The US housing market, believed to be bigger than the US stock market, is coming under pressure again, with the Federal Reserve (Fed) raising the Fed funds rate aggressively to curb inflation. Outstanding mortgage debt in the US was c.USD18tn in 2021 and is estimated at c.USD13.3tn by end-2022 and c.USD13.8tn by end-2023, according to the Mortgage Bankers Association’s (MBA’s) estimates.
Amid the uncertain geopolitical environment, the Fed has hiked the key rate six times this year to curb rising inflation caused by pent-up demand after the pandemic and the supply-chain disruptions due to the Ukraine-Russia conflict. This directly led to a cooling of the mortgage market and a significant drop in new-mortgage applications. Refinancing activity and new applications were down c.83% y/y and c.30% y/y respectively, as of October 2022. The MBA expects total mortgage origination to decline 9% to USD2.05tn in 2023 from the USD2.26tn expected in 2022. Purchase originations are forecast to decrease 3% to USD1.53tn next year, and refinance volume 24% to USD513bn.
The following chart shows the composition of 30-year fixed-rate and other fixed-rate terms in the US in 2022:
Trends expected to shape the mortgage sector in 2023
1. Interest rates expected to remain high and peak by mid-2023
- Inflation has risen significantly after the pandemic due to supply-chain pressures and geopolitical tensions, resulting in the Fed taking an aggressive stance on monetary policy. It has increased the fund rate six times in 2022, from 0.25% in February to 3.75% in November.
- The following graph is a snapshot of the historical trend and a forecast of US inflation.
- The Fed expects inflation to remain high in the short to medium term, according to a 2 November 2022 press release; it plans to act aggressively until inflation slows to 2%. October data published on 10 November by the Labour Department showed important drivers such as rent not increasing as much as expected, while the decline of 2.4% in price index for used cars, this was the fourth consecutive monthly drop. Inflation in airfare, medical services and apparel also reduced. However, Fed officials maintained that they will continue to observe the trends closely before taking a call on their current approach.
- The following chart shows the historical trend in Fed rates and forecasts for 2023.
- The following chart shows the historical trend in the 30-year mortgage rate, which closely tracks the Fed rate.
- The following graph shows different agencies’ forecasts of the mortgage rate. The 30-year mortgage rate is expected to remain at c.6.00%, on average, in 2023.
- The immediate short-term impact of rate hikes is visible in real estate transactions. New MBS issuance has been declining over the past one year, as depicted below. Demand for collateralised debt is expected to remain subdued.
2. Home sales expected to remain subdued for the next couple of quarters before picking up
- The US mortgage sector generates revenue mainly from the sale of home units. Therefore, a rise in the number of units sold and homeownership rates would indicate improved economic performance. Another important performance indicator is the supply of fresh units in the economy. In an increasing interest rate environment, the cost of constructing new units rises significantly, limiting new supply. Residential investment will likely continue to decrease as the housing market finds a new lower equilibrium.
- The following graphs show the sales trends of residential units and new constructions. New supply is expected to remain restricted.
*SAAR = Seasonally adjusted annual rate
Single-family home sales have dropped below 1m units and multi-family home sales to 500,000 units in 4Q22, marking a fourth straight quarterly decline. The following chart shows activity is expected to remain subdued for the next couple of quarters before it picks up.
The following graph shows the trend in purchase and refinance originations in 2022 and forecasts for 2023. Refinancing has declined rapidly after 3Q22 and is expected to remain low in the short term.
3. GDP growth expected to decline in 2023 before picking up
- GDP is a major factor impacting demand in the mortgage sector. The US economy is expected to experience a mild recession in the next 12 months, triggered mainly by rapid monetary tightening. This would be more noticeable in the coming months. The US unemployment rate is expected to rise to 4.5% in 2023 from 3.5% in September 2022.
4. Third-parties continue to optimise and streamline additional parts of the mortgage process
- Many major banks and non-bank lenders have invested in either proprietary or third-party technologies across the value chain recently to smoothen their processes. These include modernising the front-end platform, workflow management, document extraction and management, appraisal management, automated compliance, employment verification and decisioning.
