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April 11, 2024 | Premium Service | As we approach bank earnings on Friday, we want to see how things are going in the world of residential housing finance. If we look at the top performers in the mortgage sector, the ten best stocks in terms of one-year total returns are led by the two GSEs and several other names that made sense when three or four interest rate cuts in 2024 were likely. Now, not so much.
The Biden Administration is defying the U.S. Supreme Court to forgive government guaranteed student loans, but as we wrote in Zero Hedge, officials of Ginnie Mae and the Federal Housing Finance Agency are sanctioning lenders for refinancing residential mortgage loans for veterans. Really Joe Biden? And interest rates are rising. Can’t make this stuff up.
We are scheduled on Bloomberg Radio this Friday, April 12, 2024
~ 9:30 ET to talk about bank earnings and more.
Mr. Cooper (COOP), United Wholesale Mortgage (UWMC) and PennyMac Financial (PFSI) were once the top of the heap, but now more aspirational names have risen to the surface of the separation tank. The top twelve mortgage issuers are shown below based upon 1 year total return.
Source: Bloomberg
Top of the list are Fannie Mae and Freddie Mac, two GSEs which have been in government conservatorship now for 15 years. Remarkable that these illiquid stocks gained over 250% since last August. Several Street firms and a crowd of paid agents again manipulated retail investors into thinking that these firms may be released from government conservatorship. SEC Chairman Gary Gensler says not a word about this very public manipulation of the common and preferred equity of Fannie Mae and Freddie Mac. But the sad fact is, neither GSE is likely to be released from government control. Why not? Let us count the ways.
The first issue is credit. Since 2008, legal and regulatory changes make it impossible to pretend that the GSEs are sovereign credits once they leave government control. If a once and future President Donald Trump were to move to release the GSEs from conservatorship, Moody’s and the other rating agencies would be forced to downgrade both credits. Think “A+” including the Treasury credit line. But that is when the trouble will begin.
We discussed the issue of the GSEs two years ago (“No End to Conservatorship for Fannie Mae and Freddie Mac”), noting that the $7 trillion in MBS guaranteed by the two GSEs is still not included in the federal debt – even though both GSEs are under government control. Members of Congress cannot understand that the secured MBS issued by the GSEs is, in fact, part of the federal debt, albeit secured by a single family dwelling.
The second issue preventing a release of the GSEs is operational, but also goes to value. Both GSEs have deteriorated operationally over the past 15 years, losing any operational efficiency in favor of a culture that is more like the U.S. Postal Service with an angry progressive overlay. Under the Biden Administration, Fannie Mae and Freddie Mac lost most of the key personnel with actual mortgage market experience that enabled them to be competitive.
Moreover, without the pre-2008 situation where we pretended that the GSEs were still sovereign credits, Fannie Mae and Freddie Mac could never survive as private issuers. They are operationally inefficient and could never operate profitably as nonbanks with the cost of funds implied by a “A+” rating from Moody’s. Let's do some math.
If we assume a “A+” unsecured debt rating for the GSEs, neither will be competitive with PFSI, COOP or JPMorgan (JPM), which reports earnings tomorrow.
JPM is a “AA” credit and the largest issuer of prime non-QM residential MBS in the US. JPM is also the largest residential warehouse lender and servicer in the US. If both GSEs are downgraded to “A+” before they leave conservatorship, how will they compete with JPM, PFSI, COOP et al? They won’t.
Ponder this: Can the GSEs charge 60bp a year to insure conventional MBS if JPM is willing to do that same trade for say 30bp? No. JPM’s ST cost of funds is 2% vs average assets. Try 3x that number for the “private” GSEs with an “A+” rating. SOFR is 5.31% this AM. What will the GSEs pay for ST cash? SOFR +1 or over 6%. Funding costs that are 3x large banks make any release of the GSEs impossible.
Indeed, if you actually did push the GSEs out of conservatorship, you would force Fannie and Freddie to formally retain their mortgage servicing rights as collateral for borrowings. Ponder that mortgage peeps. Conventional issuers would no longer be allowed to pretend that they own the MSR and use it as collateral for borrowing. The conventional loan market goes sideways the next day. Hello. Little nuance to fuel nightmares.
Under the Biden Administration, the pricing for conventional MBS has suffered as the progressive zealots who control the Federal Housing Financing Agency have imposed penalties on lenders who are not toeing the progressive line. Many banks have stopped selling loans to the GSEs entirely, preferring the less politically tainted execution at the Federal Home Loan Banks.
Bottom line on the GSEs is that a lot of retail investors have again been misled by various Wall Street firms, who manipulate the common and preferred shares of these two penny stocks with well-time leaks and innuendo spread via social media. The sad part is that some very influential bankers have told the Biden Administration and also people around President Trump that the US Treasury can monetize the government’s preferred equity position in the GSEs at par. Nope.
The preferred stock in the GSEs held by the Treasury only has “value” so long as Fannie Mae and Freddie Mac are under government control. When and if the GSEs are released, we suspect that the common and preferred will trade at a sharp discount to reflect the earnings potential of the GSEs. Again, ask yourself how two large non-bank GSEs with “A+” LT credit ratings, and that are both issuers of conventional MBS and guarantors of these securities, will compete with PennyMac and JPMorgan? They won’t. End of story.
The final reason why the GSEs won’t be released from conservatorship is the ~ $8 trillion in extant and future MBS. Under the ratings criteria of Moody’s, S&P, etc., only a sovereign entity can earn a “AA+” credit rating of the United States. Ginnie Mae and the FHLBs are sovereign credits, but upon release, the GSEs become nonbank mortgage issuers. They will be rated as finance companies under the Moody's criteria. Indeed, the reason that the national Congress pretends that the GSE debt is not part of the national debt is because the debt is tied to the credit of Fannie and Freddie as corporate issuers.
