Update: UWMC & Rocket; Rate Cut Dreams Fade

February 29, 2024 | Premium Service | Happy Leap Year. Now almost 60 days since the end of 2023, the earnings continue to roll in from the less attractive parts of the reporting group. The mortgage sector is still led by Fannie Mae and Freddie Mac, both up more than 140% over the past year, but the odds of a release of the GSEs from conservatorship are very long indeed.

One of our favorite examples of outlier business models is United Wholesale Mortgage Corp (UWMC), a leading aggregator of residential loans. UWMC is presently locked in a life and death struggle with Rocket Mortgage (RKT) for ownership of the wholesale mortgage channel.  And despite a lot of bluff and bravado from UWMC, RKT may be winning. While UWMC had the biggest market share in conventional conforming loans in 2023, that just means that they are losing more money per loan than everyone else.

UWMC reported a net loss of $461.0 million in 4Q 2023 compared to net income of $301.0 million in 3Q23 and net loss of $62.5 million 4Q 2022. This was inclusive of a $634.4 million decline in fair value of mortgage servicing rights (MSRs). 

UWMC blamed its Q4 loss on the markdown for servicing assets, but in fact UWMC has been selling MSRs to subsidize a price war.  The battle for control of the wholesale mortgage channel is one reason why both firms reported significant losses in Q4 2023. 

RKT reported Q4 2023 GAAP net loss of $233 million, but delivered "adjusted EBITDA profitability" for the full year and in Q4 2023, for the third quarter in a row. In the world of mortgage finance, all of the disclosure metrics are “adjusted” but that does not mean that the metrics are meaningful. What is significant is that RKT can essentially fund its war of attrition with UWMC indefinitely.

Below are two snippets from the UWMC earnings that illustrate the current scene and also suggests why the mortgage sector is so poorly followed by institutional investors. First we see the balance sheet summary below showing assets, cash and FV of MSR all down. Equity is down $500m from the previous quarter.

The picture from UWMC shows the company's first full-year GAAP loss and declining liquidity. But then we arrive at "adjusted" EBITDA and we see, viola, a $500m up mark for the remaining MSR due to a change in "valuation assumptions." The table below comes from the UWMC earnings release.

During the conference call, CEO Mat Ishbia bragged about the impact of his notional $507 million increase in the value of the remaining MSR to window dress his negative financials:

Ishbia's adjustment of the valuation of his MSR is a fiction IOHO, especially given that interest rates fell in Q4 2023. Keep in mind that in Q4 2023, most issuers in the mortgage industry reported down marks on MSR other than COOP, which was up due to net purchases. Since UWMC models its MSR internally, changing the assumptions is an easy matter. Our assumption is that UWMC is continuing to sell MSR to finance its price war with RKT et al in wholesale. We see two big problems with this strategy. 

First, as soon as UWMC CEO Matt Ishbia stops overpaying for new mortgages, RKT and the other players in the wholesale channel will return in force. Ishbia apparently thinks that his monopolistic behavior in the wholesale loan channel will permanently drive away the competition. We disagree.  Many of the biggest players in wholesale are also large Ginnie Mae issuers and servicers. They will just wait for Mat to run out of cash buying expensive conventional purchase loans.

Second, UWMC, RKT and other large issuers of conventional mortgages are creating what is potentially a larger problem than short-term profitability. If you inspect the league tables for different loan types published by Inside Mortgage Finance, you’ll notice that some shops that were originating a lot of conventional loans two years ago have fallen far down in terms of new production. Why? Because they do not like the risk of underwriting conventional loans that may be underwater in the next housing correction.

"The Federal Housing Finance Agency last week issued its 2024 “scorecard” for Fannie Mae and Freddie Mac, urging the two government-sponsored enterprises to “harmonize” their single-family representations-and-warranties framework," Inside Mortgage Finance reported earlier this month. "That included defect identification, remedies and repurchase alternatives."

Industry leaders believe that the FHFA wants the GSEs to offer issuers like UWMC and RKT "repurchase insurance" to the tune of 25bps per loan. If the industry sees an increase in loan delinquency without a decrease in mortgage rates, firms that are stretched for capital and liquidity could be put into a very difficult situation. Either you pay FHFA Director Sandra Thompson 25bp for "repurchase insurance" or she hits you with a loan repurchase demand.

Laurie Goodman, Jun Zhu and Michael Neal of Urban Institute wrote last year:

The table below shows The IRA Mortgage Equity group and some key performance metrics sorted by tangible book value (TBV) per share. Notice the disparity between RKT and UWMC, on the one hand, and Mr. Cooper (COOP) and PennyMac Financial (PFSI), in terms of TBV per share. There is a huge gulf in terms of valuation between firms that are building book value for investors and those that are bleeding cash into a very difficult secondary market for loans.

Source: Bloomberg

Our view of the mortgage world is that the gain-on-sale model typified by RKT and UWMC is fine in a falling rate environment, but in a rising or stable interest rate environment, the firms that acquire and hold MSRs have an advantage. We have always viewed UWMC as a redux of Countrywide Financial, but with the added consideration of Mat Ishbia's hyper-aggressive market strategy and the loan quality issues found in the wholesale channel. But ultimately, the performance of PFSI and COOP makes the case for value.

Source: Google Finance

Rate Cut Dreams Fade

Watching the Street firms backpedal away from predictions of an interest rate cut by the FOMC this year is becoming more and more amusing. The Fed's favorite gauge of inflation rose in January by the most in a year. The Fed's heavily limited core CPI, which excludes food and energy costs, increased 0.4% vs December.

The majority of investors are still banking on a rate cut by the Fed later this year, but we worry that markets and issuers are totally wrong-footed if inflation numbers continue climb and a rate cut is push backed into 2025. Jeremy Siegel at the Wharton School, for example, warns that a June rate cut is not "in the bag." Look for more analysts to retreat from the rate cut creed.

"If fortune favors the prepared, then no market is going to have much luck," writes Simon White of Bloomberg. "A re-acceleration in inflation is increasingly on the cards, an eventuality that is materially underpriced across asset classes. That means portfolios are cheap to hedge, as well as leaving markets subject to outsized moves when they do price in inflation’s return."

We think that the Street's pricing for interest rate cuts this year will slowly shift to a more neutral posture by Easter. Any indication that inflation measures are accelerating will speed this process. The fact is that Wall Street still cannot come to terms with the idea that ultra-low interest rates in 2020-2021 were an anomaly. These low rates are not likely to be repeated baring a complete meltdown of the economy and/or the financial markets. And looming in the background of all of these discussions is the massive federal budget deficit.

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