FOMC vs TGA; PennyMac Financial & United Wholesale Mortgage

May 25, 2022 | Premium Service | In this issue of The Institutional Risk Analyst, we start with a general market comment and, from that vantage point, then slide into the earnings reports from PennyMac Financial Services (PFSI) and United Wholesale Mortgage (UWMC).

The general comment is fairly simple to summarize: a massive surfeit of cash sloshing around the financial system and growing as stocks sell off, threatening to inundate the Fed with cash seeking a risk-free home. In theory interest rates are rising c/o the FOMC, but in fact risk-free collateral remains scare and rates seem more inclined to fall than to move higher.

At the end of last week, reverse repurchase agreements (RRPs) with the Fed of New York grew to over $2 trillion while the Treasury’s General Account (TGA) has soared to almost $1 trillion due to strong tax payments. As the TGA rises, bank reserves at the Fed fall 1:1. This illustrates why the Powell FOMC is going to find it very difficult to manage a reduction in the system open market account or SOMA. This fact will directly impact the financial performance of mortgage banks and all financials, especially issuers of securities.

“Treasury is still decreasing bill supply and that seems to be driving the market firmly into the arms of the RRP facility as the only place of refuge,” said Gennadiy Goldberg, a senior US interest rates strategist at TD Securities, Alexandra Harris of Bloomberg News reports. “The big implication is that with RRP usage remaining high, QT will drain reserves from the system rather quickly at the start of runoff.” It is managing the “runnoft,” to paraphrase the film "O Brother Where Art Thou," which is the task facing Jerome Powell.

Last week, as the TGA was rising on the back of stronger than expected tax payments, total reserves at the Fed fell by almost half a trillion dollars. “As a result, outstanding bank reserve balances dropped by $466 billion in the week ended April 20,” reports Harris, “the largest weekly decline on record.”

This outflow of bank reserves has the impact of forcing investors and banks back into the market for T-bills, which is already under downward rate pressure due to the Treasury’s large cash position and lack of new issuance. Observe that the 10-30 year complex in Treasury securities seems to want to rally in the worst way. Net, net, the dynamics in the market are actually forcing interest rates down even as the FOMC pretends to raise the cost of credit.

The impact of the conflicting flows between the Federal Reserve and Treasury is visible in terms of the uncertainty in the markets. Bond spreads and primary lending rates are soaring, but benchmarks such as the 10-year Treasury note are displaying a reluctance to move higher. The result is a flattening yield curve and a primary market for residential mortgages that is going to be more challenging as the year progresses. The difference between 30-year mortgage rates and the 10-year Treasury is widening, yet industry profits are falling fast due to chronic overcapacity.

PennyMac Financial Services

The story with PFSI is similar to that facing the entire industry, namely falling production volumes and not as rapidly falling production expenses. Some firms are actively reducing headcount, others are trying to redeploy valuable people to servicing and loss mitigation. In either case, cutting volumes in half has focused the entire industry on cost.

The bottom line is a draconian cut in operating profits as the industry slowly manages down operating costs to fit ~ 50% of the $4.4 trillion in new origination volume seen in 2021 in 2022. The table below from the PFSI supplement shows earnings before interest, depreciation and amortization (EBITDA). Note that the upward adjustment to the MSR in Q1 2022 was 2x PFSI’s reported income.

The decline in operating income is relatively easy to see, but what is more troubling and less easy to see is the sharp deterioration of the net production revenue less loan officer (LO) compensation. In Q1 2021, PFSI reported $585 million in production income with production expenses of $222.6 million or 38% of production revenue.

In Q1 2022, in sharp contrast, PFSI reported $235.6 million in revenue and production expenses of $226.3 million or 96% of production revenue. This shocking collapse in profitability is visible across the industry and shows how difficult it is for the mortgage industry to manage operating expenses. Of note, net production income for the industry has fallen from 124bp in Q1 2021 to 5bps in Q1 2022, according to the most recent survey from the Mortgage Bankers Association. The table below from the PFSI Q1 2022 earnings supplement shows the production results for the firm.

