It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way—in short, the period was so far like the present period, that some of its noisiest authorities insisted on its being received, for good or for evil, in the superlative degree of comparison only.
A Tale of Two Cities
March 9, 2022 | One of the truths of finance is that there are big banks and then there is everybody else. Banks are “government sponsored entities” or GSEs just like Fannie Mae, Freddie Mac and the Federal Home Loan Banks. All of these entities have privileged access to government subsidized funding, liquidity, and payments. We discussed this topic and the new rules for nonbank mortgage companies in our recent column in National Mortgage News ("Dissecting the FHFA’s issuer eligibility proposal")
The cost of funds for the entire US banking system in Q4 2021 was just 15bp, as we note in the most recent IRA Bank Book Q1 2022. The gyrations of interest rates since the start of the full-blown Ukraine war with Russia have turned a rising rate narrative of several weeks ago into a falling rate narrative. And nobody is more impacted by interest rate volatility than mortgage banks, which typically pay several points over SOFR or even Ameribor for funding.
Those GNMA 2.5s trading for next month in the TBA market were on a 97 handle at the end of February, but now are trading near par with the resulting drop in yields. Yet even as benchmark rates have backed up in recent weeks, most of the mortgage sector is trading at a steep discount to book value. Commercial banks, meanwhile, continue to trade at a premium. Why? Because nonbank finance is heavily correlated to interest rates.
Consider the sad case of Finance of America (FOA), a venerable mortgage shop that went public via a special purpose acquisition company or “SPAC.” Bear in mind that when you go public by SPAC, you are usually acquired by the SPAC. If the SPAC pays a premium above book value for the target, then goodwill is booked as an intangible asset. If the value of the stock subsequently declines dramatically, then a write down of the goodwill often follows.
“Due to a sustained decline in the Company’s stock price,” FOA disclosed on March 2, 2022, “the Company recognized a $1,381 million accounting impairment of the outstanding goodwill and certain intangible assets in the fourth quarter of 2021 to align the Company’s book value with a supportable control premium.”
To put it in plain terms, the company reported $2.4 billion in total equity in September 2021 but after the adjustment to goodwill, now reports just $1.1 billion in total equity, having written down capital by 55%. The tangible equity of FOA at $480 million, which is all that ever mattered, rose by $40 million in the same period. That sound in the background is the trial lawyers sharpening their cleavers.
Meanwhile, the folks at United Wholesale Mortgage (UWMC) deserve a big hat tip for structuring their SPAC transaction with Gores Holdings IV, Inc. in such a way as to avoid creating goodwill. The March 1, 2022 prospectus from UWMC (the “Company” below) describes the transaction:
“The business combination transaction was accounted for as a reverse recapitalization in accordance with U.S. GAAP as UWM was determined to be the accounting acquirer, primarily due to the fact that SFS Corp. continues to control the Company through its ownership of the Class D common stock. Under this method of accounting, while the Company was the legal acquirer, it was treated as the acquired company for financial reporting purposes. Accordingly, the business combination transaction was treated as the equivalent of UWM issuing stock for the net assets of the Company, accompanied by a recapitalization, with the net assets of the Company stated at historical cost, with no goodwill or other intangible assets recorded. The net proceeds received from Gores Holdings IV, Inc. in the business combination transaction approximated $895.1 million, and the Company incurred approximately $16.0 million in costs related to the transaction which were charged to stockholders' equity upon the closing of the transaction.”
Both UWM and FOA trade well-below the heady IPO valuations of a year ago, but the former avoided the ugly investor disclosure of a goodwill write down by structuring its transaction with Gores Holdings as a reverse merger. The clever structure of the UWMC transaction, however, has distorted the book value multiple on UWMC, currently 49x. And therein lies a tale for the future.
The FOA experience is instructive, however, because it provides a yardstick to understand how much the Fed’s policies inflated the asset prices of mortgage companies in 2020 and 2021. And this is one big reason why attempts by Ginnie Mae and the Federal Housing Finance Agency to impose bank like capital requirements on independent mortgage banks can only end in tears.