R. Christopher Whalen
Feb 25, 20227 min
Updated: Feb 26, 2022
February 25, 2022 | With the Russian invasion of Ukraine, the financial markets will quickly become comfortable with Vladimir Putin’s naked aggression and focus anew on the Federal Open Market Committee. What the FOMC does or does not do in the next few months will have a big impact on markets and economies around the world. Besides rising interest rates, the big story in the US is the growing recession in housing finance, a dramatic reversal that could impact the macro outlook for US jobs and growth in 2022. Banks and nonbanks alike are desperately trimming expenses to right size headcount to falling revenues. Just watch the job postings for loan underwriters on the major career portals and you get an idea of the scale of the adjustment now underway. Below for subscribers to our Premium Service, we review results for several industry bellwethers and comment on interest rate trends more generally.
The Bank Policy Institute just finished an important conference in Washington, “Informal Symposium on Monetary Policy, Bank Regulations, and Money Markets.” The agenda included four timely topics:
The outlook for deposit rates and deposit levels,
The prospects for the Fed’s new Standing Repo Facility (SRF),
How the Fed’s balance sheet and money market rates will evolve as the Fed tightens policy, and
Treasury market functioning as the Fed switches from purchases to redemptions.
BPI’s summary raises some interesting questions for investors and risk managers:
“The participants noted that deposit rates could initially rise only slowly as the Fed raises interest rates, resulting in a large flow from banks into money funds, boosting the Fed’s Overnight Reverse Repurchase Agreement Facility and driving down reserve balances. Such flows could complicate Fed tightening and imply the Fed might choose to allow the spread between the interest rate it pays on reserve balances (the IORB rate) and the interest rate it pays on reverse repos (the ON RRP rate) to widen at liftoff. Participants generally did not think that the Fed’s new Standing Repo Facility would be free of stigma. If the SRF does not work as intended, the Fed may meet resistance shrinking its portfolio of securities as scarcity in the market for reserves materializes sooner than expected (as happened in 2018), requiring the Fed to stop redemptions and instead raise the federal funds rate more aggressively. Participants judged that as the Fed switched from Treasury purchases to redemptions, market functioning should be OK as long as there are no disruptions such as a war in Europe or a sharp rise in rates because the path for monetary policy tightening is marked up. Any such disruptions could result in flows that overwhelm the market’s capacity, which could require a difficult-to-explain reversal of quantitative tightening or worse, spark broader financial instability.”
Since the conference, war has begun in Ukraine, but the FOMC seems to be focused on dealing with the internal inflation situation in the US. The discussion at the BPI event echoes some of the concerns regarding liquidity we have discussed over the past year, particularly the prospective scarcity of risk-free collateral in a scenario where the Fed shrinks the SOMA portfolio. And we continue to worry that the Fed staff in Washington has yet to accept that QE was an error in judgement and in public policy.
The more important question for US monetary policy is how and whether it is possible to reduce the central bank's portfolio without again courting disaster in the credit markets, as the Fed did in 2018 and 2019. Former Treasury Secretary Lawrence Summers noted in comments last year to The International Economy Magazine.
“With regard to the Fed’s balance sheet, I think there is some confusion here going back to an earlier era when the Fed did not pay interest on reserves. I think of quantitative easing as the Fed issuing reserves which are essentially floating-rate government obligations and buying longer term government instruments. I’m not sure why that is a good idea. Everybody else in the economy is turning out debt. For the Fed to turn in the debt of the government of the United States, at a time of unprecedented uncertainty and remarkably low long rates, seems to me a quite odd decision. I wish tapering had already begun and I hope it will play out before too long.”
Meanwhile, as we near the back of the 45-day reporting period for public companies for 2021, the mortgage lenders and servicers are providing a look at the rapidly changing environment in the secondary market for home loans.
Home Point Capital (HMPT), reported a tiny profit in Q4 2021 that was only made possible by the sale of the remaining Ginnie Mae servicing. With the company selling tradable assets and moving to an outsourced servicing model, we’d not be surprised to see a sale sooner rather than later. This is not an uncommon situation in the industry, but most mortgage issuers are private.
HMPT's gain on sale margin dropped from over 2% a year ago to ~ 50bp now, illustrating how lender margins can fall even as primary-secondary spreads widen. Since loan originators are selling the loans, Goodman et al (2013) note, the profit margin depends on the price at which they can sell them, rather than the interest rate on the security into which they sell the loans.
Industry leader Rocket Companies (RKT) saw profits drop by $2 billion in 2021 vs 2020, but with stable operating expenses. As with other players in the industry, the ramp up in operational capacity to address the record volumes in 2020 and 1H 2021 is now a glaring problem. A year ago RKT was trading over 6x stated book value, but today is trading less than 2.5x. Notice in the chart below that 2019 and 2021 are relatively “normal” years, with net profits lower than gross operating expenses. The year 2020, on the other hand, was extraordinary.
Source: Edgar
The situation at HMPT illustrates a broad trend in the industry, namely that many independent mortgage firms are cutting back on headcount and also reducing the utilization of credit lines from commercial banks. As is usual at the end of a bull market in home lending, a number of warehouse lenders have stepped back from certain products or repriced to fit a higher risk environment.
Generally, the move in rates since January has left many smaller banks, REITs and others holding collateral that is now trading closer to 97 than 103, which is where GNMA 2.5 MBS started the year. There is a growing liquidity problem for smaller depositories due to the lack of alternatives to recover the bank's capital from seasoned loans given the shift in the Treasury yield curve. Most small banks and credit unions don't have the resources to effectively hedge loans or available for sale securities.
To give an example of the volatility that many financial companies and REITs have seen in the past 18 months, consider New Residential Investment (NRZ), an externally managed REIT controlled by Softbank unit Fortress Investment. The largest nonbank owner of mortgage servicing assets reported $964 million in profits in 2021 vs a $1.3 billion loss the year before.
NRZ revenue was basically flat to down slightly year-over-year, but the firm continued to rebuild capital and liquidity after the near-miss of 2020. The difference in results was the $2.2 billion write-down of the NRZ servicing portfolio in 2020. And NRZ’s compensation and benefits were twice as high last year compared with 2020, but the firm still made more money! The volatility in corporate operating results due to FOMC policies such as QE is mind boggling and visible in public company filings such as NRZ.
One bright spot in the world of consumer lending is Upstart Holdings (UPST), the lead generation play that has partnered with Cross River Bank to originate and sell loans. The company’s revenues and income continue to grow explosively, driven by the fat fees that UPST takes out of its loans. Some consumers pay a several point upfront fee on funds raised to UPST, a margin banks can only dream about.
Revenue was up 264% YOY to just shy of $850 million. Adjusted EBITDA was 27% of revenue or $232 million. This capital light originate to sell model has enormous upside leverage since much of the risk is shouldered by Cross River and the other bank partners of UPST. In 2022, UPST is focusing on the auto lending sector, a highly competitive space that has disappointed more than one new entrant. Time will tell if the UPST methodology will succeed.
Even with the strong financial performance, UPST has seen its valuation cut by 60% since March of last year, when its common equity traded at a mere 31x book value. Today UPST is only 12x book at $132 per share or twice the valuation of bank exemplar American Express (AXP). And UPST brags that 70% of loan originations are fully automated, “with minimal fraud.” Again, only time and some aging on the portfolio will tell the tale of credit. In the meantime, UPST is the only one of this group that is still up over the past year and has optimistic guidance for 2022.
Disclosures | L: EFC, NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, NOVC
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