R. Christopher Whalen
May 10, 20238 min
May 10, 2023 | Premium Service | Key risk indicators visible in the world of credit are not exactly confirming the rosy scenario coming from Buy Side managers and their enablers in the economics profession. Congress is playing chicken with the debt ceiling, for example, but we think the amount of US debt already demands a credit downgrade. Just the increase in debt service costs is enough reason for a ratings action. When will Moody’s, KBRA et al admit that S&P is right and downgrade the US Congress to “AA+”?
Besides the dysfunctional behavior of the federal government, another reason for a sovereign downgrade of the US is the equally skittish behavior of the central bank. The Fed’s use of “abundant reserves” from 2019 onward looks an awful lot like a subsidy for the Banco de Mexico circa the 1980s. The US Treasury is, after all, the main beneficiary of QE.
Looking at the accumulating ill-effects of this deliberate Fed policy (i.e. QE) of enabling ridiculous fiscal behavior in Washington, we think an explanation is in order. Not only did the Fed monetize trillions of dollars in Treasury debt since 2008 and especially since 2019, but it also taking billions in cash flows from trillions more in mortgage bonds, diverting income from private investors to the benefit of the US Treasury. This is the sort of dissolute behavior that traditionally has been observed among the more decrepit societies of the developing world.
Indebted nations that threaten credit default should be marked accordingly – if the rating agencies have any value to investors. That is, of course, the real question raised by the lack of action by the credit rating agencies. Bill Nelson of Bank Policy Institute notes even more aberrant behavior at the Fed as even more piles of sovereign debt accumulate due to failed banks:
“Yesterday the Fed released its always excellent biannual financial stability report (available here). The report includes an entire section on the Federal Reserve’s actions in response to the recent banking turmoil pp. 53-54. The section discusses regular discount window lending (primary credit) and lending through the Bank Term Funding Program. In the section and in the entire report, there is no mention of Fed lending to bridge banks or to the FDIC as receiver even though such lending currently accounts for 73 percent of Fed lending in response [to] the banking turmoil.”
Essentially, the FDIC now must assess new deposit insurance fees on large banks to take the Fed out of its loan to the three FDIC receiverships created since March. FDIC will also get $50 billion from JPMorgan (JPM) when the financing for the First Republic Bank (FRC) failure matures. The Fed is always an expense to the Treasury, keep in mind, unless the banks pick up the cost of now three large bank failures. That deal Jamie Dimon did buying First Republic Bank from the FDIC does not look so great now, yes?
Meanwhile in the world of credit and banking, the interest rate hikes by the FOMC have left trillions of dollars worth of bonds and bank assets trading at a sharp discount to par. We noted previously that First Republic Bank boasted a gross yield on its loan book of about 3.25% at year end.
The Real Deal reported this week that FRC had been making below market loans to all sorts of borrowers on New York City residential properties below $1.4 million. As the bank neared failure, it tellingly began to run away from this market. “It was clearly First Republic trying to get out of these loans because no one wants them,” Barbara Ann Rogers told The Real Deal about loans approved but never closed. “No one wants to buy a portfolio of 30-year fixed mortgages at 3.25 percent.” Ditto.
We begin to perceive yet another benefit of the Fed’s QE medicine, namely a tendency to underprice risk on a systemic basis. FRC was really a whole bank full of underpriced loans that pretended to manage money. Now, in a “normal” interest rate environment, whole sectors of the world of banking and finance are trading at a sharp discount to book value. When any company trades below 0.7x book value, it suggests that the fair value of the firm is overstated.
Update: Rithm Capital
One of the leaders in the world of nonbank finance is Rithm Capital (RITM), the largest nonbank owner of Ginnie Mae mortgage servicing rights (MSR). Formerly controlled by Softbank unit Fortress Investments, RITM changed its name a year ago to showcase its move back to the future and a multi asset strategy. Over the past decade, RITM has opportunistically accumulated a number of other businesses and portfolios, as shown in the table below.
At the end of April 2023, the price of RITM was cut in half when the company missed analyst expectations. Since the high of $18 in June 2018, RITM has experienced several sharp declines in valuation, particularly the downward move in February of 2020. In a sense, RITM illustrates a stock that did very well during the early period of Fed intervention in the fixed income markets, but has been sliding since the Fed ended its open market bond purchases. If you perceive a strong correlation, we agree.
Rithm Capital Q1 2023
RITM currently trades below 0.7x book value, which is a nice way of saying that the market does not believe the stated book value. The company reported income of $164 million before taxes, with losses on origination like much of the rest of the industry.
