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March 9, 2023 | Updated | Premium Service | On February 28, 2023, Kroll Bond Rating Agency (KBRA) put six classes of notes on Watch Developing issued from three transactions collateralized by subprime auto leases originated by an affiliate of RAC King, LLC. The rating action came following various news articles citing the fact that American Car Center (“ACC”) was ceasing all operations and closing its headquarters in Memphis, Tennessee on February 25, 2023.
The shutdown came after the reported failure of an ABS securitization led by Atlas, the new vehicle created by Apollo (APO) to acquire the structured products group (SPG) from Credit Suisse (CS). Why this first ABS deal for Atlas was allowed by APO to fail is unknown, but this is another negative development in the unwind of CS. It also confirms the poor market conditions in the ABS sector more generally.
A number of readers have asked why KBRA and other agencies are not taking more aggressive action given the situation in the ABS market. There has been no bankruptcy filing as yet for ACC, but that seems a distinct possibility. Westlake is reportedly taking the servicing book from ACC. CS still has the warehouse assets apparently, but no word on how the transfer of the servicing will impact the bank.
Will Silvergate Survive?
Meanwhile, Silvergate Financial (SI) continues to attract more attention from short-sellers, this despite the fact that most of the supra-normal returns have been squeezed out of the stock. We profiled SI back in February of 2022, when the bank was “only” trading at 2.4x book value vs 12x in March 2021, at the height of the crypto craze. The stock peaked at $219 in November 2021.
How did we know that SI was probably a time-bomb for counterparties and investors? First obvious risk indicator was legal and regulatory risk of know-your-customer (KYC) and anti-money laundering (AML) compliance for a depository facilitating crypto transfers. At least with similar stories like Robinhood Markets (HOOD) and Interactive Brokers (IBKR), the crypto trades occur away from the broker-dealer.
Ian Katz at Capital Alpha Partners notes that “there’s now an open discussion in the industry about whether the bank and its holding company, Silvergate Capital, are more likely to file for bankruptcy or be forced into FDIC receivership.”
So long as the subsidiary bank of a bank holding company (BHC) is solvent, it is possible to recapitalize the bank. If, however, the bank is insolvent or has other regulatory issues that affect solvency, then the State of California and/or the FDIC can declare the bank insolvent and place the depository into a federal receivership. In the event, the BHC loses 100% of the investment in the bank and often files bankruptcy.
The reason we were suspicious of SI going back to 2020 was that the equity of this small mortgage bank was following the market progression of crypto stocks rather than banks, always a bad sign. Banks are designed and regulated to be boring underperformers. When a bank evidences market performance that is dramatically different from other banks, that is usually a sign of something being amiss.
Besides SI, perhaps the greatest example of the outlier rule was Lehman Brothers Bank FSB, the non-bank affiliate of Lehman Brothers. In the years leading up to the great financial bust in 2008, Lehman Brothers Bank was the best performing bank in the US with equity returns over 50% annually. The bank was used as the conduit for MBS issuance by Lehman and was shut down in 2009.
A recent article in National Mortgage News asked a popular question: “Are shaky nonbanks putting Ginnie Mae at risk?” The answer to that question is no. In fact, for a number of reasons Ginnie Mae is a source of risk to independent mortgage banks (IMBs), depositories and the financial markets more broadly.
The idea of IMBs as a source of risk to the US government is accepted doctrine in Washington. In fact, Ginnie Mae and the federal agencies that it serves, including the FHA, USDA and VA, take liquidity from the private financial markets and create the very liquidity problems that so vex housing agencies and the Financial Stability Oversight Counsel Chaired by Treasury Secretary Janet Yellen.
Since the 2008 financial crisis and the National Mortgage Settlement in 2012, the cost of servicing residential mortgage assets soared several-fold, making it impossible for less efficient depositories to service government loans. Punitive fines and concerns about reputational risk helped further to drive virtually all large banks such as JPMorgan (JPM) out of the government market, mostly recently Wells Fargo (WFC).
As a result of the exodus of banks and even some nonbanks from the government market, a growing proportion of GNMA servicing assets are controlled by finance companies, real estate investment trusts (REITs) and private funds, which lack internal liquidity or the ability to retain significant capital. Banks still finance government lenders, even if they are no longer willing to take direct risk lending to low-income consumers.
While Fannie Mae and Freddie Mac provide liquidity and other support to conventional issuers, Ginnie Mae takes liquidity from the government market and creates other unnecessary obstacles that prevent IMBs from accessing vital bank financing. For example, due to budget snafus and internal disfunction, Ginnie Mae is unable to process requests for new acknowledgement agreements in a timely fashion. Backlogs stretch back more than a year. Meanwhile, funding requirements are growing with the level of defaults.
Given that government issuers are required to fund loss mitigation activities from the buyout of the loan to resolution, a process that sometime takes years, the fact that Ginnie Mae cannot assist issuers in expanding financing arrangements to support loss mitigation is tragic. But this striking example of the disfunction and indifference of Ginnie Mae is only the beginning.
