New York | We had a great trip last week, participating in Ellie Mae’s (ELLI) Experience 2019 and surveying the rich (and water sodden) agricultural sector due north of the Golden Gate Bridge. You may have seen the announcement that ELLI has agreed to a buy-out led by Thoma Brava for $99 per share. Suffice to say the valuation is well-above the 50-60% of book value that most of ELLI’s customers in the world of mortgage lending enjoy. That is, the few that are actually publicly listed.
Q: Why is a non-QM mortgage loan like a corporate bond on transformational REPO? Hold that thought.
One of the key topics of discussion at the ELLI event was the long-awaited growth of the market for non-qualified (QM), non-conforming, non-government loans that don’t qualify for guarantees or credit “wrappers” from Fannie, Freddie or Ginnie Mae. Today the non-QM market is limited to a few industry pioneers like Citadel Servicing Corp. of Irvine CA, the self-proclaimed “leader in Non-QM/Non-Prime Wholesale and Correspondent Lending products.”
Camp Kotok -- June 2019
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Citadel originates the non-QM paper and retains the servicing, and earns an appropriate return for the risk. But the basic problem with non-QM lending is that outside of the prime market for jumbo loans dominated by banks, non-QM lending is limited to a few highly specialized non-bank lenders, industry veterans who hand-underwrite these loans much like a serious garage in southern California builds race cars.
Non-QM lenders have cash capital and an audience of hard money investors to “take out” the loan from the underwriter. Each non-QM loan is different – even more so than with your typical conventional loan. Each has a story and all have limited liquidity in terms of short- and long-term financing. Whereas you can finance a QM loan that has received an agency endorsement like a T-bill and get execution over par and with no margin on the security, for non-QM loans financing is far more costly. Thus we speak about “specified pools” of hand picked loans that have characteristics such as credit or geography.
The same financing cost barrier that inhibits the growth of non-QM lending, especially by non-bank lenders, also is an effective obstacle for an important subset of the non-QM universe, namely home equity lines of credit (HELOCs). There was a lot of discussion at the ELLI conference about the impending return of HELOCs as an asset class for 2019-2020. Some even see HELOCs as a potential replacement for reverse mortgages. Not on both counts. And why not? Three reasons:
Home equity loans or HELOCs are a traditional bank product that is frequently treated as an unsecured, 100% risk weight loan by regulators and are typically held in portfolio and serviced by the lender
Non-banks are ill-equipped to originate HELOCs because of funding costs and the lack of liquidity in terms of a natural take out by end investors
Investors dislike the attributes of HELOCs which are priced against 1st liens and do not reflect the credit and prepayment risk of the asset
With the rare exceptions of banks and non-bank firms such as Citadel or Angel Oak Mortgage, the non-QM and HELOC markets are owned by banks and really are a product meant to be retained in portfolio and serviced by a bank lender. Large banks have a cost of funds averaging 1.25% as of year end or 3-4 points below the cost to a non-bank. Small banks fund even lower, closer to 50bps than 1%.
The larger banks such as JPMorgan Chase (JPM), Wells Fargo (WFC) and Bank America (BAC) will aggressively bid for large prime jumbo loans which are non-QM mostly due to size, whether as first liens or HELOCs. Yet overall the banking industry’s portfolio of HELOCs has been steadily shrinking for the past decade.
So the big obstacle to the growth in non-QM loans and also HELOCs can be summarized in three factors: 1) high funding costs for non-bank originators, 2) crazy high pricing/low yields due to the bid from the larger banks and 3) end-investor reluctance to take default risk on a non-QM loan with no guarantee from Uncle.
The fact of government guarantee on agency mortgages and regulatory requirements for banks, insurers and pensions has made Buy Side investors lazy over the years. Letting Uncle Sam subsidize the default risk on residential (or even multifamily) mortgages is much easier than paying for the servicing and loss mitigation. Indeed, were the true credit costs born by investors in agency RMBS the real returns would be negative by several points, an illustration of the huge subsidy that the federal government provides to the US housing finance sector. Imagine the coupon on current FHA production sans the credit loss cover from Uncle Sam. Double the coupon and keep going.
While the federal government subsidizes some sectors, it acts as a brake on others, specifically in the way that regulation post 2008 limits liquidity and risk taking. Last week in our discussion with David Kotok of Cumberland Advisors, we spoke about how the rules for demonstrating liquidity imposed upon the 29 largest banks, the supposed “globally systemically important banks” or GSIBs, almost caused a market meltdown in December. But there are many other areas where global regulators have changed the rules in such as way as to make the financial system more, not less, fragile. Such an area is the wild and woolly world of “repo collateral transformation” used to finance trading in over-the-counter (OTC) derivatives.
So we asked above why the world of non-QM lending is like a corporate bond? Answer is collateral, namely non-agency, non-US Treasury risk that is subject to haircuts when used as security to raise cash. "Collateral upgrades" is another possibility suggested by Ralph Del Guidice. Just as a non-bank lender often lacks the collateral to finance its business effectively, non-bank funds and financial firms operating in the OTC derivatives markets now face even higher capital requirements as a result of the post-2008 regulatory onslaught.
