The Next Trade: Banks, Nonbanks and Mortgage Servicing Rights

April 6, 2022 | Premium Service | Back in Q1 2020, March 24th to be precise, the FOMC rescued the markets from the shock of COVID and nearly swamped several mortgage lenders and REITs in the process. The Fed’s early open market purchases were actually focused on the wrong TBA contracts, further exacerbating the impact of “going big” with liquidity, but the Fed eventually got it right. Now two years later, we are reversing the go big liquidity trade. FRBNY EVP Lori Logan thinks that the natural “runn oft” from the Fed’s system open market account (SOMA) is about 15 CPR, but we think that the Fed’s got it wrong again by more than 2x. Based on the FOMC minutes released yesterday, Ms Logan and her colleagues at the FRBNY are about to inject huge volatility into the markets as they struggle to reduce the size of the SOMA. What is the next big trade in this increasingly uncertain environment?

Let’s start with a few basic observations about the nature and volatility of change in the months ahead.

Credit: Starting in 2020, the FOMC greatly skewed credit costs via quantitative easing, driving asset prices higher and loss-given default to record lows for many asset classes. Real estate has been the chief beneficiary of the Fed’s manipulation of LGD, but there is also a general impact on commercial assets. Over the next year, we expect to see LGD for real estate assets rapidly normalize as asset prices start to weaken, but that adjustment process could take years given tight inventory. The chart below shows loss given default (total charge-offs - total recoveries/total charge-offs) for $5 trillion in bank-owned real estate loans.

Source: FDIC/WGA LLC

Financials: During QE, the manager mob rushed into financial stocks, driving valuations for banks toward 2x book value and forcing valuations for nonbanks names to levels that make little sense. The shift in terms of Fed policy has taken the air out of some of the most excessive examples such as Silvergage Capital (SI), but we think that banks will continue to trend lower as investors come to appreciate that the baseline for bank earnings is 2019, not 2021. Think of JPMorganChase (JPM) just below 1.5x book as a bellwether for bank valuations more generally.

One of the unfortunate aspects of the shift in Fed monetary policy is that many banks and nonbank financials. Our friends at Piper Sandler put the situation succinctly in a note last week:

Translated into plain terms, there are a lot of depositories and nonbanks that were lulled to sleep during 2021, when the market risk was in one direction and the mortgage industry was minting MBS with 2 and 2.5% coupons. Today the on-the-run MBS is now a 4% coupon, meaning that much of last years production is under water and headed lower.

We expect to see a large number of financials reporting mark-to-market losses on loans and MBS that got caught in the interest rate shift that has occurred over the past 90 days. Equity managers may see any resulting price weakness as a buying opportunity, but we repeat that the baseline for 2022 bank earnings is 2019 and not 2021. The FOMC took $40 billion from quarterly bank earnings due to QE. It will take years for banks to rebuild asset returns.

MSRs: One question we hear a lot from readers is what is going to happen with mortgage servicing rights after several years of near-record pricing. The good news is that prepayment rates are falling and average lives are rapidly extending, suggesting higher net-present value for MSRs generally. Prepays for Fannie Mae 1.5s, 2s and 2.5% MBS coupons are below 20% CPR and falling rapidly, implying double digit returns for holders.

The big question with MSRs, however, is credit. As the Fed raises interest rates, home prices will react as the pool of available buyers shrinks in reaction to reduced affordability. While home supply constraints are a factor in terms of home prices, the lower income homeowner is likely to be impacted disproportionately in an economic downturn. The biggest risk in the mortgage industry is low-income home owners facing financial problems.

Home owners that have been able to migrate from FHA loans to conventional loans w/o private mortgage insurance may constitute a risk hotspot in the world of conventional servicing. Investors who have paid premium multiples of 5x annual cash flow may find that the assets they own are actually comprised of a large portion of FHA borrowers who will behave accordingly.

In Ginnie Mae MSRs, the risk/return calculation is even more profound because of the higher natural delinquency rates in government loans and also the tendency of mortgage servicers to modify delinquent loans that came under COVID. We continue to hear reports that large portions of loans that were modified during COVID will eventually re-default, suggesting that mortgage servicers and investors with exposure to Ginnie Mae MSRs will encounter rising expenses. End investors who bought Ginnie Mae MSRs during the peak of QE may come to regret these decisions.

Source: MBA, FDIC

Ginnie Mae MSRs, for example, that were being capitalized at 3-4x cash flow are likely to trade sharply lower as delinquency rates “revert to the mean.” The chart below from JPM shows Fannie Mae MSR prepayment rates. Note that Fannie late vintage (2021) CPRs on 1.5s, 2s and 2.5% MBS are already in single digits.

Bottom line is that we see credit as the big trade idea for 2022. How rising interest rates impact the credit exposures for banks, financials and the bond market will provide many opportunities to investors, but largely in terms of falling valuations. One of the biggest risks to financials is one name: Citigroup (C), which is trading below half of book value due to concerns about exposure the Russia due to the war in Ukraine. Negative news from Citi could take the entire financials complex back to Q1 2020 valuations.

Whereas in 2020-2021 the dominant trade thesis was long and SPACs were proliferating like flowers in Spring, now the trade is short across many sectors and asset classes. Many of the startups, investment flows and SPAC transactions that proliferated in 2020-2021 are likely to be casualties in the next several years.

Disclosure: L: EFC, NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC