Assume Loss Given Default > 100% | PennyMac & Western Alliance Bank

In the darkest hole, you'd be well advised

Not to plan my funeral 'fore the body dies, yeah

"Grind"/Alice in Chains

February 5, 2024 | Premium Service | In this issue of The Institutional Risk Analyst, we ponder the broader repercussions of the abortive earnings release by New York Community Bank (NYCB). We then take a look at the earnings from PennyMac Financial Services (PFSI) and Western Alliance Bancorp (WAL). 

First let’s review the tragedy of errors at NYCB. When you make it to the front page of most global financial newspapers, you have achieved something and not necessarily something good. No doubt the officers and directors of NYCB are surprised at the market’s reaction to their clumsy disclosure last week. That is precisely the problem.

First, the managers of NYCB apparently failed to recognize that going over $100 billion in assets is an enormously big deal for a community bank. The dreaded $100 billion demarcation line is well-known in the industry and especially for National Banks. Going big means that all aspects of the institution are now under additional scrutiny and that minimum levels for financial, systems and controls, and operational requirements have been raised. 

Moreover, ever since NYCB jumped to an OCC charter in order to get the purchase of Flagstar approved in 2022, they have been living in a very different world than was the case under the NY Department of Financial Services. With the DFS, banks can negotiate, checkbook in hand. Tammany Hall with a Progressive Face.

With the OCC, banks just get down on their knees and beg for forgiveness. The fact of a $300 billion residential loan servicing business at NYCB adds to the misery of dealing with the OCC. Just ask the folks at Cenlar FSB (Cenlar FSB, COOP, BLND and the Great MSR Migration).

NYCB did not speak to shareholders nearly enough about what it means to be a large bank, including the need for additional capital and risk management resources. Dividend cut? Yeah. The bank needed to talk about capital, systems and controls, and what this would cost going forward. Pre-release the bad news next time. That's what big banks do.

This leads to the second point, which applies to NYCB and all banks with commercial real estate and multifamily exposures. Loss Given Default on urban progressive multifamily assets is now assumed by regulators to be > 100%. And just by coincidence, the data has been telling us this for more than a year.

Source: FDIC/WGA LLC

You’ll notice in the financials for NYCB that capital leverage ratio is below 8% capital to assets. In the old days pre-Flagstar and Signature Bank, NYCB could run a fully loaned out book and even add additional exposure via brokered deposits. This worked because losses on multifamily real estate were low or zero. The value of commercial and multifamily assets in NYC had mostly gone up for a century. Loans were often interest only and owners could take out cash at refinancing every seven years or so. Happy days. But no more.

Times Square | January 2024

When we rated banks at KBRA, many of the community banks in NYC had gone years without any measurable defaults on commercial mortgages or financings for multifamily apartments. But in today’s commercial real estate market, regulators are now hypersensitive to changes in commercial risk exposures at legacy urban banks.

We spoke to several lenders who confirm that Fed, OCC and FDIC officials have been working the phones to check whether other NY banks are planning public disclosure of large commercial defaults. The operative assumption by regulators today is that the valuations and loan-to-value ratios of commercial property financed by banks are suspect. Historical loss data for these same commercial loan portfolios is now irrelevant.

What really annoys us about NYCB and other banks with commercial exposures is that they knew months ago that the OCC was demanding pre-emptive increases in capital and loan loss reserves. Why? On the assumption that some commercial property valuations in the $20 trillion market are in a free fall and that, accordingly, defaults will spike in 2024.

Several banks we contacted said that last year OCC examiners began demanding higher reserve levels, setting up a showdown with the external auditors. These are the same auditors who approved lower loan loss reserve levels in Q3 2023! Love that volatility. Loss given default for bank C&I loans is running over 80% so a boost in reserves makes sense.

Q: What do Silicon Valley Bank, First Republic Bank, Signature Bank and New York Community Bank have in common? Same auditor, KPMG.

