R. Christopher Whalen
Aug 9, 20215 min
August 9, 2021 | In this Premium Service issue of The Institutional Risk Analyst, we review a couple of earnings announcements, including Mr. Cooper (NASDAQ:COOP) and New Residential (NYSE:NRZ). The big surge in income and net worth caused by the Federal Open Market Committee last year is rapidly ending. Winter has returned to mortgage land. More, virtually every nonbank mortgage finance company that went public in 2020 now trades below its offering price, Inside Mortgage Finance reports. The big question this week is whether the planned IPO for Better.com will be pulled, an eventuality sadly that we predicted several months ago when things looked much brighter in the world of 1-4 family mortgages.
Source: Google Finance
The chart above gives you an idea of the performance of a representative slice of the world of independent mortgage banks (IMBs). Only Guild Mortgage (NASDAQ:GHLD), a strong purchase mortgage lender that was actually public in a former life, is up over the past year as of Friday’s close.
Meanwhile, mortgage application app Blend Labs (NYSE:BLND), which we profiled earlier (“Profile: Blend Labs, Inc”), is down more than 10% since its July IPO. Readers will recall that BLND acquired Title365 from COOP for almost $500 million just prior to the IPO, an astounding valuation for a title insurance underwriter that greatly enhanced the revenue of the seller and makes the buyer look, well, ridiculous.
Mr. Cooper’s veteran operating team produce the best disclosure in the mortgage sector, providing investors with a good description of the firm’s operations and market conditions overall. The Q2 2021 financials show both the deceleration of the mortgage sector and the vast profits that were generated between April of 2020 and today.
Total book value per share at COOP rose from $21 a year ago to over $37 in Q2 2021, a big achievement that pushed the firm’s considerable tax loss carry forwards down to just 35% of total equity from 70% a year ago. This improvement addresses a major criticism from some quarters of the ratings community about the quality of COOP’s capital structure.
Pretax operating income for COOP was just $227 million vs $354 million a year ago, reflecting a big drop in originations. Similar results were visible across the industry, with Loandepot (NYSE:LDI), which is down 57% this year at Friday’s close, delivered a double digit decline in volumes and a 94% sequential decline in earnings.
Most striking, LDI CEO Anthony Hsieh declared when his earnings were released: “We’ve entered a transitional period and expect to see industry consolidation as some lenders may not be in a position to withstand the headwinds, whereas we are confident and excited for the future.” Of note, Inside Mortgage Finance reports, Hsieh talked about layoffs and cost cutting, a trend we expect to see pick up a great deal of steam during the rest of 2021.
The results described in COOP’s Q2 2021 presentation illustrates the situation going forward. Most of the pretax net income for the firm in Q2 2021 came from the sale of Title365. Without this one-time event, pretax for COOP would have been below $100 million. Total EBITDA, however, excluding Title365, was over $215 million, but this was half the cash flow generated a year before, as the table below from COOP’s quarterly presentation illustrates.
COOP reported a negative mark-to-market of $180 million on its mortgage servicing rights (MSR) as mortgage rates and swap rates decreased during the quarter, but coupon spreads actually rose modestly at the end of the period. The month-over-month value change attribution for MSRs across the industry was overwhelmingly due to the shift in the Treasury yield curve, SitusAMC reports. COOP ended Q2 2021 with a 115bp valuation for its MSR, down from 122bp in Q1 2021.
Most significant, COOP saw its pretax originations margin fall from just over 3% a year ago to 1.36% in Q2 2021, a stark example of how quickly things can change in the world of mortgage finance. COOP indicates that pricing pressure in the increasingly competitive correspondent channel was responsible for the decline in volumes and spreads. It is interesting to note that COOP’s servicing book grew to $654 billion year-over-year, this even with prepayment rates remained in the 20-30% average range over the past year.
New Residential
Since the start of 2021, NRZ has made some big strides, including the acquisition of Caliber Home Loans. Combined with NewRez (formerly Shellpoint), the addition of Caliber gets NRZ to $170 billion estimated 2021 originations and $490 billion in servicing UPB. Caliber is a solid business and, along with Freedom Mortgage and GHLD, has a strong presence in all three channels, wholesale, correspondent and retail/direct-to-consumer. The addition of Caliber was a necessary piece of the puzzle, but NRZ has acquired that piece at the top of the originations market and the related public equity valuations for IMBs. NRZ CEO Michael Nierenberg likes to buy at the top.
If you skip over the many pages of sales fluff in the NRZ financials and focus on the Appendix of the company’s Q2 2021 presentation, the picture also reflects growing operating stress, but with some significant differences vs COOP. The fair value of the NRZ MSRs and excess servicing fell $200 million to $3.8 billion, unlike the organic growth shown by COOP. Gain on sale revenue fell sequentially from $403 million to only $286 million in Q2 2021, consistent with the contraction in volumes seen across the industry.
But most significantly, NRZ continues to grow leverage and credit exposure, while COOP and other issuers have been pushing down leverage. NRZ barely made $121 million in net income Q2 2021, including $34 million in the reversal of loan loss provisions back into income. In 2021, NRZ has reversed $54 million of credit loss provisions back into income.
Origination pretax income for NRZ was $800 million in 2020, $191 million in Q1 2021 and $75 million in Q2 2021, a very stark illustration of trends across the mortgage lending sector. Net servicing revenue was negative $111 million, including almost $300 million in realized losses from MSR amortization and resulting decreases in cash flow. Total revenue fell 62% from $1.2 billion in Q1 2021 to $454 billion in Q2 2021.
Outlook
The challenge facing both NRZ and COOP is that any uptick in volumes due to lower benchmark interest rates is likely to be offset with higher prepayments, putting pressure on servicing income and also origination expense. Also, the decline in interest rates since June has not yet resulted in an increase in refinance activity, the single most profitable transaction for any mortgage lender.
Origination expenses at NRZ, for example, have grown even as revenue peaked last summer and since declined sequentially. When origination revenue peaked at $459 million in Q3 2020, origination expense was just $147 million vs $219 in Q2 2021 with less than half the origination revenue. Again, expense management will be a favorite topic across the industry going forward into 2H 2021.
Since the middle of June, the benchmark 10-year Treasury note has rallied, driving yields lower and pulling the 30-year mortgage rate down as well. In the near-term, this will pull millions more existing loans into the money for refinance. This fact will also tend to increase prepayment rates, which will generate servicing losses as MSR amortization increase. Higher loan origination volumes will help, but higher origination expenses and tighter spreads will drive less revenue down to the net income line.
Like commercial banks, IMBs are suffering from tightening spreads in the secondary loan market. If the 10-year Treasury note continues to rally and spreads continue to tighten, then the balance of 2021 could see operating conditions continue to deteriorate and IMB public market valuations under downward pressure.