R. Christopher Whalen
Apr 28, 20225 min
April 28, 2022 | Premium Service | Looking at the financial results for Flagstar Bancorp (FBC), you can see the pain being felt by the entire industry devoted to manufacturing and selling residential mortgages. “A Trifecta of Bad Mortgage News for Flagstar: Lower Volumes, GOS and Layoffs,” declared Inside Mortgage Finance quite accurately. BTW, GOS means “gain on sale,” the most important three words in lending. Then we turn to Annaly Capital Management (NLY), a REIT that buys agency mortgage backed securities (MBS), and the situation is remarkably different. How do we parse this tale of two very different mortgage players?
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Flagstar Bancorp
First we start with FBC, a company we profiled this time last year (“Profile: NYCB + Flagstar Bancorp”). In 2021, FBC was one of the best performing banks in the US, as we noted in our profile of NexBank (“Profile: NexBank Capital, Inc.”). FBC is also among the larger subservicers of residential mortgage loans and also the second largest warehouse lender to other banks and nonbank mortgage companies.
A year later, FBC is seeing revenue and earnings slow after a torrid 18 months of mortgage banking activity. Of note, the progressive mafia led by Senator Elizabeth Warren (D-MA) is still holding up the regulatory approval of the FBC merger with New York Community Bank (NYCB). The chart below from the FBC earnings report shows how FBC’s performance has changed with the sharp increase in interest rates during Q1 2022 and the continued decline in earning assets.
Notice that the GOS income and thus pretax income for FBC were down sharply in Q1 2022, a reflection of the adverse change in pricing that has occurred in the secondary loan market since the end of 2021. More, while net interest margin increased 15bp to 3.11%, utilization rates measured by the volume of loans held for sale and also warehouse loans to mortgage lenders declined. That is going to be the story for most of 2022, falling volumes and slowly rising NIM. Also note that FBC’s average deposits decreased 9%, driven by a decline in custodial deposits. The bank’s cost of funds edged up to 0.26% vs 0.31% in Q1 2021.
Total revenue for FBC fell to $325 million in Q1 2022 vs $513 million in Q1 2021, again due to the sharp decline in mortgage related activity. Net GOS revenue was just $45 million in Q1 2021 vs $227 million a year ago. The GOS margin of 0.58% contrasts with the 1.84% in Q1 2021, when the residential mortgage industry was experiencing record volumes and profits. The chart below from the FBC report shows trends in NIM, which rose above 3% for only the second quarter since 2019, even as earning assets have fallen for three consecutive quarters.
Annaly Capital Management
We purchased a position in NLY at roughly half of book value in April of 2020, when there was blood in the streets and a number of REITs were near the tipping point due to margin calls. By “going big” with securities market intervention, the Fed of New York moved forward TBA rates down in yield by couple of hundred basis point in 30-days, forcing issuers with short positions to essentially give dealers all of their cash for a month.
Wind the clock forward two years and NLY is trading at 0.8x book value and has managed to survive the past two years of QE madness and actually thrive. The traditional investor in agency MBS has diversified into mortgage servicing rights (MSRs), a move we applaud and now accounts for 10% of capital. MSRs are negative duration assets with cash flow, similar to a Treasury interest only (IO) strip but with more volatility due to the idiosyncratic nature of prepayments on residential mortgages.
No amount of computer power can really, really enable you to predict when Fred and Wilma are going to sell or refinance their home. Family decision cycles, for example, vary with geography and income. But with skill and a lot of data, issuers can certainly encourage and facilitate such blessed events, which in good times generate substantial income. Today, as we noted in our last Premium Service comment in The Institutional Risk Analyst, many conventional issuers are losing money on every conventional loan they close.
NLY benefits when there are few prepayments on mortgages, which impacts both the MBS and also the MSR. In a rapidly rising rate environment, prepayments on MBS you bought at a premium are painful. But NLY now hedges that basic dynamic by owning MSRs and benefitting from the extension of maturities on mortgage portfolios. We also applaud the sale of the middle market loan portfolio in Q2 2021, focusing NLY on the residential asset.
NLY’s NIM rose slightly in Q1 2022, but so did the cost of funds due to the dramatic shift in the Fed’s interest rate narrative. Even though the FRBNY has continued to purchase securities through the month of April, interest rates have backed up dramatically. In fact, Q1 2022 was one of the worst periods ever for the bond market and fixed income investors, yet NLY managed its position quite well. The table below is from the NLY Q1 2022 earnings presentation.
NLY is positioned nicely to manage its portfolio in a rising rate environment. The new issue market for residential loans is going to slow dramatically in 2022, with volumes moving to the relatively safety of the FHA and Ginnie Mae assets, on the one hand, and non-QM loans on the other. Comparisons with the 2006 period are entirely appropriate, albeit for different reasons.
Net mortgage spreads are near or above 5-year highs, thus we believe that the environment for REITs like NLY is promising, especially with the added benefit of the MSR portfolio in the mix, which increases in value as rate rise. The major risk factor, as in 2020, is whether the end of FOMC purchases of MBS is going to impact market liquidity and thus the cost of funds. The chart below from the NLY Q1 2022 earnings presentation shows the MBS current coupon vs the average yield for 5-10 year Treasury paper.
With most industry MSR valuation models using high-single digit assumptions for prepayment rates going forward, there is a great deal more visibility on future cash flows than NLY and other REITs have enjoyed in many years. Liquidity remains a potential risk, but as reserve assets decline and bank purchases of government MBS return to normal levels, we think that the agency REITs like NLY will have the wind at their backs for a change. Sadly, lenders and issuers such as Flagstar will not have the same degree of visibility on future volumes and earnings.
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