Managing in an Uncertain Future

Rate Volatility and the Observed Impact on Premium Pricing

By Richard Martin Curinos

There is little doubt we are in a new normal for interest rates. After more than a decade of accommodative monetary policy actions by the Federal Reserve Bank, the policy path forward is clear and the fight against inflation remains paramount.

As a result of the shift in Fed policy, first mortgage rates have increased rapidly this year, to levels not seen in more than 20 years. In response the market has swung from predominately a refinance business to a purchase-dominated one. Alongside this dramatic rise in rates and uncertainty around just how high rates will go, the lending market also faces supply constraints and key demographic shifts to drive overall demand as many millennials reach prime household formation years.

Amidst this uncertainty, firms like Curinos offer insight and actionable intelligence into comparative mortgage price positioning, as well as key performance drivers that ultimately allow lenders to anticipate today and navigate tomorrow. Preparation is key for any business to thrive in any market environment. Specific to this, some firms directly source, profile, and evaluate daily indicative rate sheets from multiple lenders, generally depositories and independents of varying production capacities distributed throughout the country, leading to some recent observations in the premium pricing practices of mortgage lenders.

The loan manufacturing process is costly with fees assessed at different pipeline production touchpoints, including appraisal, underwriting and/or loan closing, with those expenses typically passed through to and paid for by the borrower. Premium pricing, any note rate priced above parity due to the higher- than-market coupon, presents the borrower with the opportunity to offset loan production costs by committing to one of those higherthan-market note rates in exchange for a cash rebate from their lender.

The daily process of deriving a go-to-market price or net price, evaluating all credit risk attribute impacts, colloquially loan level price adjustments (LLPAs), for all partner lenders is a monumental undertaking that requires a tremendous amount of heavy lifting. However, in doing so mortgage partners can quickly and easily compare their price position to their competitor’s. Often, teams of mortgage analysts, acting as stewards of this data, are able to identify trends in the pricing execution of a statistically significant representation of the capital markets pricing desks throughout the mortgage lending industry.

By controlling for many of the different pricing scenario attributes for the conforming 30-year fixed product, including region, loan size, credit score, and occupancy, we were able to compare recent net pricing from our own 300+ lender partners, across the note rate stack, to net pricing from 6 months and 12 months prior. Narrowing our focus to the rebate pricing options, we observed the following: the percentage of rebate pricing scenarios is half where the market was a year ago and, today’s average rebate pricing is nearly 100 basis points less.

The velocity at which first mortgage interest rates rose this year was jarring and this level of volatility would have strained capital markets pricing desks trying to establish optimal execution in a market that saw rates run up over 50 basis points in a single week. In setting prices where the market was, traders may have inadvertently overlooked pricing rates at the top of the note rate stack.

Additionally, taking into consideration the Fed’s recent policy path, an unwavering determination to tamp down inflation at all costs, leading many to speculate on a forthcoming recession, there exists a palpable prepayment risk to the end investor. Whether first mortgage interest rates pull back because of an economic downturn in the form of a Fed-induced recession or a correction from rates rising too quickly and overshooting a true market levels, there exists a deep-rooted prepayment concern. Borrowers would be keen on refinancing, in short order, out of their higher interest rate obligation given a modest rally in rates. The result would be costly to the secondary market purchasers of those premiumpriced assets.

From the borrower’s perspective as affordability diminished, higher rates combined with home values at or near record highs, principal and interest payment shock coupled with debt-toincome qualifying ratios edging higher, there were limited scenarios where premium pricing would have been an attractive or viable option. Taken in concert with a borrowing community that had grown accustomed to several years of rates in the 2s and 3s, paying for a lower rate was that much more palatable.

Whether one or more of these factors led to the recent, observed dislocation in premium pricing, the catalyst is attributable to this year’s unparalleled rate volatility. When the rate volatility of this year subsides and first mortgage rate activity normalizes, rebate pricing will see a return to prior levels. The next question traders may have to answer is, how will rates price in a deflationary environment?

Richard Martin is Director of Real Estate & Consumer Lending for Curinos. Prior to Curinos, Rich held various senior roles in both capital markets and margin management functions within both depository institutions as well as regional and national independent mortgage companies.