Washington | This week The Institutional Risk Analyst is attending the Mortgage Bankers Association annual conference in Washington, D.C., where we will be reporting on the presentations, meetings and other events. Last week we spoke to Michael Lau, CEO at Pingora Asset Management. Mike is one of the leaders of the mortgage finance industry, particularly when it comes to the world of mortgage servicing rights or MSRs. Pingora currently manages $1.5 billion in MSRs representing approximately $125 billion in unpaid principal balance (UPB) of residential mortgages on behalf of a variety of institutional clients.
The IRA: SO Michael, you have been traveling the country, meeting with lenders and investors. What is your take on the US mortgage finance sector as 2018 heads to an end?
Lau: I was just in Kalamazoo, Grand Rapids, and Scottsbluff. Yesterday I went into the old Lehman Aurora building in Scottsbluff. They only finished the building in 2007 and, it was Lehman, so it was state of the art. They had two million loans there, blah, blah. It is like walking back in time. Every cube is still there. Every office is still furnished. There are still signs that say Aurora Bank. It is bizarre. And of course, the building is two-thirds empty.
Mike Lau and James Tunkey at Leen's Lodge, June 2018
The IRA: In the mid-2000s, Aurora was one of our favorite examples of an outlier among banks at Institutional Risk Analytics. The Lehman FSB was the best performing thrift in the US in 2006 because of the flow of mortgages that went through its conduit. They had 50% equity returns. And then one day it wasn’t there. But turning to MSRs, talk about how you view the steady increase in valuations for loans and servicing over the past year and even the past five years. How do you explain this market to clients and help manage their expectations?
Lau: In terms of large, bulk acquisitions of MSRs, the pricing has been driven by a handful of firms that have a relatively insatiable appetite for assets along with very cheap leverage. We exercise pricing discipline in order to manage to the return expectations of our investors. When we re-engineer the pricing on some of these large bulk deals being won by other firms, the way we model and particularly this year, these deals are trading on an un-levered basis at a 5-6% IRR. There is risk on these assets regardless of where interest rates are and because of the credit quality of the book. There’s always risk in MSRs. There are a lot of entities in the market today that are incented to grow because of the way they are compensated.
The IRA: We could mention some names, but we take the point. All of the mortgage loan production of the past five years was mispriced thanks to the Fed destroying the risk premium and also the term structure of interest rates. The 10-year Treasury, for example, should have a 4% handle had the FOMC not done QE 2-3 and Operation Twist. Adding leverage does not help. In working on the GNMA MSR Liquidity paper this year, we finally understood the risky tradeoff between retaining the MSR and selling participations in the servicing strip to those same hungry investors you describe. How do you parse that risk? When you have to describe MSR credit risk to investors, how do you talk about retaining enough cash flow from the servicing strip to carry you through periods of higher defaults?
Lau: The risk we worry about is rising cost to service due to higher delinquencies in the book. At some point in the next few years we are going to have a mild recession. You are starting to see the real estate markets moderating in many of the hot markets like Dallas and Denver. I was in Dallas last week. The home market above $500,000 in Dallas, which is a nice house, has suddenly gone from multiple offers to none. The same thing is occurring in Denver. We are see indicators that we are approaching an equilibrium between buyers and sellers, and even tilting towards a buyers market.
The IRA: You see the same in New York. Our friends at Weiss Research called the turn in some of these markets a year ago, but the broad media is only just catching on because the Case-Shiller average lags the market. How do you think about valuation of MSRs in a market where leveraged financial buyers will hit every target in sight?
Lau: We put our best foot forward. Honestly, we tend to lose those bulk deals that are $3 billion or more in UPB, Fannie and Freddie collateral and a discount weight average coupon (WAC). We tend to lose those pools by 10-15bps. We find it hard to rationalize being more aggressive on these deals.
The IRA: There seems to be a significant divide between how the sellers and newer buyers see pricing and how some of the more seasoned servicers view the longer-term cost of servicing, especially in the discount coupons. The recovery rates on the $2.5 trillion in bank owned 1-4 family collateral are so good that they mask the credit cost – at least for now (see chart below). Banks are still three quarters of the total servicing book, compared to the 50-50 split with non-banks in the lending sphere. But have we see the end of the large bulk sales of MSRs?
Lau: The larger holders of servicing that did not like the asset have parted ways with it. The banks and non-banks that have the larger portfolios today are the ones who want to keep it and like the asset. They are generally accumulating more through origination or outright purchase. I don’t expect to see a material number of large deals in the near term. When you look at the divide between the banks and the non-banks, there will continue to be non-bank portfolios that range from two or three hundred million in UPB to a couple of billion that will be coming to market. On the origination side, margins are continuing to be pressured and volumes are weak. The purchase money market is going to be down next year. Refis have moderated to what we know is closer to normal, roughly 15-20% instead of what we’ve seen due to the artificially low rates we’ve had for the past ten years.
