Last month, the Federal Reserve announced its third round of quantitative easing, or QE3, which entails open-ended purchases of mortgage debt in an effort to support the housing market. Since the announcement, mortgage rates have fallen by roughly 0.2% and are now at record lows, providing a welcome incentive for prospective homebuyers.
But borrowers aren't the biggest beneficiaries of these historically low rates; the banks that make mortgage loans are.
The Fed's latest move
One of the main goals of QE3 is to provide support to the nascent housing recovery by lowering mortgage rates further. So far, it has been decently effective. The day before the announcement, the rate on a 30-year fixed-rate mortgage stood at 3.57%. Last week, the average rate dipped to 3.37%, according to Freddie Mac's Weekly Primary Mortgage Market Survey.
While this 20 basis point rate reduction is definitely a positive development, many argue that rates should be even lower. They contend that QE3's benefits could be more fully captured by borrowers if only banks were willing to accept lower profits on the mortgages they originate. Let's take a closer look at this argument.
A broken transmission channel in the mortgage market?
Over the last year, something of a quirk has developed in the mortgage marketplace. It has to do with the spread banks earn on the mortgages they make. Since the financial crisis, banks have continued to originate mortgages, but they have sold the majority into the bond market.
By doing so, they profit from the difference between the bond yield and the mortgage rate. The larger this difference, or spread, the more money they pocket. Until just about a year ago, the spread tended to be less than 1%. But it's now closer to 1.5%, allowing many of the nation's largest banks to reap big gains from their mortgage businesses.
For instance, Wells Fargo, JPMorgan, and US Bancorp all reported record quarterly profits in the third quarter, fueled by a surge in mortgage loans. Wells originated $139 billion worth of mortgages for the quarter, up from $89 billion a year earlier, while JPMorgan issued $47 billion, up from $37 billion. Similarly, US Bancorp's revenue from mortgage banking more than doubled in the third quarter.
And smaller lenders Bank of America (NYS: BAC) and Citigroup, who are still struggling to unload toxic mortgages from their balance sheets, also reported substantial increases in the number of mortgages originated.
Even regional banks like New York Community Bancorp (NYS: NYB) and BancorpSouth (NYS: BXS) are benefiting from high mortgage volumes. New York Community Bancorp reported a better-than-expected profit in the third quarter, fueled by a whopping five-fold growth in mortgage banking income. And BancorpSouth saw its earnings double to $23.8 million, led by mortgage lending revenue that grew almost ninefold from a year earlier, coming in at $13.5 billion.
Why aren't the benefits of QE3 being passed on to borrowers?
While QE3 has been successful in narrowing the spread between agency mortgage-backed securities and Treasury yields, the spread between primary mortgage rates and agency mortgage-backed securities has actually widened. Hence, many argue, banks aren't fully passing on the benefits of their lower funding rates to borrowers. Calculations by economists at TD Securities suggest that, since QE3 was announced, banks have passed on an average of only 40% of their lower funding rates to borrowers.
Part of the reason why has to do with the fact that Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs) that dominate the mortgage market, have been requiring banks to repurchase soured loans. This so-called "putback" risk incents banks to originate only those mortgages that meet highly conservative standards, effectively eliminating mortgage credit for a wide swathe of Americans.
Two other reasons why, as highlighted in a speech by New York Fed President William Dudley last week, are a high degree of concentration in the mortgage market and higher guarantee fees charged by the GSEs. For instance, the two largest lenders, Wells Fargo and JPMorgan, accounted for a whopping 44% of all mortgages in the first half of the year. Mr. Dudley explained:
The incomplete pass-through from agency MBS yields into primary mortgage rates is due to several factors -- including a concentration of mortgage origination volumes at a few key financial institutions and mortgage rep and warranty requirements that discourage lending for home purchases and make financial institutions reluctant to refinance mortgages that have been originated elsewhere. On a related note, higher guarantee fees charges by Fannie Mae and Freddie Mac have increased the fixed cost of originating loans and this has also increased the spread between primary and secondary mortgage rates.
As you can see, QE3 has been somewhat beneficial for borrowers, but most can't reap the rewards of lower rates because of the lack of mortgage credit for all but the most qualified of borrowers. And the Fed's plan has actually turned out to be bad news for companies like mortgage REITs because it further threatens their already low net interest margins.
On the other hand, shares of the nation's largest mortgage lenders, including Wells Fargo, JPMorgan, US Bancorp, and Bank of America, all gained slightly after QE3 was announced, though most have since returned to pre-announcement levels. Wells Fargo and Bank of America registered the biggest spikes following the Fed's decision, with shares of both gaining around 1.6% the day after.
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The article Why QE3 Helps Banks More Than It Helps You originally appeared on Fool.com.
Fool contributor Arjun Sreekumar has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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