The increase in interest rates has also taken much of the profitability out of purchasing delinquent government loans out of Ginnie Mae pools (aka “EBOs”), a big part of PFSI earnings in 2021. In Q1 2021, EBO revenue added $283 million to the bottom line, more that total servicing revenue for PFSI in that period and roughly 25bp per loan. The same line item in 2022 saw revenue of $95 million or just 7.4bps earned on each resolved delinquent loan. Provisions for loan losses rose 50% to $30 million in Q1 2022.

The sharp upward mark in the value of the PFSI MSR helped reported earnings significantly, as shown in the chart from the PFSI Q1 2022 earnings presentation. Notice the interaction between the changes in valuation for the MSR, production income and the results from the PFSI hedging operations. In 2020 when the firm reported 60% equity returns, it was net of a $1.1 billion negative markdown of the MSR due to mid-double digit mortgage loan prepayments. Half of the $12 trillion mortgage market was refinanced in 2020 and 2021.

PFSI's common equity is down 30% YTD, reflecting investor concerns with the plummeting equity returns for this leading mortgage issuer. In 2020, PFSI generated 60% equity returns, but in 2021 just half that amount and only 21% in Q1 2022. Through the balance of 2022 and beyond, PFSI will be forced to tighten operating expenses to keep pace with declining revenue and industry volumes. Upward valuations may continue to be a positive for the rest of 2022, but servicing assets are overvalued today vs the likely NPV of the asset.

United Wholesale Mortgage

If PFSI is a good example of the broader mortgage industry, UWMC is an outlier and one that displays a good deal more volatility than do other issuers. The common equity of UWMC is off 60% in the past year, even though the SPAC transaction is still showing a premium multiple to book value. But with firms like UWMC, what is book value? Piper Sandler wrote on May 19th:

Like PFSI, volumes fell and expense less so at UWMC, generating a squeeze in operating results. The table below from the UWMC earnings report illustrates key operating metrics. Note that GAAP income was “only” cut in half because of a $390 million increase in the value of the MSR vs Q1 2021 and $170 million sequentially, an adjustment that is non-cash. When asked during the earnings call about his rosy view of the outlook, Ishibia said:

As a result of falling lending volumes, adjusted EBITDA was just $128 million in Q1 2022 vs $711 million in Q1 2021, including a negative mark on the MSR. UWMC, of note, derives its own valuation for the MSR – a Level 3 asset under GAAP -- using internal models and assumptions. It is fair to say that UWMC could not sell its MSR in today's market for anything like the reported value.

UWMC has stated that it will not be laying off employees, thus it remains to be seen how CEO Matt Ishibia will manage expenses going forward. Ponder the logic of Mr. Ishibia in his Q1 2022 earnings conference call:

Expenses at UWMC were basically unchanged in Q1 2022 vs the previous quarter. Rhetoric aside, we expect to see some rather aggressive cost cutting from UWMC in Q2 2022 and beyond. The big concern with UWMC is the rate of growth in the company from 2020 to today. The firm now has $2 billion in “non-funding debt,” meaning corporate borrowing that is not directly contributing to revenue and profits, but likely underpins the MSRs.

One interesting comment from Ishibia on the Q1 2022 earning call concerned his focus on the wholesale channel, arguably UWMC’s strongest suit and a consistent #1 ranking for the firm. He describes why top performing LOs would rather be independent brokers in a tough loan market:

Will the snowball of LOs migrating to the higher ground of the broker channel come to the rescue for UWMC? We hope so, but like the folks at Piper we remain skeptical. Winter has come in mortgages and its likely to be the longest, nastiest winter in residential assets since 2008.

The issue this time is not credit at first, but market risk and the bizarre reality of trillions in conventional and mortgage paper that is 200bp or more out of the money in terms of refinance. In this vast pool of new mortgages with LTVs averaging close to 50% lies a good deal of hidden credit risk that will emerge during the approaching recession. With a recession and higher loan defaults will come repurchase claims from the GSEs.

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