Interest Rates, Mortgage Lenders & MSRs

February 15, 2024 | Premium Service | In this issue of The Institutional Risk Analyst we delve into the world of interest rates and residential mortgage credit as Q4 2023 earnings conclude. The largest residential mortgage issuers had decent quarters, though mostly due to servicing income and falling leverage. Treasury Secretary Janet Yellen frets about the systemic risk from nonbank servicers, but the chief challenge for the industry is a lack of new loan origination volumes, high financing costs and a dwindling group of bank lenders.

Truist (TRU) stepped back from lending to nonbanks in December 2023, Inside Mortgage Finance reports, mostly because of a lack of demand for warehouse credit from lenders. Some bank lenders are backing away from smaller nonbanks, which are disappearing rapidly into acquisitions or liquidations. With short-term loan warehouse rates around SOFR +1-1.5%, most lenders remain underwater on their production for sale into MBS.

Fair value marks for mortgage issuers in Q4 showed the impact of falling interest rates in December. Note that the entire group reported down marks on mortgage servicing rights (MSRs), with the exception of Mr. Cooper (COOP). The ebb and flow of prepayments, acquisitions and other adjustments make following the exact value of mortgage servicing assets difficult. Suffice to say that COOP continues to be a buyer of MSRs, along with Carrington Mortgage,  Rithm Capital (RITM) and Freedom Mortgage. 

Source: EDGAR

One issuer that has been a seller of MSRs is United Wholesale Mortgage Corp (UWMC), this to subsidize its ongoing price war in the wholesale channel. “In 2023, UWM was the largest seller of bulk MSRs with $107.9 billion off-loaded," according to Inside Mortgage Trends. UWMC won’t report earnings until February 28th, a rather stark comment on the attitude of management towards investors.  

We’ve noted in past issues that using MSR sales to subsidize the 1% loan paydowns is a high-risk trade for UWMC shareholders. As soon as CEO Matt Ishbia stops overpaying for loans, the other players will return to the wholesale channel. Ishbia's expenditure of resources buys nothing but expensive loans. But the bigger worry for UWMC is potential putback risk on the conventional mortgages that the firm sources from the wholesale channel.

So far, the consumer channel is relatively quiet in terms of default activity. Most of the pain is being felt by commercial lenders. But when trouble starts in residential 1-4s, you can be pretty sure that you’ll see it first in wholesale production before the other channels. One day not too far down the road, UWMC may be selling MSRs to offset the cost of loan repurchase demands from the GSEs. Indeed, the FHFA is thinking of taxing issuers 25bp for indemnity on doubtful loans.

At RITM, meanwhile, management continues to talk about being a multi-asset manager even though the core of the business remains residential mortgage finance.  The acquisition of Sculptor Asset Management was an expensive exercise but one that did not change the overall model. The acquisition of Specialized Loan Services (Q1 ‘24) from Computershare (CPU) increases the focus of RITM on residential mortgage. Thus the question comes, will RITM ever spin-off the residential mortgage business? Our answer: Not in this cycle.

So long as residential mortgage defaults remain quiet, then mortgage issuers of all descriptions will prosper. But as and when credit starts to become a serious problem in the market for 1-4 family loans, these issuers will suffer and RITM will lead the group down.  The chart below shows the unpaid principal balance of RITM's servicing book and the cost of servicing, which reflects the cost of servicing performing mortgage loans. As and when loan defaults rise, the cost of servicing for RITM will surge dramatically. Add a zero.

The mortgage surveillance group is shown below sorted by 1-year Total Return. Notice that in addition to the GSEs, top performers based on total return include highly speculative stocks such as non-agency issuer Angel Oak Mortgage (AOMR) and Blend Labs (BLND). Troubled reverse mortgage issuer Finance of America (FOA), which sold its last MSRs in Q4 and is controlled by Blackstone (BK), is near the bottom.

Source: Bloomberg (02/15/24)

Notice that the first two stocks on the list are Fannie Mae and Freddie Mac. Since last summer, these stocks have been bid up on speculation that the GSEs will be released from captivity. We see no realistic possibility that either of the GSEs will be released from conservatorship. That has not stopped speculation in the common shares and also the preferred, however, but we think this activity is poorly informed. Neither GSE is even remotely ready to operate as an independent company after 15 years under government control. 

Of note, the consolidation of the residential mortgage market continues. One of our long-term holdings, Guild Mortgage (NYSE: GHLD), agreed to acquire the retail lending assets of Academy Mortgage Corporation, a privately held Utah-based lender. Academy boasts approximately 200 branches and more than 1,000 employees who will transition to Guild, including more than 600 licensed mortgage originators.

On the interest rate side, most lenders have gotten little relief from the interest rate rally in December in terms of volumes or profitability. The false narrative about interest rate cuts is being replaced by something less optimistic, with short-term interest rates eventually falling but long-term yields are expected to rise. The chart below shows the Treasury yield curve and SOFR swaps. Please notice that the SOFR swaps curve is not inverted, but it is negative.

Source: Bloomberg (02/15/24)

“Stocks and other risk assets face the perfect storm if longer-term yields continue to outpace their shorter-term counterparts in a bear steepening of the yield curve. An increasingly plausible re-acceleration in inflation makes this outcome more likely,” writes Simon White of Bloomberg. 

With the Street backpedaling away from predictions of an early interest rate cut by the FOMC, we continue to believe that the first shoe to drop will be an end to the Fed’s balance sheet reduction. Reverse repurchase agreements (RRPs) have dropped below $500 billion for the first time since 2020. RRPs have provided net liquidity to the markets as the balances have fallen and offset the tidal movements of cash into and out of the Treasury’s general account.  

Once RRPs drop further towards zero, the Federal Reserve Board will be under pressure to restart reinvestment of payoffs from the system open market account (SOMA).  FRB Dallas President Lori Logan is said to be pressing other FOMC members to restart reinvestment of SOMA payoffs immediately, but Chairman Jerome Powell has made clear in recent statements that he wants the balance sheet smaller.

While there are a great number of people inside the Fed who ponder the appropriate level of reserves in the system, the fact is that they don’t really know. The Fed actually models liquidity as a percentage of GDP, which is another way of saying that they don’t know.  But what we do know is that the amount of borrowing by the US Treasury is only going to increase. Thus the size of the public debt, and not some magical relationship with GDP, is probably a better guide for the size of the Fed’s balance sheet going forward. 

Again Simon White states the situation nicely:

"A persistent bear steepening of the curve is the worst outcome for markets, as it implies Treasury bills are likely to continue being attractive to money market funds (MMFs), depleting the Federal Reserve’s reverse repo (RRP) facility and thus increasing the likelihood of funding stress."

The Institutional Risk Analyst (ISSN 2692-1812) is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy, or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.