The Economics Behind the HARP Program
HARP, The Home Affordable Refinance Program, is a streamline refinance program developed to help borrowers who have continued to make their mortgage payments, but have be unable to refinance due to a decline in their home value. Underwater borrowers have been stuck in a “no-win” situation of sorts, being stuck in a well above market mortgage rate (over 6% in many cases) despite being current on their existing loan and maintaining strong credit. Various fees and a LTV ceiling cause the original HARP program to flame out unsuccessfully. Blame was quick to be cast among the major lenders, the GSE’s, as well as the Government.
The early results of HARP 2.0 are in, and the program’s modifications appear to be spurring strong activity. Are the big bad “too big to fail” banks finally relenting and playing ball? As an investor in the securitized mortgage market, I see aspects of the market that the average borrower or market participant does not. In this post I will walk through the economics of mortgage origination for HARP loans, break down exactly how much these banks are making, and how they are able to do so.
Mechanics of Securitization
Many realize that mortgages are sold into Fannie/Freddie pools but few know the intricacies. If a borrower has a rate of 4% on a 30yr mortgage, the investor of the pool only receives 3.5%. The remaining 0.5% (50bps) is split between the servicing fee and GSE “guarantee fee”. Similar 4% loans will then be aggregated together into a pool. A “30year 3.5” is a pool of 30yr 4% mortgages with a coupon of 3.5%. As of today’s close, a 30yr 3.5% pool trades at a price of ~$105.75. If you tack on the 1% origination fee that most charge, and the servicing rights which are valued at another 1%, the originators (Wells Fargo & Company (NYSE:WFC), JPMorgan Chase & Co. (NYSE:JPM), Bank of America Corp (NYSE:BAC)) are making almost 8points on a standard plain vanilla conforming mortgage.
Historical spreads of what’s known as the “primary-secondary” spread show that mortgage rates are actually higher than they are supposed to be. The current coupon mortgage rate measures the yield of the hypothetical par mortgage (30yr 3’s trade at almost 104 so there’s no tradable par bond). Today that rate is 2.34%. The average 30yr mortgage rate to borrowers, as measured by Bankrate, is currently 3.61%, or almost 130bps over the current coupon rate. Longer term this primary/secondary spread averages closer to 70bps, not 130bps, so rates are about 50-60bps higher than they should be here.
The Value of HARP Loans
HARP loans are particularly valuable in the eyes of investors due to prepayment friction. A borrower may only “HARP” a loan once. As these borrowers are generally all under water on their loan, it isn’t feasible to finance into a standard loan. As such, these borrower are trapped in these loans. The street, with good reason, projects these mortgages to prepay very slowly going forward. To mortgage investors, the stability of these cash flows due to extremely low prepayments is worth significantly more than the average pool.
Our example above showed that a 4% mortgage rate would trade into a 3.5% pool which is a $5.75 profit to the bank excluding origination. The value of HARP loans can vary, but these typically trade up at least 2-3 points over TBA collateral. ”TBA” is the industry jargon for generic new collateral. So if a 4% HARP loan was originated and quoted at +3, the price would be $105.75 + $3.00, or $108.75. Add on the origination and servicing fees and near 11 point profits are being earned.
Lack of Competition is the Driver
One of the quirks with the HARP program is that you’re only allowed to enter into a HARP loan with your original servicer. Noted mortgage analyst Laurie Goodman of Amherst Securities explains, “HARP 2.0, announced in November 2011, introduced significant new benefits to servicers for refinancing their own loans. In contrast, different servicer refinances received at best marginal improvements…This tends to lock a borrower into refinancing with their existing lender, which conveys tremendous pricing power to the banks. A lack of competition has allowed current servicers to charge higher rates to these borrowers, when the economics of origination would suggest lower rates are in order. And borrowers have little choice but to pay the higher rates, as the rules favor same servicer refis to a very strong extent.”
The Menendez/Boxer bill being tossed around Congress proposes to allow borrowers to enter into a HARP loan with different mortgage originators. This would ostensibly create greater competition and lower profits for the three main originators (Wells Fargo, Chase, and B of A). To nobody’s surprise, the big banks are adamantly against this proposal and it’s easy to see why. Not only would their oligopoly on HARP loans be put into jeopardy, but the extra premiums which are able to be extracted would also go down.
Summary
While it is encouraging that more and more underwater homeowners are gaining the benefits of today’s low interest rates, tremendous profits are being made at their expense. Lack of competition is the primary catalyst, but the underlying economics to the large “too big to fail” banks will do nothing but stoke additional anger in the general public. Expect this trend to continue until the dynamics of the program is changed once again, possibly in HARP 3.0. Until then, the cash cow will continue for the TBTF banks.
By: David Schawel, CFA of economicmusings