The Dodd-Frank law and various regulations since adopted required many changes in the world of finance, particularly derivatives. Both the Dodd Frank Act and the European Market Infrastructure Regulation (EMIR) mandated that all eligible OTC swaps traded by Swap Dealers (SDs) and Major Swap Participants (MSPs) be cleared centrally with central counterparties (CCPs). In theory, this meant that the good old days of the prime brokerage desk trading OTC swaps with non-bank clients with little or no collateral were over. But think again.
While some of the larger Buy Side firms became actual clearing members of the major exchanges post 2008, most non-banks remain dependent upon banks for financing and, in some cases, collateral finance. How does this work? Say you are a non-bank with little working capital outside of your warehouse for non-QM loans or a fund invested in barely or even non-investment grade corporate debt. Your friendly securities firm takes your corporate bond paper, does a repo transaction to raise cash, and uses that cash to cover the margin on your derivatives trades.
The dealer bank trades corporate debt for cash (for a fee), but uses its own government or agency collateral to meet the margin call for the customer. Thus the bank holds the crap and all of the risk – sometimes for its own book, sometimes for clients. Tales of MF Global. Recall that the margin rules in Dodd-Frank and other laws and regulations around the world are meant to increase the proverbial “skin in da game” for swaps customers, especially the non-bank customers of banks.
Since most of these Buy Side customers did not have the capital to actually meet the new margin requirements, the Sell Side of the Street had to come up with a solution to circumvent the true intent of the new rules. The alternative would be to limit client positions as intended by Dodd-Frank and greatly reduce the fee income to the largest Wall Street banks. Keep in mind that in the world of actual securities, the rules on cash margin are set in stone. Only is the magical world of OTC derivatives are large banks allowed to explicitly evade margin requirements in such a reckless fashion.
Back in 2013, the folks at Sapient Capital Markets asked some obvious questions about collateral transformation. We provide our answer.
Will there be unintended consequences for putting the repo market between the buy side and CCPs? A: Yes
How will collateral transformation react in a stressed market? A: Badly
What is the potential for liquidity risk and rehypothecation? A: Depends how quickly the old plunge protection team can fix the contagion
What are the dangers in the new OTC landscape? A: Numerous and growing
Now of course, in a stressed scenario, a non-bank mortgage lender can liquidate a pipeline of fully government guaranteed agency loans within a day, posing little risk for the firm or the fully secured warehouse lender. The portfolio is essentially self liquidating. Even a portfolio of low-LTV non-QM loans would be reasonably easy to sell, remembering that this is a first lien claim on a real asset.
But in a transformational repo trade, the bank is exchanging corporate for risk free exposures, this to guarantee a margin call of OTC derivatives. Kinda makes us feel a bit queasy. Bank of New York Mellon (BK) noted in a June 2017 presentation ominously entitled “Collateral: The New Performance Driver.”
“Over 90% of participants noted a direct impact on their collateral obligations due to regulations such as OTC uncleared margin requirements. Both the demand for high-quality collateral and the frequency of margin calls have increased for almost all participants.”
Indeed, it is fair to say that today most of the major banks and non-bank dealers offer some sort of transformational repo product. The rub is that there are so many companies clustered around the neutral zone between investment grade and junk that we can see ratings volatility figure prominently in the forward analysis of value-at-risk (VAR). And we have not even talked about the leverage coming from the particular derivatives trade.
To us, the risk on a fully secured first lien mortgage loan, qualified or not, is an order of magnitude lower than leveraging selected portfolio assets to finance the margin on a derivatives trade – especially to the futures commission merchant is not affiliated with BK, JPM, WFC, etc. And we’re pretty sure that the intent of Congress when Dodd-Frank was passed in 2010 was that “skin in the game” was meant to be cash equity available to absorb first loss.
Using borrowed money to finance a margin call in transformational repo seems almost absurd, but perhaps this is just a sign of the times, an environment where market behavior is increasingly distorted by well-intentioned regulations and open market operations. Should we be more critical of the over-aggressive FCM financing a non-bank’s junk corporate bond collateral or the mortgage servicer or REIT that leverages capital invested in a servicing asset to generate free cash to finance new lending or acquisitions?
Fortunately we don't need to answer that question. The Federal Reserve Board is proceeding apace with the nationalization of the US money markets. And it seems pretty clear reading the proverbial tea leaves that the central bank stands ready to buy all of the detritus of Wall Street as and when the markets go through the next tantrum.
"Minutes from recent FOMC meetings suggest the Fed is exploring an O/N repo facility, which could potentially replace the pre-crisis era temporary open market operations used to target the fed funds rate," notes Goldman Sachs (GS) in a research report appropriately entitled: "Global Rates Insights: From leaky floors to leaky ceilings."
GS continues: "How such a facility is implemented can have material consequences for market functioning. In this report, we explore the design choices for such a facility, along with market implications of these choices. Our analysis suggests that the Fed can continue to effectively control unsecured overnight rates using IOER adjustments, especially given the Fed's signals that it intends to stop balance sheet reduction early."
William Dudley, Bloomberg
David Henry, Reuters