The IRA: You can thank the Fed for that. The Fed manipulated the yield curve and drove a lot of loan volume as asset values rose, but now rising rates are killing demand even as spreads tighten. We suspect that a lot of those low coupon FHA loans, which are assumable, will never prepay. But why are volumes falling with so much accumulated equity, especially for refinancing?
Lau: A lot of consumers are loathe to tap the equity in their homes. It is hard to rationalize doing a 4 7/8 or 5% loan today. Pricing is not ideal from a consumer perspective. The low coupon FHA loans will be a great tool for owners when they are ready to sell their house. We really have not seen a lot of assumptions in the past ten years but I believe that we will see an increase.
The IRA: What is behind the poor profitability in the mortgage market? Is it the tightness of credit spreads generally or the decline in lending volumes?
Lau: I honestly believe that there are two major themes on the loan origination side of the equation, whether we are talking about retail, wholesale or correspondent channels. Loan officer compensation is the elephant in the room that needs to be addressed and it is going to be a challenge. Dodd-Frank dictated how the Congress wants loan officer comp to be done to avoid steering, but it has created some unintended consequences as it relates to implementation. Production has always driven this industry. The better companies are around 100 to 110 bps in terms of loan comp, but the vast majority are around 125 to 150 bps. When you look at the loan officers being paid that much money and the companies that take all of the risk and have their equity at risk are working for a 5 bp margin pretax, that is not sustainable.
The IRA: Well, as you just stated, the mortgage industry is essentially paying out equity to retain loan officers. What is the solution?
Lau: We as an industry go through this periodically when we are on the downside of the lending cycle. We shoot ourselves in the foot because nobody has any pricing discipline and everyone is focused on maintaining market share. Lenders rationalize this by saying that they will be able to maintain fixed overhead. They hope that eventually, the marginal cost and marginal revenue lines will cross and they will make a lot of money. That is the beautiful thing about mortgage banking on the origination side because when you are in that position, you really make a lot of money. But few lenders are going to reach that point because they refuse to deal with the fixed part of the overhead relative to what realistic volumes are today.
The IRA: As in the 2000s, the FOMC stimulated interest sensitive assets and a bubble resulted. You have just described the basic problem with neo-Keynesian economics. The Fed pulls lots of future sales into the present with low interest rates, but then volumes fall when the market demand is exhausted. Look at what is happening to auto sales. Everyone thought we would stabilize auto sales around 16-17 million units annually, but the auto market is shrinking after years of boom time sales growth driven by cheap credit.
Lau: At the end of the day, 70% of the costs for most mortgage lenders is people. It is always challenging to cut people. You can look at the other 30% and tighten the belt, but if you are going to make significant cost reductions you have to lay off people. We have overcapacity. This industry is staffed to do $2 trillion in production annually, but we’ll do $1.6 trillion this year -- maybe.
The IRA: Is the solution merely headcount reduction or do you have to come up with a new formula for compensating loan officers?
Lau: In order to get the industry back to profitability, we must instill discipline around loan officer comp. The problem is that nobody wants to be the first one. If a lender reduces comp by 25 bp, then the better producers are going to go down the road to a competitor. That’s the fear that companies have with their better producers. Obviously lenders cannot collude on loan officer comp, but this is where we need leadership in the industry. You’ve got to have the bigger lenders take the step first. There has always been a differential between the big banks and the smaller non-bank lenders. And then you have Quicken which does not have loan officers and thus has a huge advantage in terms of their ability to price and be profitable.
The IRA: Even with the huge television spend and marketing cost you think Quicken comes out ahead of the industry? That tells you that the industry needs to look at that model. What is the second issue affecting profitability after loan officer compensation?
Lau: We are a dinosaur of an industry when it comes to IT. We have not effectively used technology. We still have paper files that are an inch thick. We are so slow to adopt any kind of cutting edge technology. You must have the best technology and work flow to be profitable. It is still a very clunky process to originate loans, which is part of the reason that I don’t work on the origination side. I manage a large servicing portfolio with 34 people, but only because we have sophisticated technology that we built to run our business efficiently.
The IRA: Given what you are saying about operating costs and technology, is even being in the lending space a good idea? Should smaller players with access to capital be spending to build a loan business right now?
Lau: This is the part of the cycle where the strong get stronger. This creates really good opportunities. The weaker are going to go away, either through acquisition or attrition. You will see much more consolidation next year than we saw this year. Production people are always optimistic. They always think that rates will fall and volumes will come back. But even after the rate hikes by the Fed, I still think that we are 50 to 100 bps away from what the natural market rate should be without the influence of the Fed.
The IRA: Thanks Michael.