If a future POTUS decides to release Fannie Mae and Freddie Mac from conservatorship, then the US Treasury will first need to negotiate yet another amendment to the agreement with the GSEs. Fannie and Freddie will need to pay the Treasury a guarantee fee to maintain the sovereign credit rating on the extant and future MBS issuance by the GSEs. Looking at the senior tranches of GSE credit risk transfer (CRT) paper, the yields trade wide of “BBB” corporate bond spreads. Yikes.
If we use past GSE credit risk sharing transactions as a guide, the annual fee paid by the GSEs to the Treasury should be about 25-30 bp on say ~ $8 trillion in MBS. That is the mid-point between "A" and "BBB" on the Moody's/S&P ratings scales.
AAA: 1 bp
AA: 4 bp
A: 12 bp
BBB: 50 bp
BB: 300 bp
B: 1,100 bp
CCC: 2,800 bp
Default: 10,000 bp
If the nonbank GSEs are forced to cut the guarantee fee they charge conventional issuers in order to compete for conventional loans with JPM and also the FHLBs, and then must pay 30bp annually to purchase a credit wrapper from Uncle Sam, just how exactly do Fannie and Freddie make money? They don’t. You take the GSEs out of conservatorship, the big banks led by JPMorgan and U.S. Bancorp (USB) will own the conventional loan market within a year.
At the end of the day, the preferred equity position held by the US Treasury in the GSEs is impaired. If the GSEs must pay Treasury to wrap $8 trillion in conventional MBS, then the model does not work. Remember, the GSEs have all of the operational and financial responsibilities of PFSI or COOP, must advance cash to their correspondents pay P&I and T&I on delinquent loans, and must also provide credit insurance to holders of MBS. The GSEs are not banks like JPM. Indeed, if you take the GSEs out of conservatorship, then they may need to get credit lines from JPM et al to fund advances and the purchase of delinquent loans.
If we assume that the private GSEs trade wide of the FHLBs in the short term debt markets, then release from conservatorship for Fannie Mae and Freddie Mac will never happen. The ICE “A” spreads for corporates are currently 78bp over Treasury yields, so figure +50bp to the curve for the private GSEs? And under Basel III, the “private” GSEs will be 100% risk weight credits. Figure SOFR +1 for a ST credit line from Jamie Dimon means that both GSEs will be underwater on day one.
Ally Financial
We last looked in on Ally Financial (ALLY) in the summer of 2022, when interest rates were rising and the Street narrative had not yet skewed toward aggressive Fed rate cuts. That skew in the Fall of 2023 turned out to be completely bogus, but this is what happens when you let Sell Side firms and their trained economists drive the narrative.
ALLY ran hot in the second half of 2023 as expectations of a “soft landing” were rampant, but have also been disproven as default rates on credit cards and auto loans have gone vertical. At the end of Q1 2024, ALLY ranked 52nd among the top banks in the WGA Bank Top 100 Index based upon total market return. ALLY is scheduled to report Q1 2024 earnings on April 18th.
The 2023 results for ALLY were, as before, mediocre. Net income was in the bottom quintile of Peer Group 1 at 0.51% of average assets vs the peer average of 0.89%. Although Q4 2023 was a bad quarter for the industry, ALLY managed to do far worse than average.
Source: FFIEC
Part of the reason why ALLY has weak income is the pricing of the firm's loans. Even though ALLY is in the consumer finance business, its gross loan spread is barely above larger lenders such as PNC Financial (PNC). More, if you compare ALLY with CapitalOne Financial (COF), the comparison is even less generous.
Source: FFIEC
As you can see, ALLY has pushed up its gross spread compared with 2022, but it is still too low to accommodate the bank's high cost of funds. We have long been concerned that ALLY does not have nearly enough spread on its loans to provide enough dry powder to fund loss mitigation in a severe recession scenario. The fact that equity managers pile into this stock at the first sign of rate cuts is remarkable but not surprising since ALLY does not really have a strong funding position.
Source: FFIEC
As you can see in the chart above, ALLY is the outlier among the group of banks in this report, including COF. ALLY has a cost of funds that is a point higher than monoline credit card issuer COF, but a gross loan spread five points below COF? Keep in mind that ALLY has some of the highest overhead expenses in Peer Group 1 and almost 75bp higher than the peer average. That is not a good place to be when we are talking about elevated interest rates and rising loan delinquency.
The chart below shows net loss rates for ALLY and the group in this report. The fact that COF is over 2.5% net loss is interesting but unremarkable. The $400 billion asset monoline credit card issuer has the gross spread and the funding to handle that level of loss easily. But the fact that ALLY is at 1.5% net loss is troubling because the bank lacks the raw earnings power of a COF or Citigroup (C). Both of these issuers have double-digit gross spreads in their subprime portfolios.
Source: FFIEC
ALLY reported a 69% efficiency ratio at the end of 2023, a full five points above the peer average of 63% and nowhere close to big bank bellwether JPM in the mid-50s. A mid-50s efficiency ratio at the House of Morgan means than half of each dollar that comes in the front door goes down to the bottom line.
In our last note, we showcased Bank OZK (OZK), for our money one of the best managed lenders in the country. George Gleason has an efficiency ratio in the 30s. Gleason know that he is not running JPM, thus he keeps expenses low and pays depositors generously.
In times of economic stress, banks with above average asset returns and below average expenses like OZK survive. IOHO, ALLY needs to push yields up and push that efficiency ratio down 10 points. Just take the example of Jane Fraser at Citi and do it -- if you want to survive the coming storm.
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