R. Christopher Whalen
Oct 26, 20239 min
October 26, 2023 | Premium Service | In this edition of The Institutional Risk Analyst, we ponder the changing fortunes of the sector f/k/a fintech as it returns to its roots in subprime consumer lending. We dive deep into the world of Basel III and mortgage servicing rights (MSRs), arguably the cheapest capital asset in the world of mortgage finance. But first let's look in on Texas Capital Bank v. Government National Mortgage Association et al.
The fun in the litigation between Texas Capital Bank (TCBI) and Ginnie Mae has not really gotten started yet. Judging by the number of out-of-town counsel filing for admission to the court Pro Hac Vice this case will chew up a lot of billable hours. And each foreign attorney must find sponsors among local counsel within 50 miles of the Federal Courthouse in Amarillo, TX. TCBI is trading in the mid-$50s today vs almost $90 per share in 2021.
We reviewed this considerable mess previously (“Texas Capital Bank v Ginnie Mae”) and await developments with some trepidation. The cause of our discomfort is that the folks at Ginnie Mae have created a public process whereby the security of a loan on government guaranteed asset and/or MSRs is called into question. If TCBI is forced to take a loss on advances made to Reverse Mortgage Investment Trust (RMIT), then the whole market for financing government loans could be adversely impacted.
The legal battle between TCBI and Ginnie Mae raises another question, namely how the Basel III proposal will impact nonbank lenders and servicers. When a bank provides warehouse loans or financing for MSRs, the line is contracted for a term but the actual transaction is structured as a repurchase agreement. Regulatory skepticism about mortgage assets could effect financing rates for lenders, which means higher mortgage rates for consumers.
Today commercial credits used to finance loan production and sale are 100% risk weight loans for Basel purposes, meaning $8 in capital per $100 of loan. Will that risk weight now increase? JPMorgan (JPM) and New York Community Bank (NYCB), which we own, are the leading warehouse lenders. Both are likely to remain committed to the residential mortgage sector, but other smaller players will likely exit. Virtually all of the nonbank names we follow in our mortgage surveillance group, shown below sorted by 1 year total return, will be impacted by the new Basel III rule for banks.
Mortgage
Source: Bloomberg (10/26/23)
The risk weight for banks owning mortgage loans is expected to go up under the new Basel proposal -- over 100% vs 50% today for a well-underwritten mortgage credit. The graphic below from the most recent earnings release by Mr. Cooper (COOP) lays out the case for increased nonbank share in both lending and holding MSRs.
COOP reported a strong quarter driven by above peer loan production and $970 billion in unpaid principal balance (UPB) of servicing. COOP also claims a significant, 50% cost advantage over large banks in terms of mortgage servicing. It is not always a good thing to publicly declare that you are the low-cost provider in a consumer facing industry, but the COOP direct-to-consumer (DTC) channel is very efficient. Eric Hagen at BTIG on COOP:
"We believe the stock valuation has received only partial credit up to this point for having put up one of the strongest relative returns among non-bank originator/servicers as mortgage rates have risen materially over the last year. While it benefits from higher rates, we think the stock has even better opportunity for valuation upside if volatility comes down. We separately see an emerging opportunity for high-yield investors to get more involved as management said it was starting to look more closely at additional fixed-rate unsecured debt for next year, which it could use to stay opportunistic around more bulk acquisitions, and/or pay down some of its secured MSR lines which are typically floating-rate."
Pay attention to that last point about nonbanks like COOP accessing the debt markets, as they indicated in their earnings release. Freedom Mortgage just closed a refinancing of two debt issues, both of which were said to be oversubscribed. Our observations in the loan market suggests that there is a significant appetite among high yield investors for commercial mortgage exposures.
Due to the changes in Basel III, we expect all of the major mortgage issuers to be adding or increasing term debt and market facing financing facilities for whole loans to diversify away from bank warehouse lines. To that end, we are seeking some clarity from regulators on how Basel III will impact nonbank mortgage firms such as COOP and Guild Mortgage (GHLD), the latter of which we own.
Most of the focus of the Basel III rule is on bank investments in 1-4s and MSRs. There has been no discussion as of yet about commercial warehouse and MSR lines for smaller banks and nonbank lenders. Given the significant changes proposed in the risk weight of the underlying residential loans, a change in commercial exposures is possible but unlikely.
Banks are already at 100% risk weight on fully secured warehouse lines and 250% risk weight on financing for MSRs, just like the risk weight for owning the MSR asset. This equates to 20% capital behind the MSR, for example (8% * 250%). The almost European level of hostility toward mortgage loans and MSRs from US bank regulators is astonishing and makes little sense in today's market.
Regulators should be encouraging banks to create and retain MSRs, but in fact the opposite is the case. With MSRs trading for mid-single digit capitalization rates, banks ought to be buying with both hands to offset losses on loans and securities. Sadly, the Basel proposal will force smaller banks to shed servicing assets because of the ill-informed perspectives that pass for serious thinking among prudential regulators.
We do not expect the existing risk weights for commercial warehouse facilities to change as part of the Basel III process, but the other changes to risk weights for 1-4s held for investment could be punitive and drive more liquidity from banks out of the mortgage market.
