Robert Segal

Since spring, the Federal Reserve has consistently cited progress in the U.S. labor market, a sign it remains on course to normalize monetary policy. At the same time, the central bank noted stubbornly low inflation, which is creating caution among officials and could limit the pace of rate increases.

The Fed said the economy has been expanding moderately, and acknowledged gains in consumer spending and housing investment. Even so, officials stated they were continuing to monitor inflation developments closely, an indication of unease that it continues to run below the 2 percent objective.

More recently, Federal Reserve Bank of Boston President Eric Rosengren said that global turmoil argues in favor of being cautious about starting the process to normalize monetary policy, in a speech that emphasized central-bank interest-rate increases likely would come slowly.

“Indications of a much weaker global economy would at least increase the uncertainty surrounding policy makers’ economic growth and inflation forecasts,” and that could affect how officials should proceed in boosting the Fed’s target off its current near zero levels, Rosengren said.

Cleveland Fed President Loretta Mester, however, said the economy can handle an increase in the Fed funds rate. “A small increase in interest rates from zero is not tight monetary policy, and with the economic progress we’ve made and that I expect to continue, monetary policy can take a step back from the emergency measure of zero interest rates,” she said.

According to the CME Group, the Fed will announce the long-awaited liftoff at its Dec. 16 meeting. As of this writing, based on Fed funds futures, there was a 74 percent chance the Fed funds rate will remain at 25 basis points after the Sept. 16-17 meeting. That compares with 59 percent for the Oct. 18 meeting and only 38 percent for the December confab.

Indentifying Potential Profits

Further out on the curve, a Bloomberg survey of economists predicts the 10-year Treasury note (currently 2.25 percent) will end the year with a yield of 2.5 percent; that figure will increase to 3.05 percent by the end of 2016. Comparable figures from market forecasts are 2.27 percent (2015) and 2.47 percent (2016). Mortgage rates should climb a similar amount, according to Freddie Mac. The GSE predicts the 30-year fixed-rate mortgage (currently 4.04 percent) will reach 4.30 percent by December 2015 and 5.2 percent in December 2016.

In the search for yield, many bankers have booked longer-term mortgages rather than selling them on the secondary market. In its Quarterly Banking Profile, the FDIC said one- to four-family residential real estate loans increased by $25.1 billion or 3.5 percent at community banks in the one year period ending March 31, 2015. This compares to $10.0 billion or 1.3 percent for the prior 12 months.

As the first Fed rate hike approaches, a number of institutions are evaluating whether or not to sell their fixed-rate production to Fannie Mae or Freddie Mac, in an attempt to reduce interest rate risk. The GSEs, however, have made this option more costly in recent years, by dramatically raising their secondary marketing fees.

To offset the credit risk of insuring mortgage loans they acquire, the GSEs charge a “guarantee fee” which is passed through from the borrower’s monthly P&I payment. The Federal Housing Finance Agency (FHFA), the GSE regulator, has regularly upped guarantee fees in order to boost financial stability at Fannie and Freddie and to shrink their footprint in the mortgage market. The changes were expected to move Fannie and Freddie pricing “closer to the level one might expect to see if mortgage credit risk was borne solely by private capital,” according to the FHFA.

In its 10-Q report for the period ending March 31, 2015, Fannie Mae said the average guarantee fee charged on new acquisitions was 61.2 basis points. While this fee was down from 63.5 basis points in the third quarter of 2014, it is well above the average of 28.9 basis points in 2012 and 26.1 basis points in 2011. For a lender offering a mortgage loan at 4 percent, Fannie Mae’s credit insurance requirement (the guarantee fee) represents about 15 percent of the customer’s interest payment. Assuming a five-year average life, the lender is relinquishing about three points of the loan’s value to pay for the insurance.

Given the cost of this credit insurance, financial institutions may wish to consider other avenues rather than selling to the GSEs. One option would be to hold on to the loans and finance them with long-term funding. As an example, five-year funding is available from wholesale sources at a cost of about 1.7 percent. For the 4 percent mortgage loan, this is a spread of 2.3 percent that could be locked in for five years. Another alternative is selling loans directly to another financial institution. Compared to a 30-year fixed-rate MBS yielding about 3 percent, the whole loan asset may offer considerably more value.

Many financial institutions conduct a “best-execution analysis” when looking at various sources of wholesale funding. The same concept can be applied to the mortgage portfolio. After evaluating investor prices and funding costs, the lender can determine the most profitable strategy. By only selling to the GSEs, the institution may be overpaying for insurance.