Nonbank Lenders: The Dead Pool

October 6, 2022 | Premium Service | In 1998, Buddy Van Horn directed “The Dead Pool” starring Clint Eastwood, Liam Neilson, Patricia Clarkson and Jim Carey. The film told the tale of the curator of a macabre list of soon-to-be-dead celebrities. The Guns & Roses soundtrack was a memorable backdrop for Eastwood’s last “Dirty Harry” film, which featured this timeless line from Inspector Callahan: “Well, opinions are like assholes. Everybody has one.” With that important caveat, below follows our view of the walking dead and soon-to-be kaput players in the world of nonbank finance.

With the Fed doubling down on rate increases, the pressure on all manner of nonbank finance companies and fintech platforms is growing. The gentle souls in the economic community talk about a “break” but have no idea about the details. When you are long loans and short Treasuries, and both positions move against you, and the margin calls start coming, that is a “break” that leads to the failure of a nonbank firm. With volatility off the scale and the MBS market shutting down, the real surprise would be if a few nonbank firms did not fail between now and New Year’s Day.

Angel Oak (AOMR) is not part of our mortgage equity surveillance list, largely because of our astonishment when this issuer of non-QM mortgage securities decided to go public in 2021. The mortgage REIT currently trades at 0.8x book value, which is not the worst in the group by any means and the equity is down a mere 30% YTD vs say -60% for Chimera (CIM) or Blend Labs (BLND) at -80% YTD. But it is notable that the mortgage REITs have not participated in recent equity market rallies.

Source: Google Finance

AOMR is an externally managed REIT controlled by Angel Oak Capital Advisors, LLC, which is an alternative credit manager and vertically integrated mortgage origination platform for private mortgage loans. Sreeni Prabhu, co-founder, Managing Partner and Chief Investment Officer of Angel Oak Capital Advisors, just took over as CEO of the REIT. He replaced CEO and President Robert Williams, who helped take the company public last year.

Inside Mortgage Finance reports that late Friday AOMR disclosed it had received a two-week extension on a warehouse financing facility it has with Barclays Bank for its loans. The new termination date is Oct. 14, 2022, after which we assume the firm will shut-down new loan purchases unless a replacement warehouse line is found. As we noted above, when you see you long loan position crater and are also losing money on your hedge, that is when your lenders start making margin calls and eventually shut you down.

Next on our list of firms to watch is United Wholesale Mortgage (UWMC), the spiritual reincarnation of Countrywide Financial that has exploded from relative obscurity a few years ago to being the top aggregator of wholesale loans in the US. UWM has been deliberately overpricing its loan purchases to drive other lenders out of business, a novel business strategy concocted by CEO Mathew R. Ishbia. We have noted Mr. Ishbia’s tendency to make bizarre public statements and take other actions that erode investor confidence in UWMC.

UWMC is down 45% over the past year, has a 12% dividend yield and is trading +200bp in credit default swaps. While UWMC has a reasonably positive reputation in the market in terms of operations, its decision to meet or beat any bid in the wholesale channel is not good for earnings. More, UWMC continues to provide evidence that Ishbia and his team are a little light on capital markets savvy as well as the way that public companies manage disclosure.

For example, on September 30, 2022, UWMC dropped an 8-K announcing that it “entered into the Amended and Restated Loan and Security Agreement (the “MSR Loan Agreement”), as borrower, with Citibank, N.A. (the “Lender”), as lender, providing UWM with, up to, a $1.5 billion facility to finance the origination, acquisition or holding of certain mortgage servicing rights (the “Citi MSR Facility”).” Ishbia continues:

The fact that this facility is uncommitted means that this is not news. Yet for some strange reason, UWMC decided to go through the time and trouble to issue a press release. What this tells us is that Mr. Ishbia is more concerned with managing appearances to his retail shareholders than he is about looking ridiculous to credit professionals and institutional investors. An uncommitted line from a bank is like a handshake. It is meaningless. Moreover, the fact that UWMC does not have term financing for its MSRs makes the announcement all the more perplexing.

Next on our list of members of the Dead Pool is Ally Financial (ALLY), the bank holding company that funds itself like a nonbank with hot money from the brokered deposit markets. We illustrated the weakness of ALLY’s funding in our last missive (“Large Banks: QT Winners & Losers”).

The $185 billion asset ALLY has among the highest cost of funds in Peer Group 1, 4x the large banks; an equally high credit loss rate; and overhead expenses that are significantly higher than its larger peers. In an environment with rising defaults, we believe that ALLY’s business model could come under significant liquidity stress.

Another nonbank platform that is suffering from the rapid withdrawal of liquidity from the market is Upstart Holdings (UPST), the poster child for nonbank liquidity risk. The stock cratered last quarter after management disclosed that UPST had been surreptitiously warehousing consumer loans on balance sheet. As with the case of Angel Oak and other lenders, when the liquidity leaves the market the originate-to-sell model disintegrates. First, investors back away from the market for loans and ABS, and second, the bank lenders pull back in terms of credit lines.

UPST is down 92% over the past year and is trading +250bp in CDS, a nose bleed level of default risk that is comparable to other wounded nonbanks such as Affirm (AFRM), which is trading over 300bp in CDS. By comparison, U.S. Bancorp (USB) is quoted this morning +60bp over the Treasury curve in CDS. The high probability of default reflects the uncertain funding environment, which directly impacts the ability of fintech lenders to do business. The Street has negative estimates for revenue and earnings for the rest of the year.

This list is just a sample of the carnage that is forming in the world of fintech lenders, a sector that was encouraged and made real by the open market operations of the FOMC. Now that the tide is going out on many of these speculative platforms because the conditions that allowed them to thrive and raise capital have been sharply reversed.

If the FOMC continues to raise interest rates through the end of 2022 and then maintains an elevated federal funds rate for 2023, then we look for many of these platforms to shut down or be sold for recovery value. Welcome to the brave new world of quantitative tightening or "QT" c/o the FOMC.

Disclosure: CVX, CMBS, NVDA, WMB, JPM.PRK, BAC.PRA, USB.PRM, WFC.PRZ, WFC.PRQ, CPRN, WPL.CF, NOVC, LDI, SWCH

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