Are Mortgage Rates too High?
Board: Macro Economics
One of the Federal Reserve’s primary goals is to get inflation in residential housing prices. The Fed is well aware that for a majority of Americans, the main component of their net worth was the equity in their house. When the credit crash/housing crash occurred, it wiped out the net worth for a lot of folks. With negative equity in their homes, their net worth was literally a negative number. We all know the story, so there is nothing new here.
The Fed understands these facts and has driving down interest rates in an attempt to support house prices. Rightly or wrongly, the Fed has done their part to boost housing prices.
What is NOT well known by the masses is that the banks have used this opportunity to boost their margins for originating mortgages. A mortgage broker friend of mine recently told me that the banks had the largest margins in his 30+ year history in the business.
The New York Federal Reserve bank released a white paper last week that quantifies this margin.  A picture is worth a few billion dollars, so I suggest you look at the paper, if only to see Figure 1. It is a graph of “The Primary-Secondary Spread.” Excerpt:
The vast majority of conforming mortgage loans in the United States is securitized in the form of agency mortgage-backed securities (AMBS). Principal and interest payments in these securities are passed through to investors and are guaranteed by one of the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, or by Ginnie Mae. Thus, investors are not subject to loan-specific credit risk but only face interest and prepayment risk—the risk that borrowers refinance the loan when rates are low.
When thinking about the relationship between the primary market, in which lenders make loans to borrowers at a certain interest rate, and the secondary market in which lenders securitize these loans into AMBS, policy makers and market commentators usually invoke the “primary-secondary spread,” which is calculated as the difference between a representative yield on newly-issued AMBS—the current-coupon rate— and an average of mortgage loan rates obtained (usually) from the Freddie Mac Primary Mortgage Market Survey (PMMS).
The graph shows the current spread at about 125 basis points (1.25%) versus a more typical value of about 50 basis points for most of the 2000’s until the crisis. As you might expect from a Fed white paper written by 6 PHD economists, it has a lot more detail in the 31 pages. They calculate the bank profit per $100 of loaned money. They also show this being at record highs.
The paper offers a number of factors that might be influencing the margin. One of the strongest arguments is “capacity constraints.” The banks are so overwhelmed doing refinancing, they are quoting long lead times and turning away business. Just like in any industry, this allows them to raise their prices. The paper does not talk about it much, but a related factor is the concentration of loans. During the first half of 2012, Wells Fargo, JP Morgan and US Bancorp originated half of the mortgages in the US. Wells Fargo alone has > a 33% market share.
BOTTOM LINE is that residential mortgages should be about 75 basis points (0.75%) lower than they currently are if the bank margins reverted to the mean. As simple calculations show, if you could persuade these banks to lower their margins to historical numbers, the housing market would see even STRONGER support. More people would qualify to buy more houses. In the meantime, this part of banks business is booming thanks in large part to the feds ZIRP policy.
 New York Fed white paper: The Rising Gap Between Primary and Secondary Mortgage Rates