Meanwhile in the credit markets, the Fed’s pivot is not yet resulting in higher lending volumes. While falling LT interest rates in the Treasury market helped stocks for a time, the downward move of the 10-year Treasury note has not really helped the housing markets, specifically mortgage-backed securities (MBS) and mortgage servicing rights (MSRs). Investors, looking at the still wide spreads between Treasury paper and MBS are not biting, in part because of uncertainty about interest rates. And banks continue to be net sellers of Treasury debt, MBS and whole loans.

Source: FDIC

Last week, several Democratic senators urged the Federal Reserve to cut interest rates, which they argue have “aggravated the country’s persistent crisis of housing access and affordability,” reports The Hill. In a letter to Fed Chair Jerome Powell, Senator Elizabeth Warren (D-Mass.), John Hickenlooper (D-Colo.), Jacky Rosen (D-Nev.) and Sheldon Whitehouse (D-R.I.) said the central bank’s decision to rapidly raise rates “has resulted in higher costs for homebuyers and renters, as well as a lack of new construction.” 

Senator Warren and her colleagues are totally wrong about interest rates and home prices. The Fed’s decision to drop interest rates to zero in response to the COVID lockdown in 2020-21 drove up home prices dramatically and semi-permanently. Mortgage interest rates then rose for almost two years up to 8% in the third week of October 2023, but home prices continued to rise due to low supply.

Since then, advertised residential mortgage rates have fallen a point or more. But despite the mini-rally, three quarters of all mortgages remain deeply out of the money for refinance. And home prices continue to rise, as shown by the chart from FRED. Notice that average home prices in San Francisco have begun to fall.

If Senator Warren and her Democratic colleagues in the Senate want to address rising home prices, then they should ask Chair Powell to raise interest rates up into double digits and keep them elevated until we crater residential home prices. A lot of banks and nonbank mortgage lenders will fail in the process, but we can just add this to the economic tab for COVID.

The lack of supply of homes, not just volatile interest rates, is the true culprit when it comes to inflated home prices. Chairman Powell and his colleagues on the FOMC made a short market worse, and permanently inflated home prices by playing God with interest rates and markets starting in 2019. Get used to it.  At least until the maxi home price reset later this decade.

The chart below shows the fair value of MSRs owned by all US banks. Notice as you read the discussion below that the modeled fair value of MSR reported by banks was rising through Q3 2023, but our calculation of implied value (red line) was not. Hmm.

Source: FDIC/WGA LLC

Meanwhile in the world of mortgage finance and MSRs, JPMorgan, the largest US residential loan servicer, took down the valuation of its $7 billion servicing asset by 7% in Q4. Guess what the down mark will look like in Q1 2024 unless the 10-year Treasury retraces back to say 5%.  Wells Fargo (WFC) took down the fair value of its MSR 12% or $1 billion to $7.4 billion. 

Gabriel Poggi at BTIG wrote this note last weekend:

The table below shows the fair value of MSRs for JPM, WFC, U.S. Bancorp (USB) and PennyMac Financial (PFSI). Notice that the changes are double-digits and reflect the modeled estimate for fair value for our favorite intangible asset. Gain-on-sale accounting is purely aspirational, no matter how many jobs it creates. Sad to say, new mortgage lending volumes are not up double digits, no matter what the model may say. As a result, we expect to see net runoff in MSRs and lower servicing income going into Q1 2024. 

Source: EDGAR

PennyMac Financial Services

In 2023, PFSI was the #2 aggregator of conventional loans in the US, but the total market last year was just $1.4 trillion and most of these were expensive purchase mortgage loans.  The chart below shows the forward estimates used by PFSI in their disclosure, but analysts are backing away from the rate cut narrative.  If the FOMC slow walks rate cuts this year, we’ll see another year of sub-$2 trillion volumes. 

Source: PFSI

How is PFSI making money in a low volume market? Servicing. The servicing book of over $600 billion in unpaid principal balance (UPM) of loans has supported PFSI and, indeed, allowed the firm to de-lever its balance sheet. The value of escrow balances has also grown. The critics calling for PFSI to roll over in 2022 were very wrong. Yet even in a falling interest rate environment, the firm’s servicing book may runoff faster than expected. We suspect that lending revenue will be at the low end of estimates for 2024.

