R. Christopher Whalen
Feb 9, 20237 min
February 9, 2023 | Premium Service | This week The Institutional Risk Analyst was in Houston for the Southern Secondary Conference sponsored by the Texas MBA. Below we discuss some of our insights from the conference and then take a look at the earnings results for Rithm Capital Corp. (RITM) and PennyMac Financial (PFSI).
As we’ve noted for some time, things are very difficult in the mortgage finance channel, but the world is not ending just yet. There was a combined $75 billion in new CUSIPs issued in the Fannie/Freddie/Ginnie market in January, well-below the run rate needed to hit ~ $1.9 trillion in production in 2023. Yet while lending activity in TX is down overall, immigration from CA, NY, IL, strong employment growth and overall lack of regulation and zoning restrictions should continue to be positives for new purchase business in Texas.
The context for the Southern Secondary is an industry in retreat, with banks and non-banks alike cutting back expenses and exiting the market as industry capacity painfully right-sizes to volumes. In Q4 2022, home lending at Wells Fargo (WFC) was down 57% YOY, one reason the bank is withdrawing from correspondent lending.
A number of other lenders have exited correspondent lending and vendors such as Blend Labs (BLND) are shrinking headcount accordingly. Better.com is likewise treading water as special purposes acquisition corp (SPAC) Aurora Acquisition Corp (AURC) is seeking yet another extension to complete its merger with BetterHoldco, Inc. We view the latest move as mostly theatrics because there seems to be no way for AURC to buy Better.com without provoking litigation over the valuation.
News that key BetterHoldoco shareholder SoftBank Group has reported yet another massive loss makes us view the Better.com situation as problematic. Last May, Better.com CEO Vishal Garg disclosed that he was personally liable for part of the $1.5 billion that SoftBank committed to Better.com in anticipation of an IPO. The deal never happened and SoftBank advanced only $750 million to Better.com. What happens next?
In a recent filing, AURC disclosed that its bankers had largely resigned, this apparently due to the threat of delisting by NASDAQ and further action by the SEC and other regulators against SPACs as an issuer class. Fact is, SPACs have gone from the flavor of the month back in 2020 to a shunned asset class today with ample headline risk. AURC might be well-advised to allow the extension effort to gently fail and return the funds held in trust to investors.
PennyMac Financial reported on February 2nd and the results were about what we expected. Volumes are down, but servicing assets and book value are up. The flow of early-buyouts (EBOs) from Ginnie Mae MBS pools are slowing dramatically as dwell times for delinquent assets extend. Notice the surge of EBO revenue in Q4 as the bond market rallied 100bp and execution improved accordingly (Earnings Presentation Pg 15). Notice too the 10-fold increase in expenses related to EBOs.
Every mortgage lender in the US is dealing with the impact of the deeply inverted yield curve. Carrying spreads are negative and the execution in the TBA market is likewise badly skewed. Issuers are avoiding the expense of buyouts of delinquent loans and are simply leaving the notes in the pool as they work with the borrower.
Advance lines from banks are being priced today at SOFR +200bp or higher on agency and government assets, thus the negative carry facing mortgage lenders is measured in points. For PFSI, however, the key to survival has been aggressive management of operating expenses as volumes have declined and earnings from the servicing book slowly rise.
PennyMac Financial Services
The earnings report by Rithm Capital, the largest nonbank owner of MSRs, were supported almost entirely by servicing income as new loan originations have dried up. The valuations of the RITM MSRs is near a 5x multiple, including for new production. Over 98% of RITM’s MSR portfolio is out of the money to refinance, with a portfolio weighted average coupon (WAC) of ~3.7% significantly below current new production. The same metric for PFSI is 4.3%. The chart below shows the valuation multiple for RITM’s MSR portfolio.
Rithm Capital
The Street is pounding the table on both PFSI and RITM, both of which rallied substantially in Q4 2022. The real issue with both of these names, however, is future credit costs. It is interesting to note that neither PFSI nor RITM provide a statement of cash flows with their earnings release.
As delinquency reverts to the historical mean in terms of loss given default, we expect to see all issuers come under growing liquidity pressure. If these pressures grow sufficiently, then you will see RITM, PFSI and other large government issuers start to sell MSRs to raise cash.
When the periodic income and escrow earnings from MSRs are insufficient to keep large government issuers solvent and they are forced to sell assets, that is the signal that we are entering a true liquidity crisis in housing finance. We suspect that the IMBs will be sellers of conventional assets to defend their Ginnie Mae MSRs. Meanwhile, we look for commercial banks to be buyers of conventional servicing assets.
The general view of most attendees at the Southern Secondary is that the market exits by WFC and New York Community Bank (NYCB) will not result in a huge rush to sell MSRs. Calls to WFC by several issuers have been met with responses that indicate that the process of down-sizing will take years. The 2017 sale of the 1-4 business by Citigroup comes to mind as a model for the WFC process.
That said, in 2023 there will be some very motivated sellers of MSRs going forward, especially if the FOMC keeps rates at or above current levels for all of 2023. Both Housing Wire and Inside Mortgage Finance are banging the drum publicly for doom and gloom due to lower MSR prices, but markets say otherwise. The lack of earning assets across the fixed income spectrum, we believe, will continue to drive investors into MSRs even as issuers come under growing liquidity pressure.
The bond market rally in Q4 took some bank MSR marks down just as AOCI also fell, but we may swing up in valuations in Q1 as negative AOCI balance rises again. Of note, while we are not yet at record nominal MSR valuations vs the 1990s, one veteran commented on our panel that the difference between today and 1990s is in the greater values of escrows thirty years ago. If we equalize for the change in interest rates over the past three decades, the valuations may actually be higher.
The BIG question looming over all of these discussions about MSR valuations and credit concerns for larger issuers is home prices. The chart below shows the progression of home price appreciation since the high-inflation years of the 1980s, when Fed Chairman Alan Greenspan first turned up the gas on inflation. The home price appreciation of the 2001-2007 period caused by the FOMC under Greenspan set the stage for today's inflation.
While the valuations for MSRs today are greatly helped by rising interest rates, as 2023 continues weaker prices for homes may start to increase negative pressures on MSR valuations. The sharply rising cost of loss mitigation activities in 1-4s. will eventually start to offset rising interest rates as a factor in MSR valuations.
Historically the value of escrow balances has accounted for as much as 20% of MSR valuations, according to an analysis prepared for WGA LLC by MIAC. But as we leave behind the market distortions of QE and see credit loss metrics normalize, look for the embedded cost of credit in MSRs surge. At the end of the day, loss given default in 1-4 family mortgages is a function of home prices.
Source: FFIEC
Final thought. Keep your eyes on the FHLBs in next few weeks as they prepare to announce open ended forbearance for banks that are book insolvent due to QT. Like the banks, the FHLBs and the GSEs also have capital impairment issues due to QT. Regulators like to beat on the IMBs over capital or MSRs, but then they give the banks a free ride -- even if some of these institutions end up failing due to M2M losses.
The Q4 numbers for accumulated other comprehensive income (AOCI) for the US banking industry will look better, but rising market interest rates in Q1 2023 may be quite ugly in terms of AOCI and the M2M on the retained book. Notice that many banks reported lower deficits in terms of AOCI in Q4, but MSR valuations also declined. These two relationships -- MSRs and AOCI -- are essentially linked via market interest rates. As funding costs rise, banks which lack large negative duration positions in MSR will come under pressure to sell low-coupon exposures that are underwater.
Source: FFIEC
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