We are finally heading toward the end of the Great Credit Crisis that began in 2007 as mortgage delinquency and default rates continue to drop. But another big event is coming, and it is inevitable. You can call this one the Great Origination Crash.
When mortgage interest rates rise again substantially, loan production will plummet as refinances dry up. And this time, total loan production is going to remain depressed for many years to come.
The new crash won't happen this year, and it may not happen in 2013. However, it becomes far more likely for 2014, and it looks very likely to happen before the end of 2015.
Everyone knows that rising rates reduce refinancing. We're in the middle of a refinancing boom period, and they always come to an end.
But this time, there are two new twists. The coming crash will be more severe than normal, and the post-crash total mortgage production is near-certain to remain subdued for a very long time – maybe even for a decade.
It's the length of the coming dry spell that really will make the new crash different. To understand how this could happen, let's take a look at how the mortgage industry has evolved in the past two decades.
The first big refi boom was in 1993. That year, there were two refis produced for every purchase loan. Interest rates rose in 1994, and the total U.S. mortgage production in 1995 (refinances plus purchase loans) sank 46% below the 1993 level.
In 1999, we also saw the end of a refi boom that had peaked in 1998. By year 2000, total mortgage production dipped 33% below the 1998 totals. It would have been worse, but the purchase market was stronger.
Today, we've been through a much more extended refi boom period, stimulated in part by the Home Affordable Refinance Program. Refinances outnumbered purchase loans by about two-to-one in 2009, 2010 and 2011. In 2012, refinances have outnumbered purchase loans by an unprecedented three-to-one ratio.
Moreover, when prior refi booms ended, lenders had more options to deal with the problem. In 1994, lenders opened up the subprime purchase loan business. In 1999, they could offer subprime refinances as well as purchase loans.
After the refi boom of 2003, history's largest, lenders rolled out interest-only loans and pay-option adjustable-rate mortgages. These loans kept the refi market going to some extent because they lowered monthly payments even as interest rates were rising.
But all of these options increased credit risk. Now, they are gone – so when refis crash again, there won't be much volume left.
A gradually improving market for purchase loans can't possibly make up the difference. We believe total annual mortgage volume will drop by 50% or more in the coming crash. And that's just the start of the story.
Super-low mortgage rates hit the scene in 2009. We've now been through four straight years of incredibly low rates, thanks to the Federal Reserve.
By July of 2012, SMR's property records database showed more than 33% of all existing mortgage borrowers had loans with rates below 5%, and 53% had loans with rates below 6%. By the end of 2013, these numbers will be higher. Thus, all of the folks with super-low-rate loans may never refinance again.
At the same time, today's low-rate loans pay off principal faster than the norm. And record numbers of people have been refinancing into 15-year or other short-term mortgages, which also pay off principal fast. This means fewer borrowers owe large sums. Yet, it's the borrowers who do owe a lot that are most incented to refinance.
In fact, our July study found that in total, 74% of all existing borrowers either had low-rate existing loans, short-term mortgages or loans with balances below $100,000. All would be unlikely future refinancers.
By the end of 2013, the universe of unlikely future refinancers will only increase, perhaps to 80% or 90% of the borrower universe. So when the new crash begins, we'll be left mainly with the purchase mortgage market for a long time to come.
The purchase market was only $480.7 billion in 2011; it is increasing some this year and may increase a little more in 2013. But it stretches credulity to think that purchase loans will come even remotely close to making up for the loss of refinances, which will probably be around $1.5 trillion for 2012.
What the Fed gives today, it takes back later. The extremely long period of super-low rates has removed most borrowers from the refi market of the future.
However, the next crash also will have some positive effects. Prepayment problems with serviced loans will largely disappear for an extended time. And home equity lending will surely increase. Homeowners are again building equity against which to lend, thanks to faster principal payoffs from low-rate mortgages and 15-year mortgages, plus rising home values.
The next crash and its aftermath will be the worst for mortgage bankers that depend on origination volume for most of their income. It will be a lesser issue for big servicers, and a positive for home equity lenders.
Stuart A. Feldstein is president of SMR Research Corp., a home loan research firm based in Hackettstown, N.J. He can be reached at (908) 852-7677.