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I saw something on Threads the other day that inspired this off-cycle release about two topics near and dear to our hearts: mortgage lock-in and financial engineering. We’ll be back to our regularly-scheduled Resi Wrap programming later this week, dad-jokes, dinosaur art, and all.

There is an idea in housing these days broadly described as “mortgage lock-in,” whereby for-sale existing housing inventory is depressed because current homeowners are unwilling to walk away from their low fixed-rate mortgages.

While many, including Fannie Mae here with a rather unscientific survey, have theorized that the lock-in effect is overstated, the most basic economic analysis supports the idea that doubling a homeowner’s financing cost presents an incremental barrier to listing their home.

We recently shared a link in Resi Wrap about a company called Roam, that is trying to profit from this dislocation by taking advantage of a little-known feature of FHA and VA mortgages. That is, loans backed by these government agencies are assumable, which means that the owner/borrower can transfer their loan to a new buyer/borrower, as long as that new buyer/borrower would qualify for the original loan.

It is a useful idea, albeit one that focuses on a relatively small corner of the housing market. In this case, by making a loan assumable, the lender is willing to accept a change to the CREDIT profile of the borrower. For why this is significant, a brief primer on how mortgage risk works:

In a mortgage, a lender can lose money in several ways:

-       Default risk – when a borrower fails to pay the mortgage, leading the lender to take a cash loss on the loan of varying severity, depending on the price the lender receives when selling the home after foreclosure

-       Rate risk – when interest rates in the economy rise above the lender’s expectations, such that the loan pays the lender less interest than the lender could receive from extending credit at the new, higher rates (and possibly less than that lender’s cost of financing its own debts, which is what caused Silicon Valley Bank and First Republic to go under earlier this year)

-       Prepayment risk – when the borrower refinances a home sooner than the lender expected, forcing that lender to redeploy their capital at a lower interest rate than the one at which they originally lent.

The lender mitigates each of these risks either by directly hedging their exposure (ie trading treasury securities and derivatives to manage their overall exposure to interest rate moves) or by underwriting the risks they are unable to hedge, so that they can quantify and diversify those risks.

In the case of the assumable FHA / VA loans, the lender is effectively saying that as long as the new borrower offers the credit, assets, and income characteristics that define that lender’s “credit box,” they do not mind if the actual borrower itself changes.

More recently, I ran across this post on Threads:

The idea that the poster is proposing is to offer a mortgage product that allows the borrower to transfer their collateral (ie the underlying home) while keeping their loan. We can refer to this as a “Collateral Transfer Mortgage.” As opposed to the Assumable Mortgage, this proposal would allow the borrower to keep their mortgage with them and port it over to a new home.

Going back to our risk framework above, similar to the Assumable Mortgage, the new home would have to fit into the lender’s “collateral box” for this to make sense. For instance, I could not take out a $400k mortgage on a $500k home (80% loan-to-value), and then turn around and replace that with a home only worth $380k (105% loan-to-value).

On its face, this idea would seem quite a bit easier to process than the assumable loan. Why, after all, should a lender care if I were to change my collateral to something of equal or greater value? Perhaps they even could impose additional requirements, like a 5% haircut on the new home’s valuation to protect against shoddy appraisals in a fast market, or geographic restrictions to ensure the overall geographic mix of their loan book is not impacted.

One problem, however, that would impact the willingness of lenders to support this product, is that the Assumable Mortgage has a meaningful impact on that lender’s interest rate risk. Why? It turns out that the 30-year,fixed rate mortgage is not actually underwritten to assume that it is held for 30 years. This is because the average homeowner stays in their home for far less than 30 years. This has the effect of somewhat mitigating the upside interest rate risk held by lenders, because most borrowers have historically often been willing to prepay an in-the-money mortgage (ie one whose interest rate is lower than the current prevailing rate), against their own economic self-interest, because they wanted to physically move houses.

Historically, the average tenure of home-ownership has averaged approximately 7 years.

As a result, the 30-year, fixed rate mortgage is typically priced as a spread to the 10-year treasury bond, roughly assuming an average tenure of 10 years for each borrower (a slightly conservative estimate). 10-year bonds usually carry lower interest rates than 30-year bonds, because they carry less duration risk (the risk of interest rates going sharply higher during the holding period of the bond). In a world of Collateral Transfer Mortgages, a borrower would literally never prepay an in-the-money loan when moving houses. Instead, they would simply take their low-rate loan with them to the next house. In other words, the lender would have to assume the worst case scenario: that the borrower will prepay when rates go lower, but hold all loans to maturity when rates go higher. As a result, a Collateral Transfer Mortgage would inherently need to carry a slightly higher interest rate than a traditional one, if for no other reason than it would have to price off of the 30-year treasury bond instead of the 10-year treasury bond (even if the 30Y were cheaper than the 10Y, the degree to which a mortgage prepayment feature represents an option for the borrower would make the Collateral Transfer Mortgage more expensive).

Still, it stands to reason that some subset of the home-buying population would presumably be willing to pay some premium for the option to bring their low-priced mortgage with them to their next house. So why have we not seen this product created and adopted yet? I would point to the fact that we are only now reading about a consumer desire for this product, as we sit at the 20+ year highs on mortgage rates.

This is what’s known as closing the barn door after the horse has already run away. The best time for the Collateral Transfer Mortgage would have been any time in the last 14 years. Unfortunately, most consumers prior to the recent rate rise would almost certainly have been unwilling to pay even a small premium to secure mortgage portability, egged on as they were by real estate agents and mortgage salespeople urging them to purchase the largest home their leveraged buying power could afford. (Never mind that I wrote a back-of-envelope business plan for Collateral Transfer Mortgages in 2013. I’m weird).

So now that housing market participants are (rightfully) refocused on interest rates, is there hope for this product yet? I think we may have a very brief window of opportunity. While it’s tough to see consumers paying for upside protection at this very moment, with the yield curve as inverted as it is, it is certainly possible that this recent rate spike will have forced a critical mass of borrowers to find rate religion in the near future. For instance, if the Fed were to cut short-term rates to 3% over the coming years, per its most recent dot plot, but with no view to a return to the Zero Interest Rate Policy and Quantitative Easing of the 2010’s, perhaps the right marketing pitch from a large enough player could successfully launch the Collateral Transfer Mortgage.

I would also point out that the increase in duration risk this implies for lenders may end up happening anyway, thereby reducing the premium needed to cover their risk. In recent years, homeownership tenure has increased rapidly, including well before any sort of lock-ineffects would have been witnessed (from 2022 forward).

One possible explanation for this is that technology has very much encouraged longer homeownership tenure, including:

·       Remote work tools like Zoom reducing the necessity of physically moving to take a new job

·       Property management businesses and tools, ranging from Mynd to AirBnB to Angie’s List to modern smartphones, make it easier for homeowners to maintain their original home as a rental (especially important as a contributor to lock-in effects).

At some point, if this of longer home ownership tenure continues, and the shape of the yield curve normalizes, a portfolio lender looking to make a marketing splash to take share might feel it’s in their best interest to launch the Collateral Transfer Mortgage and see if the world beats a path to their door. Watch this space!