The reason that you follow RITM is because CEO Michael Nierenberg is a smart asset manager. He is not at all reticent about calling the end of the residential mortgage trade and the dawn of the commercial credit cycle. He stated in the earnings call:
“Cash and liquidity sits in and around $1.5 billion, putting us in a great position to take advantage of the market dislocations we're seeing. We do expect plenty of assets to come out for sale into the marketplace as a result of some of the market dislocations. Our third party fund business continues to be a major focus as we transition to growing our business as an alternative asset manager. With that in mind, we are evaluating alternatives for our mortgage company and will likely file an S-1 in the coming months. This will allow us to create other pools of liquidity to the extent we create a public entity and further diversify our business model.”
The idea of spinning off the mortgage business is not new, but it carries with it great significance. First, the spinoff must include all of the Ginnie Mae exposures of RITM because a REIT cannot be a government issuer. The predecessor of RITM originally acquired Shellpoint and later Caliber in order to qualify as a Ginnie Mae seller/servicer, but now must include all Ginnie Mae exposures and MSRs with the licensed entity. The unresolved scandal at HUD involving Michael Drayne turned around RITM's efforts to obtain a Ginnie Mae issuer license for the REIT, an effort that was unsuccessful.
While RITM is sending the Ginnie Mae assets off in an IPO for the New Rez lending business, it will probably also contribute the rest of the residential MSR portfolio to the vehicle and thereby shed most or all of the for-profit business assets that have operated as an appendage of the REIT. The mortgage company servicing represents 75% of RITM’s full MSR portfolio. The diagram below shows the MSR portfolio of RITM from the quarterly supplement.
Rithm Capital Q1 2023
The key takeaway from the table above is that RITM, like Mr. Cooper (COOP), is happy to see the weighted average coupon (WAC) of the portfolio well-below 4%. This is an important distinction. Other firms in the industry such as PennyMac Financial Services (PFSI) prefer a higher note rate on their servicing books because of potential refinance events when interest rates fall. We think that RITM and COOP have it right. RITM notes: “98% of our Full MSR portfolio is out of the money to refinance, with a portfolio WAC of ~3.7% significantly below current new production.”
The focus on the lower coupon rate of the MSR is important because of the leverage that RITM uses to finance its MSR. Nierenberg told investors: “When you look at [MSR] multiples, a multiple right now is roughly 4.9 times, that includes all of our seasons. MSR is essentially roughly unchanged in the quarter. Again, 4% to 5% CPR for the full portfolio, unlevered returns, give or take something between an 8% and 10% right now is what we're seeing in the marketplace.”
Interest expenses for RITM were up 123% YOY, forcing the firm to shed overhead expenses at a rapid clip. The importance of the breakup with Fortress is made apparent by looking at the income statement and the absence of the $25 million management fee in Q1 2023. The table below shows income and expenses for RITM.
Rithm Capital
The concern for the future is that RITM faces a protracted period of high interest rates with weak lending volumes and rising credit costs. The decision to spin off the mortgage lending business is obviously driven by the prospect of rising cash flow needs as default rates on residential mortgages rise and financing costs normalize.
Also, RITM are smart traders and they recognize that the next opportunity is coming from the mounting train wreck in commercial real estate. Again, the fact of QE enabled some truly regrettable transactions in commercial real estate. RITM w/o the residential mortgage business might be an interesting story, but a story much like the beginning of the journey a decade ago. Slide 13 in the RITM earnings presentation is shown below.
Given that RITM is now reported to be relying primarily upon Goldman Sachs (GS) to finance its MSRs and mortgage operations, any large increase in default activity could add instability to the mix. Our view is that GS does not have the funding base to provide competitive financing to nonbank mortgage firms. Overall funding costs for GS are roughly 2-3x those for JPMorgan (JPM).
Net, net, RITM seems to have come to the conclusion that monetizing the mortgage business is a better alternative than retaining the lender as a for-profit appendage of the REIT. RITM does not disclose its principal and interest (P&I) advances on its large portfolio of Ginnie Mae servicing, but the cost is likely comparable to other leading issuers.
And down the road, when and if interest rates fall significantly, RITM and other issuers will face margin calls on financing for MSRs as prepayments on new production soar. The 5x multiple on the RITM MSR portfolio may seem reasonable at a distance, but putting new loan production with 6 plus percent coupon on at a 5x capitalization rate for the MSR is a tad aggressive in our view.
RITM notes that “Newly originated MSRs this quarter had a weighted average mortgage rate of 6.37.” Now you know why Mike Nierenberg is so interested in spinning off his mortgage business. Truth is, new production MSRs ought to be capitalized at 3x multiples or half the levels seen at many issuers. When interest rates eventually fall, perhaps in 2024, those late vintage mortgage loans with 6% coupons will evaporate like spring snow in the sunshine.
The Institutional Risk Analyst 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.