- Many mortgage originators still follow traditional processes that can be easily automated; this leads to high costs and long cycle times as shown below.
5. Other trends to watch in 2023
- Non-bank lenders’ market share continues to grow, driven mainly by few players with a strong digital focus. More and more technology focused lenders are remapping front-to-back operating model, including streamlining document management.
- Next-generation “subservices” introduce more efficient digital platforms. Subservices refer to experienced outsourcing partners that do not own the right to perform a service but perform it (including all administrative, compliance and financial activities) on behalf of a master servicer for a monthly per-loan fee. The market is experiencing a shift from in-house servicing to outsourcing, driven by higher regulatory scrutiny.
- Companies bundle home-buying services, including mortgages. Customers today are looking for bundled home-buying solutions. Research by the National Association of Realtors indicates that close to 95% of home buyers would consider a one-stop-shop model for their home-buying journey
Strategies lenders are adopting to manage the current challenges
- To cope with the increased cost of borrowing, banks have raised lending rates for retail borrowers and are focusing more on adopting new technologies to reduce costs. In line with market sentiment, and the drop in demand, banks are also streamlining their workforces. Mortgage giants such as Wells Fargo & Co. and Rocket Co. have cut staff in 2022, and online lender Better.com has laid off about half of its workforce since December 2021.
- Credit unions and private lenders are offering more competitive rates than are traditional lenders. This is mainly because credit unions are typically responsible to their members rather than shareholders, and although they offer the same products as a bank, they are not subject to the same federal regulations, enabling them to take on riskier customers.
- Many retail lenders are looking for offshore partners to reduce costs associated with hiring, training and onboarding staff, and lower office rent and maintenance overheads. Outsourced teams with relevant expertise can be deployed based on business demand for employees at a fraction of onshore costs, while providing flexibility, agility and innovation. For instance, during the pandemic, Bank of America (BofA) added close to 3,000 jobs in India to support the increase in retail and small business loans in its home market, the US.
- Retail consumers are increasingly choosing lenders that go beyond the traditional focus on sales and customer service and prioritise the customer experience. A BCG study confirms that by personalising a customer’s journey, a bank can increase revenue by up to USD300m for every USD100bn in assets it owns. Personalisation can also help improve loan-recovery practices. For instance, a 2018 McKinsey study indicates that engaging digital-only borrowers though their preferred channel of communication can increase loan instalment repayments by over 10%.
- Banks expect the Fed to cut rates by mid-2023. Their risk management strategies are likely expected to revolve around managing higher costs of funds and enhanced due diligence for new originations and refinancing.
- Mortgage rates are expected to remain high in the coming quarters. Rising mortgage rates mean fewer would qualify for a mortgage, leading to lower application volumes and prompting mortgage lenders and brokerages to reduce costs.
How Acuity Knowledge Partners can help
- We have nearly 20 years of experience in supporting global banks across the loan lifecycle. Our retail lending servicesoffer origination, processing, underwriting, closing and post-closing support across consumer mortgage and other retail products, covering the range of basic to complex tasks. Leveraging a mix of people, process and technology, we provide tailor-made solutions to our 90+ banking clients spanning retail, business, middle-market, real estate and leveraged finance.
About the Authors
Vipul Gupta has over 14 years of experience in working with leading global organizations in the banking and commercial lending domains. His expertise spans a broad range of credit analysis, financial modelling, portfolio management, leveraged lending, industry coverage and onshore client-facing roles. At Acuity Knowledge Partners, he leads a large portfolio management team for a mid-size US bank. He has previously led specialized leveraged lending credit analysis team covering diverse industries. Vipul holds a MBA finance and a Bachelor in Mechanical Engineering.
Sahil Bansal has over 7 years of experience in credit rating and underwriting. Working as a Delivery Lead with the Lending Services team at Acuity, along with handling the portfolio monitoring, he is actively involved in training, mentoring, MIS related activities and quality control of deliverables . Previously, he was associated with Credit Rating Agency as an Analyst in assigning external ratings to corporates having bank funding. Sahil holds a Post Graduate Diploma (Banking & Finance) and a Bachelors in Commerce.
Originally published at https://www.acuitykp.com