Nonbanks will be forced to focus on the capital markets in future for funding. The question is how fast that process will move over the next several years. The new 10% cap for bank MSR holdings as a percent of Common Equity Tier 1 capital (CET1) (currently 25%) will likewise force liquidity out of the mortgage market.
The lower cap on MSRs is mostly a problem for smaller banks like Comerica (CMA) and Fifth-Third (FITB), which have already pulled the plug on residential lending. For US mortgage market leader JPMorgan, the $8 billion in MSR and roughly $1 trillion in related UPB of servicing is easily accommodated by $240 billion in CET1 capital. The Basel III proposal is all about advantaging the larger banks, but don't be surprised to see operational risk surcharges for JPM, NYCB, Cenlar FSB and other large bank servicers.
One hidden risk and also an opportunity for nonbanks is that commercial banks may start dumping portfolio loans and related MSRs. This may also include unrecognized originated or "OMSRs" as many decide to exit 1-4s altogether. If a bank originates and retains a loan in portfolio, no MSR is recognized or placed on the balance sheet of the bank.
When the loan is sold, however, an MSR is created and recognized as part of the consideration, with each piece often going to different buyers. Let's assume half of the $3.7 trillion in bank owned 1-4s were originated by the bank that holds them today, that means that $1.8 trillion worth of unrecognized mortgage servicing assets may suddenly be looking for a home. That is an amount equal to the combined JPM and Wells Fargo's (WFC) mortgage servicing portfolios.
For the top ten nonbank mortgage issuers, a flight from residential lending by US depositories could represent an epic opportunity. Figure the servicing is worth 1.5-2% of the outstanding balance of a given pool of loans, depending on the default rate of course. MSRs from high default rate pools have negative values, like the folks at UBS AG (UBS) unit Credit Suisse.
Source: FDIC
The Mortgage Bankers Association is said to be working on a comment letter that asks regulators to push the risk weight for commercial warehouse lines down to the same levels as the loans held as collateral. Makes absolute sense, but don't expect clear thinking from Fed Vice Chairman Michael Barr or the other agencies right about now.
The fact that 99% of all mortgage assets have US government credit guarantees seems to somehow have been missed in the Basel III shuffle. We hold out only modest hope that the Basel III proposal can be fixed in terms of the housing industry and the banks. And yes, we'll be writing comments of our own before January.
Finally in the world of fintech, the rumor of a slowing economy has taken the air out of several overheated names. Our fintech surveillance group is shown below. Note the dramatic divide between the strong performers vs the weak.
Fintech
Source: Bloomberg (10/25/23)
Looking at one-year total return calculated by Bloomberg, digital commerce platform VTEX (VTEX) leads the group, followed by Mercado Libre (MELI), SoFi Technologies (SOFI) and payments giant Fiserve (FI). SOFI has shown the best inter-period performance, while FI with its $67 billion market capitalization shows far less volatility. Compare FI to the roller coaster of Global Payments (GPN), for example, a stock one third the size of FI.
Coinbase (COIN) ran up almost double during the summer, but has since given back a good deal of the gains. As the largest crypto currency exchange in the US, COIN takes on a lot of regulatory and headline risk along with the other challenges that come with virtual party poker. The large correlation with Bitcoin prices and related market hype is a key attribute to the stock. This week, everyone is bullish.
That perennial favorite of the punters, Affirm Holdings (AFRM), doubled in price between the end of August and mid-September, then gave back half the gain since. AFRM has the highest beta in the group and for good reason. With a market cap of only $5 billion, this stock is a plaything for the momentum crowd and is now headed lower.
AFRM is also a stock of the narrative today, the buy now, pay later story. With the stark warning from EU fintech Worldline (WLN) about the outlook for consumption, AFRM, Paypal (PYPL) and Block (SQ) are all retreating.
Stocks like SQ and Lending Club (LC) were once mainstream components of the fintech narrative, but no more and now occupy the bottom of the fintech list. Other aspiring mortgage fintech names like SoftBank hells pawn Better Home & Finance (BETR) are struggling.
BETR just heard from NASDAQ that it’s out of compliance with the exchange’s listing requirements. Better’s shares have been trading below $1.00 a unit for several weeks now. In accordance with the rules of the exchange, the company has 180 calendar days to regain compliance. Given the outlook for interest rates, we doubt that BETR will be benefiting from any tailwinds soon.
Speaking of narrative, all of these consumer facing names are suffering from a mainstream storyline that says that the US economy is headed for recession. The housing complex is certainly slowing, but the rest of the consumer ecosystem is not. Thus we should look at the weakness in fintech as further evidence that the Buy Side narrative is way over the ski tips in terms of a consumer led recession.
As we noted in our last comment, we think the US economy is unlikely to really slowdown unless the Fed is willing to take more liquidity out of the system. Since that seems to be increasingly unlikely, we think the US economy will continue to over-perform and defy expectations into next year. We keep waiting for a short, sharp uptick in credit costs, but the actuals are going in the other direction at present.
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