Late last year, a senior HUD official, Michael Drayne, resigned suddenly, leaving members of the mortgage finance community scratching their heads. In the intervening months, more information emerged, including a lawsuit brought by a small mortgage firm against Softbank subsidiary, Fortress Investment, and its former affiliate, New Residential Investment, now known as Rithm Capital (RITM).
The lawsuit (360 Mortg. Grp. v. Fortress Inv. Grp., 19 Civ. 8760 (LGS) (S.D.N.Y. Mar. 30, 2022) alleges that Fortress, which managed and controlled the RITM REIT at the time, conspired with at least one Ginnie Mae official to put 360 Mortgage out of business. 360 Mortgage and Fortress had a previous business dispute and relations between the two firms were strained. While claims made in civil lawsuits are often disproven, the US government has now seemingly confirmed the allegations made by 360 Mortgage in an official report.
Early this year the Office of Inspector General (OIG) for the U.S. Department of Housing and Urban Development (HUD) posted a heavily redacted report that explains the back story to the litigation against Fortress and the departure of Drayne.
The complaint alleges that an official of Fortress/RITM threatened to put 360 Mortgage out of business. Subsequent to the threat, Ginnie Mae EVP Michael Drayne reportedly took the unusual step to accuse 360 Mortgage of fraud and place the firm into default. The narrative suggests an agency that is out of control, with a large issuer using the most senior civil servant in Ginnie Mae to purse a private vendetta against a smaller Ginnie Mae issuer.
The names of the Fortress/RITM representatives have been redacted from the report. The ID for 360 Mortgage in the OIG report is “Issuer 1.” The complaint states:
"On July 16, 2018, Defendant's in-house counsel called Plaintiff's counsel and threatened to put Plaintiff out of business if it did not pay the disputed amount, and warned that Defendant had a close relationship with GNMA and that it was meeting with GNMA the next day.”
In addition, the OIG report goes on to recount other machinations by Fortress/RITM representatives and Ginnie Mae officials led by Drayne. Most significant, Fortress/RITM allegedly tried to convince Drayne to default another servicer, Ocwen Financial (OCN), after it was sued by the CFPB in 2017. The ID for OCN in the HUD OIG report is “Issuer 2.”
HUD’s OIG reports that Drayne communicated about OCN with Fortress/RITM representatives as early as 2016, sharing material non-public information about OCN and essentially discussing the sale of OCN’s assets to RITM. An excerpt from the OIG report is below. The reference to “IC” appears to be RITM:
“OIG’s review of Drayne’s emails showed that Drayne solicited IC Representative’s thoughts about Issuer 2 as far back as a year prior to its April 2017 distress. Specifically, in an email dated March 1, 2016, Drayne asked IC Representative if he could get his “thoughts about [Issuer 2] sometime in the next couple of days. Drayne told the OIG that Issuer 2 serviced a “pretty substantial amount of [Investment Co.’s] assets,” that IC Representative was in a position to “take steps that would have . . . somewhere between harmed .. . or . . . ended [Issuer 2’s] business, really,” and therefore “we would have been strategizing about . . . what might happen here and is there anything we can do to be prepared.”
The passage above suggests that the Ginnie Mae official and Fortress/RITM were discussing the termination of OCN’s status as a Ginnie Mae issuer. Given that RITM was seeking a Ginnie Mae issuer license from Drayne at the very same time these discussions occurred makes the situation even more conflicted.
Of note, HUD took the unusual step of making an appearance in the 360 Mortgage litigation as an "interested party," apparently because Drayne and perhaps other parties as yet unnamed clearly acted outside the scope of their employment at HUD. For the same reason, the redacted OIG report was subsequently made public by HUD.
One industry CEO who reviewed the OIG report told The IRA that “I have lost all confidence in Ginnie Mae and their ability to protect non-public, confidential information. This is a huge problem for the industry."
Of note, representatives of the Department of Justice, 360 Mortgage, HUD, Ginnie Mae, and RITM did not respond to written requests for comment. Fortress responded but had no comment. We suspect that this incident and the lawsuit are going to get greater attention, both from investors and also in Washington, in the weeks and months ahead.
More than six years have gone by and HUD and Ginnie Mae have yet to resolve the matter or to formally notify Congress of these disturbing events. Ginnie Mae officials learned of Drayne’s action in May 2017, but the HUD OIG was not notified until January of 2018. Drayne did not leave Ginnie Mae until the end of 2022. Incredibly, Ginnie Mae officials have refused to confirm that Drayne has left the agency and have made no comment despite several requests.
It is SOP at The Institutional Risk Analyst to take allegations from lawsuits with ample seasoning, but in this case the complaint brought by 360 Mortgage against Fortress/RITM appears to be largely confirmed by the report from the HUD OIG. We suspect that this incident and the lawsuit are going to get greater attention, both from investors and also in Washington. Five years have gone by and HUD Secretary Marcia Fudge has yet to resolve the matter or to notify Congress of these events. More, there is no mention of this lawsuit in the latest RITM 10-K.
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