R. Christopher Whalen
Nov 12, 20207 min
New York | In this issue of The Institutional Risk Analyst, we look at the earnings release earlier this week by Rocket Companies (NYSE:RKT). We also assess the market reception for independent mortgage banks (IMBs) more generally since the RKT initial public offering this past August. With returns on mortgage-backed securities (MBS) negative due to FOMC bond purchases and high mortgage prepayment rates, investors and lenders fight the Fed every day.
Mortgage Group: ACGL, AGNC, AI, BKI, BXMT, CIM, CLGX, COOP, ESNT, FAF, FBC, FMCC, FNF, FNMA, IMH, LADR, MFA, GHLD, NLY, NRZ, NYMT, OCN, PFSI, PMT, RKT, RWT, STWD, TWO
Because of forward liquidity and credit concerns, the window for IMBs to tap the public equity markets appears to have closed for now. As of this writing, there are only a handful of IMBs that have managed to follow RKT into the public markets, including Guild Holdings (NASDAQ:GHLD).
These deals and SPAC transactions for United Wholesale Mortgage and Finance of America were difficult stories to sell to investors and traded poorly in the secondary market, Barron's reports. Offerings for AmeriHome, a unit of Apollo Global Management (NYSE:APO) subsidiary Athene Holdings (NYSE:ATH), Caliber Home Loans and, most recently, loanDepot, are still pending.
With respect to UWM and its impending merger with a SPAC called Gores Holdings IV (NASDAQ:GHIV), Barron’s reported on September 23, 2020:
“Gores Holdings IV (NASDAQ:GHIV) stock fell close to 2% on Wednesday after the deal was revealed, to about $10.60. Better-known mortgage player Rocket Companies (RKT) made its debut in an initial public offering last month and faced lackluster demand from investors, having to reduce its listing price. For UWM, management’s own projections have earnings falling in the next two years, and insiders are using the SPAC merger as a chance to cash out a portion of their stake. That could explain the deal’s lukewarm reception.”
Various media outlets have attributed the delay in IPOs by mortgage firms as being due to “market volatility,” but in fact we think that investment managers are smarter than the investment bankers pretend. True, most equity managers are not very good at corporate finance, but it does not take a genius to realize that the boom in mortgage lending is due to 1) low interest rates and aggressive asset purchases c/o the FOMC and 2) that all good things do, eventually, end, especially when the earnings projections for 2021 are down.
The fact that forward projections for 2021 and beyond show falling volume and revenue is hardly a surprise to students of monetary mechanics. The FOMC's "go big" strategy has skewed market benchmarks to absurd levels, pushing returns on MBS negative in cash terms.
A mortgage servicing right (MSR), however, due to the possibility of recapturing existing clients via a loan refinance, offers positive returns for superior lenders. RKT and other IMBs in the top five are able to monetize the optionality in residential mortgages. But despite this huge positive, we also suspect that the other serious operational issues waiting in the wings have added a dose of caution to the mix with investors.
Suffice to say that our friends at SitusAMC have capitalization rates for new production Ginnie Mae 3s MSRs at over 3x annual cash flow through October, but we are a seller at 2x thank you very much.
The Ginnie Mae 4% coupon MSRs are marked today at 2x annual cash flow, but all of these assets will prepay thanks to the FOMC. Ask any operator in the industry that question and you'll get the same answer. And with the FOMC now targeting Ginnie and UMB 1.5s as part of QE, anybody who tells you about rising mortgage interest rates is badly mistaken.
A careful reading of the S-1s filed by AmeriHome and Caliber, for example, tell the astute credit analyst all that you need to know about the risks involved in the government mortgage business. Do equity managers understand such nuances? Yes, enough not to get stuffed with a bad offering by a bunch of investment bankers who cannot spell "option adjusted duration."
The table below from the Q3 2020 RKT earning report is shown below. Focus on a couple of the more remarkable points in this relatively brief earnings summary:
First, the fair value of the firm’s mortgage servicing rights declined only slightly over the past year, a testament to the excellent operational efficiency of RKT as a lender and servicer. The vast investment in operations and technology is the chief reason that RKT received a good reception from equity investors. But millions of dollars in retail advertising didn't hurt either.
If you figure that at least 1/3 of the mortgage servicing rights held by RKT prepaid in the past 12 months, this means that RKT was able to replace those MSRs despite the frightening rate of loan prepayments seen since April. And RKT booked a 5% gain-on-sale on every loan. Send those "thank you" notes to Jerome Powell at the Federal Reserve Board in Washington.
The second point that as is related to the first is that RKT has one of the highest rates of client retention in the industry. RTK states in its earnings release: “Our recapture rate was 82% for refinance transactions for the twelve months ended September 30, 2020 and our overall recapture rate was 73% for the same time period.” This is best in class performance, yet even with the huge expansion in lending volumes, the FV of the RKT MSR still fell as shown in the table above.
Third, because of the rate of prepayments and the fact that the FOMC has begun to buy 1.5% MBS coupons as part of open market operations, risk professionals and managers must haircut the MSR of firms like RKT at least by 1/3 to get to true FV. Most banks, REITs and public companies use inflated valuation multiples for MSRs, which are inevitably marked down over time.
Fourth, looking at the year-over-year change in RKT’s financials, the key takeaway for risk professionals and investors is mean reversion. The volume and profitability numbers for RKT will inevitably decline, the only question is when and how much. We believe that RKT may be able to achieve its goal of 25% national market share in terms of lending (Wells Fargo (NYSE:WFC) reached 35% in the 2000s), but the obvious question is 25% of what and at what level of profitability?
Gain on sale margins for RKT, a key indicator of industry profitability, grew 44% YOY due to the actions of the FOMC. As the industry brings more and more capacity online to capture volumes these margins will decline. Indeed, the “historically strong” 4.5% gain-on-sale reported by RKT is a 20-year record and is unlikely to be sustained, even if the FOMC continues to lower interest rates via open market purchases of MBS.
Industry profits will remain strong by historical standards, but margins will compress. RKT projects that in Q4 2020, closed loan volume will be between $88 billion and $93 billion, or an increase of 73% to 83% compared to $50.8 billion in the fourth quarter of 2019.
RKT projects “net rate lock volume of between $80 billion and $87 billion, which would represent an increase of 82% to 98% compared to $43.9 billion in the fourth quarter of 2019.” These results are unlikely to be repeated in 2021.
“Gain on sale margins of 3.80% to 4.10%, which would be an improvement of 11% to 20% compared to 3.41% in the fourth quarter of 2019,” RKT reports, indicating that operating margins for RKT and other lenders are already under substantial downward pressure. SitusAMC, MIAC and other third-party MSR valuation houses are reporting the same trend.
Bottom line: RKT is the best performer among the large IMBs operating in the residential mortgage market. Much of the increase in volumes and margins, however, are the result of actions by the FOMC and a lack of industry lending capacity coming out of the horrific year 2018, when much of the industry was unprofitable.
The mortgage industry has grown headcount by roughly 50% since April of this year, thus spreads will shrink and loan quality will fall. The short-term outlook for RKT and other stronger IMBs is good, but there remain a number of challenges ahead as we noted in our last comment on the residential mortgage sector (“The Bear Case for Mortgage Lenders”). RKT is well positioned to take advantage of the good times and also weather the inevitable housing market correction that will come in several years. Until then, make and sell as many loans as possible.
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