Mortgage Lenders Face Return of a Purchase Market

July 8, 2023 | Premium Service | If we told you that a bunch of mortgage companies and specialty banks focused on housing were outperforming much of the rest of financials in the public equity markets, even as interest rates rise, would you believe it? Oh, and home prices are rising too. Most readers of The Institutional Risk Analyst know that some members of our mortgage equity group have outperformed the large-cap banks. Whether this evolution is warranted or sustainable is not even debatable, as discussed below.

You perchance noticed that Fifth-Third Bancorp (FITB) pulled out of mortgage warehouse lending last week, this after less than a year in that channel. Suffice to say that FITB is not considered a particularly serious player in the world of secured finance. The Comerica (CMA) exit was another matter entirely. Skittish behavior by large regional banks fleeing commercial loan markets is further evidence suggesting that Q2 2023 earnings may hold more than a few surprises for banks and nonbanks alike.

Funding costs and changes in the composition of deposits are the first data points for analysts following banks in Q2 2023 earnings. As we noted in our pre-earnings comment on JPMorgan (JPM), the ability to raise the yield on your book while managing perhaps 100-200% increases in funding costs is how banks will be measured in Q2 2023.

For nonbanks in the mortgage sector, the question is why are we even here. Funding costs for nonbanks are SOFR +1-2% and rising even as new loan volumes touch decade lows. More, the prospect of short-term interest rates remaining above 5% indefinitely has big implications for the economics of the mortgage market. For this reason, the fact that some names in the mortgage complex are actually outperforming banks and fintech firms is remarkable and may offer an opportunity for the risk oriented.

Equity Surveillance List

Source: Bloomberg, CapIQ

First on the list is Arch Capital (ACGL), a multi-line insurer that also writes private mortgage insurance (MI) on conventional loans. AGCL hit a 52-week high in May, but the sophisticated financial group remains popular with the analyst community. It offers exposure to the mortgage space without direct operating risk of an issuer and is No 2 on the Insurance industry group of Investors Business Daily. Like the entire group, ACGL benefits from some upside exuberance that is fading as expectations regarding interest rates evolve.

Next on the list is United Wholesale Mortgage (UWMC), the dominant player in the wholesale channel that has grown its footprint significantly in recent years. Comparisons to Countrywide Financial are entirely appropriate. UWMC is tied with PennyMac Financial (PFSI) in purchase mortgages and we suspect UWMC will pass them in Q2 2023. Both PFSI and UWMC trail behind Rocket Companies (RKT) in terms of refinance transactions, but all have the same challenge: low lending volumes, high loan originations costs and negative secondary market spreads.

UWMC completed 2 bulk loan servicing sales as well as 2 excess servicing strip sales in Q1 on servicing assets with a total UPB of approximately $98 billion, and also completed 2 additional mortgage servicing rights (MSR) sales subsequent to quarter end. Net cash proceeds approximated $650 million from MSR and excess sales in Q1 2023 or 66 bp on the UPB. UWMC reported an operating loss of $138 million in Q1 2023 and a negative mark on the owned MSR over $330 million.

Source: Bloomberg

So obviously the question comes, why is UWMC up 40% over the past year, more than many, far larger banks and fintech firms? The first answer is that the stock is very tight, with most of the shares held off-market in “non-controlling” interests. This is why Bloomberg cannot seem to calculate the correct market value of equity or price-to-book value for UWMC (“Memo to Gary Gensler: Beware the “Non-Controlling Interest”). Notice in the table above that Bloomberg reports the price/book for UWMC is 67x. Just remember it's a $5 stock.

The second reason is that UWMC is one of the market leaders in conventionals and amassed a large enough pile of cash during COVID to bully other lenders for much of 2022. Now that pile of cash is gone and so is the aggressive, beggar-thy-neighbor approach to buying loans from CEO Matt Ishbia. The company is monetizing half a billion in MSRs per quarter to cover operating losses. We think selling MSR today is not a bad decision, but it is always best to retain your own servicing if possible -- especially when the industry faces an existential change in the nature of the mortgage business.

It seems that a number of Buy Side analysts moved investors into names such as UWMC and PFSI on the theory that the FOMC would pivot this year, ushering in a benevolent period of lower rates and coupons around 5.5% instead of over 7% today. Look for the glib analyst in the Q1 UWMC earnings call who prattles on about 5% mortgages and the end of Fed rate cuts. Meanwhile, home prices are again rising and the Fed and other central banks are being backed into a corner in terms of maintaining current interest rate levels indefinitely.

The more optimistic souls in the mortgage industry seem to have misjudged the timing of an actual interest rate decrease by the Fed, especially given the latest economic data. We also worry about 2024, when large, aggressive conventional issuers like UWMC are likely to be waist deep in repurchase claims from Fannie Mae and Freddie Mac. Putback claims will come even as volumes are subdued and loan execution in the secondary market may still be negative.

UWMC originates 75% conventional loans and with $15 billion in Q1 volume is the market leader over PFSI and RKT, Inside Mortgage Finance reports. Western Alliance Bancorp (WAL) unit AmeriHome and U.S. Bancorp (USB) are fifth and sixth in conventionals. UWMC’s portfolio has a weighted average coupon of 3.6% or half of current coupon rates, making them an ideal target for the GSEs to make putback claims. A snapshot from UWMC’s Q1 financials follows below. Of course, EBITDA is not particularly relevant for a bank or finance company.

What the table above doesn't show is that UWMC’s overhead expenses were $300 million in Q1 vs $161 million in net revenue. Like many large issuers in the mortgage sector, overhead has simply not fallen as fast as revenue, driving these companies into operating losses. UWMC has seen revenue fall by 80% year-over-year. Likewise PFSI had net revenue roughly equal to operating expenses in Q1 2023, resulting in a small GAAP profit. PFSI had better results than UWMC primarily because of the larger servicing book, as shown in the slide from PFSI's Q1 earnings presentation below.

PFSI did a better job of hedging interest rates in Q1 2023 than did UWMC and thus reported a small profit. As PFSI noted in Q1, mortgage delinquency rates decreased from the prior quarter and remain below pre-pandemic levels. Significantly, servicing advances outstanding for PFSI’s MSR portfolio decreased to approximately $427 million at March 31, 2023 from $520 million at December 31, 2022.

While a number of rather optimistic analysts and investors continue to talk about returning to 5.5% mortgage loans in the near term, we think they ask the wrong question. Rather, if the period of hyper-low interest rates that the industry has seen since 2008 is truly over, how do mortgage lenders like UWMC, PFSI and RKT look in terms of business models? Veteran mortgage executive Bill Dallas provided some insight into that question in National Mortgage News:

If we summarize the points from the interview with Bill Dallas, the message is that the future facing mortgage lenders is a purchase market with very high expenses per loan and resulting downward pressure on revenues. Purchase loans cost over $12k to originate vs $3-4k for a refinance loan. Negative economics will persist, both because of origination expenses and the backwardation of the TBA market due to the actions of the FOMC. Most lenders are losing money on every loan they close and sell, leaving the servicing strip as the only potential source of income long term.

Source: MBA

As a result, the “winners” in the mortgage sector will be those larger players with equally large servicing books that can access funding from the dwindling number of banks that are focused on the sector. We think that the valuations for some of the larger issuers discussed in this report are excessive and likely to be corrected as investors come to appreciate that 7% loan coupon rates in a largely purchase loan market could be with us for years.

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.