Source: PFSI

The trouble facing all mortgage lenders is that the average loan coupon in the $14 trillion UPB market is still below 4%.  The FOMC would need to push MBS yields down 300bp into the 3s to really move the needle on home refinance volumes. As a result and opposite to the 2020-21 period, lenders may face net runoff of MSR portfolios but weak origination volumes comprised largely of purchase mortgages. The cost of originating a conventional purchase loan is over $10,000, according to the MBA survey. A refinance loan, by comparison, is a quarter of that cost.

All of that said, PFSI has cut back on operating costs and is now positioned to wait for lower interest rates as smaller issuers exit the industry.  Fact is that investors in PFSI have done very well over the past five years compared to either NYCB or WAL or indeed most other commercial banks. Along with Mr. Cooper (COOP), PFSI remains the market leader in correspondent lending and has one of the best total market returns in the financial services industry. The chart below shows PFSI, COOP and WAL.

Source: Google Finance (1/3/2024)

Our chief concern is what possible interest rate volatility will do to the GAAP results for PFSI and other mortgage lenders. In an environment where actual lending volumes are low and credit costs are rising after a long period of muted default servicing expenses, runoff of MSRs will be painful. Remember, most private mortgage issuers do not hedge their MSRs.  PFSI spent $300 million in Q4 2023 on hedging in order to manage appearances for investors and also lenders. If that consumer recession ever materializes, hedging the MSR will become a luxury.

Western Alliance Bancorporation

We exited our position in WAL in 2023 after the market kerfuffle due to the failure of Silicon Valley Bank. Readers of The IRA will recall that WAL was the best performing bank in the US in 2021, riding the massive wave of mortgage volumes and the purchase of AmeriHome Mortgage from Apollo Global (APO) portfolio company Athene Holdings (ATH). Since 2023, WAL has continued to perform well, growing deposits and equity in a decidedly quiet market for mortgages and MSRs, two favorite assets of WAL.

Like NYCB, WAL is a play on a rising residential mortgage market.  When loan purchase volumes go up, WAL makes more money. AmeriHome is a large correspondent lender that competes with PFSI, is strong in conventionals and also plays in Ginnie Mae MBS. The government MBS exposures are of a very pedestrian flavor in terms of credit. WAL actually grew net interest income and deposits in 2023 vs 2022, as shown in the table below.

Source: WAL Q4 2023

WAL’s provisions for credit losses were up in Q4 2023 as the bank continued to normalize from the very low level of defaults during the Fed’s QE and the national loan forbearance program that was in effect during COVID. Provisions were actually down 8% YOY 2023 vs 2022, but none of that matters in an equity market where a single headline loss event can brand your bank as commercial real estate roadkill in a matter of minutes.

WAL has a well-diversified loan book and, more important, a management team used to running a national lending and warehouse financing business. The bank's default activity on C&I, commercial real estate and development lending has been well-below peer for years. Also, WAL has very little multifamily exposure.

WAL had net charge offs of $8 million in 2023, roughly 4x 2022 and above pre-COVID levels. Net charge offs were $1.2 million in 2018 and $3.4 million in 2018, but all very low compared to the $50 billion loan portfolio. The WAL $70 billion asset bank has been in the bottom quartile of Peer Group 1 in terms of net loss for the past five years.

Like NYCB, the fundamentals of WAL are strong, but the bank remains vulnerable to headline risk and other hazards that are more pressing for smaller banks and companies. The larger banks that are included in passive investment portfolios benefit from the long-bias of Exchange Traded Funds and other passive strategies. This is one reason why short-sellers will target a smaller issuer like NYCB or WAL, but not go after larger underperformers such as Citigroup (C) or Bank of America (BAC) as readily. WAL was under attack a year ago and today is stable, profitable and out of the woods -- for now.

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