Banks Reap Profits on Mortgages After QE3

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Bank profits from new mortgages have soared since the Federal Reserve began its third round of bond purchases two weeks ago, fuelling the debate over the fallout of the latest dose of quantitative easing.

The extent to which QE3 drives down new mortgage rates and helps homeowners or is pocketed by banks will be crucial to the success of the policy and the prospects for growth in the U.S. and global economies next year.

The rise in profit earned by banks from creating new mortgages came as Fed chairman Ben Bernanke sought to defend QE3 against attacks from Republican presidential candidate Mitt Romney and other critics. Mr Romney said last week the Fed was keeping interest rates “artificially low”.

Speaking in Indianapolis on Monday, Mr Bernanke said it would be “inappropriate” and “ineffective” for the Fed to raise interest rates to put pressure on Congress to tackle the deficit. QE3 would not lead to long-term inflation, he said, adding that stronger growth would help savers in the long run despite low interest rates today.

Although the average rate on a fixed 30-year mortgage reached 3.4 percent this week – a record low – mortgage rates could be lower if banks passed on the full drop in their funding costs.

“For banks which are mortgage originators this [QE3] was some of the best news they could possibly have heard,” said Steven Abrahams, mortgage strategist at Deutsche. “They will continue originating loans and selling them into the market at a significant premium.”

The interest banks pay on mortgage bonds has dropped from 2.36 percent on September 12, the day before the Fed announced its program, to as low as 1.65 percent last week. It edged up to 1.85 percent on Monday.

That means the profit, or spread, banks earn from creating new mortgages for homeowners paying around 3.4 percent and selling the loans into the secondary market has risen to around 1.6 percent. That is higher than the 1.44 percent spread they pocketed before QE3 and significantly greater than the 0.5 percent they earned on average in the decade between 2000 and 2010.

The Fed plans to buy around $40 billion a month of mortgage-backed securities from investors until there is a significant improvement in the economy. That has sent prices for the bundled mortgage loans soaring in the secondary market.

Banks say they are charging more because of capacity issues in processing new mortgages and tighter credit standards for borrowers.

“The banks are able to originate mortgages with these funds at prices well below the sale price in the secondary market,” said Dick Bove, bank analyst at Rochdale Securities. “Since the supply of new mortgages cannot meet demand until the origination facilities are rebuilt, the prices in the secondary market remain high [and] profits to the banks from mortgage originations soar.”

Banks have been snapping up MBS backed by Fannie Mae and Freddie Mac in recent years because of the assets’ relatively higher yields compared with government securities and MBS’s perceived liquidity. Banks that wait for higher prices from the Fed would also enjoy heftier profits from the quantitative easing program.

America’s banks collectively hold over $1.2 trillion of the outstanding $8.4 trillion in agency mortgage-backed securities, according to Freddie Mac. Hedge funds, mutual funds and other such investors hold about $1.6 trillion of the securities.

Bill O’Donnell, strategist at RBS Securities, said that MBS issuance had averaged less than $1.5 billion per week since the launch of the Fed’s third round of quantitative easing, much less than the central bank is buying, meaning the Fed is having to appeal to existing holders, many of whom have bought in the last two weeks.

“Investors are parking their brains and joining the party, buying up MBS knowing that there will be a willing buyer to take them out at uneconomic levels,” he said.