R. Christopher Whalen
Nov 8, 20216 min
November 8, 2021 | In this Premium Service edition of The Institutional Risk Analyst, we look at the Q3 2021 earnings results for PennyMac Financial Services (PFSI), Rocket Companies (RKT) and Home Point Capital Inc. (HMPT). Suffice to say that 2021 is not a bad year by any measure, but most operators tell us that the year is getting stranger by the day. Increasingly hectic secondary market activity in loans and servicing, shrinking spreads and soaring prices are some of the highlights.
The key trends we’ve seen so far from Q3 2021 earnings remain 1) falling volumes and 2) tighter margins across most product types vs last year. HMPT reported this week, making a “turnaround” of sorts from a disastrous Q2 by selling a GNMA mortgage servicing portfolio for proceeds a bit over $120 million and thereby paying a dividend.
The MSR sale by HMPT accounted for half of Q3 2021 revenue of $275 million, down from $510 million in Q3 2020. The GOS margin for HMPT dropped from 286bp in Q3 2020 to just 84bp in Q3 2021, again illustrating the intense competitive environment in the secondary mortgage market.
Source: HMPT Q3 2021
Market leader RKT saw an improvement in results compared with Q2 2021, but a significant year-over-year decline in revenue, loan volumes and operating cash flows. The gain-on-sale revenue (GOS) of $2.6 billion in Q3 2021 was 40% below the record $4.3 billion in Q3 2020. More significant, RKT saw a $341 million decline in the fair value of its mortgage servicing rights as prepayments on mortgage-backed securities (MBS) remain high.
Source: RKT Q3 ‘21
Not only did RKT sell MSRs, Inside Mortgage Finance reports, but it also acquired $3.6 billion in UPB of servicing assets to feed future refinance lending, an expensive investment to capture 20-30% of payoffs in a given pool.
As we noted in our last report (“Update: New Residential Investment, Fortress & Softbank”), many issuers – including RKT – don't calculate recapture correctly and thereby manipulate their metrics for customer retention. The irony, of course, is that RKT pools tend to prepay faster than the industry average. Said CEO Jay Farner during the RKT earnings call:
“In addition to generating our clients organically, we acquired MSRs with an aggregate unpaid principal balance of $3.6 billion during the third quarter. This is in accordance with our growth strategy as we have found that our industry-leading retention rate positions us to generate attractive returns through select MSR portfolio acquisitions.”
RKT has guided analysts up 10% for the full year 2021 in terms of funded volumes, but with GOS margins in the range of 265 to 295 basis points or half of last year’s peak levels. Significantly, RKT has $3 billion in liquidity used to self-fund loan volumes, meaning that it does not have to use a warehouse line from a bank. But Farner may end up using that cash to buy more loans and servicing as lending volumes fall. Farner noted that the increase in home prices actually adds profits to the industry per unit volumes:
“We're excited about 2022 because if we kind of look at where industry experts are projecting, they're talking about the continued growth. I'm seeing forecasts [8-plus] percent. We're seeing median home prices estimated to be north of $435,000. And as home prices grow, of course, mortgage amounts grow, and you understand how our business works that is great for the unit economics of our business, more revenue generated on the same units that we're putting through the system. So just in general, the industry looks very strong.”
RKT has assembled an impressive “ecosystem” of companies to take a fee out of every stage of the mortgage lending process from realtors to a home listing platform to Amrock Title to Rocket Mortgage for the loan and servicing. That said, most of the comparisons made for RKT are to 2019 financial results, a natural choice since net results in 2021 is likely to come in below 2020.
Even as volumes fall, RKT is trying to make up the difference in a falling volume market by shifting from refinance transactions to more expensive purchase mortgages. With the wholesale channel now running at break even or worse, retail loans are an expensive way to build revenue, but RKT has lower costs than many competitors. Interestingly, PFSI is taking a different route and is focused on call center and servicing income as sources for future profitability.
RKT is predicting that it will reach 10% market share by the end of 2021, a notable goal that will likely also see profits cut in half compared with 2020 levels. The table below shows revenue, income and earnings before interest, taxes, depreciation and amortization of intangibles such as MSRs. Note that adjusted EBITDA for RKT is running at 50% of last year’s levels.
Source: RKT Q3 2021
Although the FOMC has announced a tapering of its massive open market operations (aka “QE”), the Fed will be taking a bigger slice of dwindling MBS as well as Treasury debt issuance until well into 2022. Thus, for MBS issuers such as RKT, PFSI and HMPT, the market may see secondary market rates fall in Q4 2021 and 2022, this even as lending volumes decline. There are a number of factors that impact coupon rates in the world of MBS, however, as illustrated in one comment last week.
“A 1.45% 10-year yield makes Fannie Mae’s 2% the main production coupon,” according to Bloomberg’s Alyce Andres. “When rates were rising a few short weeks ago, mortgage originations switched from 2% to 2.5% coupons. More production in higher coupon mortgage-backed debt means less duration hitting the market because proportionately more payment is received before final maturity. Now, the opposite is true, and that added duration could weigh a bit on bonds.”
PFSI saw the same erosion of GOS margins and net income as RKT and HMPT, this even as total lending volumes for 2021 may actually exceed 2020, using the estimates from the Mortgage Bankers Association. Mortgage rates some 200 bps below peak levels of the end of 2018, when mortgage rates were near 5%.
PFSI notes that direct lending and servicing are driving profitability, a statement that could also be made about RKT. When issuers like RKT and PFSI, who usually eat their own cooking in terms of acquiring assets, are paying up for servicing and early-buyouts to generate new loan volumes, you know that the going in the secondary loan market is getting tougher by the day.
Source: PFSI Q3 2021
In the quarter ended September 30, 2021, PFSI reported total net revenue of $786 million, down almost 30% from Q3 2020. Total net revenue YTD for 2021, $2.5 billion vs $2.7 billion, is still close to 2020 results, however, due to the strong showing by PFSI in the first half of 2021. Total expenses for the nine months of 2021 are above 2020 levels by 15%, suggesting that significant cost cutting is a given in the months ahead.
Servicing revenue rose 7% so far this year, but the amortization on PFSI’s MSR and $80 million in hedge losses almost offset total servicing results. The shift in the Treasury yield curve in September was responsible for most of the pain in the world of hedging as a flattening trend caught many investors and issuers unawares.
What many operators in the mortgage finance sector know, however, is that a need for operating expense reduction and rising cost of asset creation are two factors that are largely beyond their control. Meanwhile, a flattening Treasury yield curve signals increasing concern that Federal Reserve efforts to keep inflation in check will derail the economic recovery.
We suspect that the FOMC’s compromise is to end purchases of MBS and slow acquisitions of Treasury debt, a policy mix that may hold new surprises for mortgage issuers. Specifically, a softer bid for MBS relative to Treasury yields may allow for wider spreads in 2H 2022. In the meantime, look for lending volumes and spreads to remain under pressure.
Disclosures | L: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF; S: UWMC, RKT
The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.