the GSEs meet certain affordable lending goals.
“In order to make future policymaking more effective, the ability of the primary market middlemen to enhance their margins as described above is something that those who make decisions about the design and operation of the mortgage system should think deeply about,” concluded Layton. “While the industry would naturally be vociferous against any attempt to limit their margins, a program to do so—but restricted to times of great economic stress or with respect to targeted programs designed to expand homeownership—might make sense. It would be implemented through changes in the legal contracts primary market sellers enter into with the GSEs and Ginnie Mae; what is unclear is how difficult it would be to operationalize. But it is definitely worth exploring.”