By some measures, buying a home now is more affordable than almost any time in the past 50 years. Nationwide home prices are down by a third, and mortgage rates are at record lows. But some argue that rates should be even lower.
As it turns out, there's something in the mortgage marketplace that's preventing rates from falling further, and keeping many would-be homeowners from getting an even cheaper loan.
What's keeping mortgage rates from falling further?
There's no question that a recovery in housing is imperative to a recovery in the economy. Federal Reserve Chairman Ben Bernanke has explicitly stated the central bank's commitment to revive the housing market, which he called "the missing piston" in the economic recovery.
Indeed, a major goal of the Fed's latest round of quantitative easing (QE3) is to provide support to housing by driving mortgage rates down further and making the prospect of owning a home even more appealing.
But so far, QE3 doesn't appear to have benefited homeowners much; mortgage rates are only marginally lower than before the program commenced. But QE3 has been a godsend for banks, whose profits from new mortgages have risen substantially since the Fed embarked on the program last month.
So why exactly are banks reporting abnormally large profits from mortgages?
Why banks are pulling in so much dough from mortgages
It boils down to the way banks originate mortgages, package them into bonds, and then sell them to investors, such as pension and mutual funds. Banks' profit is determined by the spread between the mortgage rate borrowers pay and the interest paid on mortgage bonds. Simply put, banks make more money when homeowners' mortgage rates are high and when the interest paid on mortgage bonds is low.
In the decade since 2000, this spread averaged just 0.5%. But over the past year or so, it has risen noticeably and currently hovers around 1.6% -- a historical outlier. On September 12, the day before QE3 was announced, the interest rate banks pay on mortgage-backed securities was at 2.36%. Towards the end of September, that rate dipped as low as 1.65%.
If banks were content with the profit margins they enjoyed just a few years ago, the interest rate on a 30-year fixed-rate mortgage would be around 50 basis points lower. According to a recent New York Times article, the reduction in mortgage rates from 3.55% to 3.05% would save a borrower some $30,000 over the lifetime of a $300,000 mortgage. That's no pocket change.
A big change in the mortgage market
Another driver for increased profits may be less competition among mortgage lenders. After the housing bust and consequent financial crisis, a few major banks have emerged as the dominant lenders.
For instance, Wells Fargo (NYSE: WFC), JPMorgan Chase (NYSE: JPM), and US Bancorp (USB -1.49%) together commanded half the market for new mortgage originations in the first half of the year, according to Inside Mortgage Finance, an industry publication. Bank of America (BAC -1.07%), which has lost substantial market share in recent years, was the fourth-largest lender in the second quarter.
This trend reveals a drastically different mortgage market than just a few decades ago. In the not too distant past, entities such as savings and loans associations, credit unions, commercial banks, community banks, and mortgage brokers played a much larger role in the mortgage market. Just two decades ago, a lender that commanded a 10% market share would have qualified as one of the largest. Compare that to last quarter, when Wells Fargo alone originated 32.4% of all new mortgages.
This virtual oligopoly in the mortgage marketplace has raised concerns from many important commentators, including the inspector general for Freddie Mac and Fannie Mae, regarding the risks it poses not only to borrowers, investors, and taxpayers, but also to the health of the housing market and the financial system.
But it should come as no surprise that the banks are keeping mum. With less competition, the remaining players are seeing fatter profit margins. Wells Fargo, for instance, pulled in revenue of $4.8 billion from its mortgage origination business in the first half of the year, representing a 155% increase from the same period a year ago.
Does QE3 actually help?
As you can see, the biggest beneficiaries of QE3 appear to be the big banks that originate mortgages. While mortgage rates for borrowers have fallen somewhat over the past month, they would likely fall much further if banks were willing to accept tighter spreads. And besides providing little support to homebuyers so far, QE3 may actually be bad news for a certain type of company -- the mortgage REIT.
Mortgage REITs make their money from a simple yet lucrative business model. They borrow money at low short-term interest rates, which they then use to buy higher-yielding mortgage-backed securities. They earn their profits on the difference between these two rates. The larger this interest rate spread, the more money they pocket.
For years now, they've benefited tremendously from the Fed's pledge to keep short-term rates near zero. While this has allowed them to maintain some pretty impressive payouts, many have seen cuts in their dividends lately.
Last month, Anworth Mortgage Asset (ANH) reduced its dividend by 17%, which represents the second consecutive quarterly drop in the company's payout. While it still offers an eye-popping 9.7% yield, the company has cut its payout by more than half over the past three years.
Anworth isn't alone. Chimera Investment (CIM -0.24%) has also cut its dividend five times in the past two years. And Annaly Capital (NLY 0.59%) has cut its dividend by a third since 2009, and lowered it by 9% in the most recent quarter.
Going forward, the outlook for these companies isn't looking as bright as it did a few years ago. Mortgage REITs face major headwinds including narrowing interest rate spreads and an accelerating trend of prepayments, bolstered by the refinancing boom.
