Interest Rates, FinTechs & MSRs

August 22, 2022 | Premium Service | In the almost 20-years that The Institutional Risk Analyst has been published, we can rarely recall a scenario for national finance that is more likely to end in tears. Market interest rates are rising and the Federal Open Market Committee has begun to shrink the system open market account (SOMA), some $9 trillion in Treasury debt and mortgage-backed securities (MBS). Dick Bove of Odeon Capital summarized things nicely last week:

“This week the Federal Reserve reduced the size of its balance sheet by a net $29.4 billion. This brings the 4-week total decline to $49.4 billion. These numbers indicate a serious intent to reduce the money supply. This is being done, I believe, because the Federal Reserve now understands that simply raising interest rates will not kill inflation. Shrinking the money supply will.”

Even as the investment community ponders whether Chairman Powell is really serious about inflation and, therefore, prepared to impose consecutive down quarters on the equity markets, the housing sector is cooling and more. Why diverting the income and gains from $3 trillion in MBS to the Treasury stimulates the economy is beyond us. Maybe somebody will ask Fed Chairman Jerome Powell at the September FOMC presser.

We’ve already talked about how the prudential regulators are forcing large banks led by JPMorgan (JPM) to raise capital and/or reduce risk weighted assets. Readers of The IRA no doubt noticed the announcement by Wells Fargo (WFC) that they are withdrawing from correspondent lending entirely. Banking aficionados will appreciate that the ghost of Norwest Bank has left the building, a reference to the aggressive merger partner of Wells Fargo & Co in 1998.

The decision by WFC to stop buying third party mortgages is a sesmic event for the housing market. It could take down the bank’s risk weighted assets significantly, more than $100 billion, but represents a huge decrease in market liquidity for 1-4s.

Note that Bloomberg has current coupons in MBS at 4.35 as of Friday’s close, suggesting 5.5% as a breakeven loan coupon rate in conventionals. This is a full point lower in loan coupon rate than 45 days ago, a remarkable swing in price. We expect to see more banks exiting the warehouse and correspondent space, including most of last year’s late arrivals.

Source: Bloomberg

Meanwhile, the Federal Housing Finance Agency and the Government National Mortgage Association (Ginnie Mae) issued new eligibility requirements for issuers. Overall, the new rules are a pleasant surprise for the mortgage industry, which is fighting for its life as rates rise and volumes fall faster than operating expenses.

There is, however, some bad news, namely an area where the two proposals are not aligned. The Ginnie Mae proposal includes a risk-based capital (RBC) rule that would impose a punitive 250% capital charge on government mortgage servicing rights (MSRs). This is effectively a declaration of war on the non-bank issuers with large Ginnie Mae servicing books such as Mr. Cooper (COOP), Lakeview, Rithm (RITH) and Freedom. But should the industry sound battle stations and go to war? Maybe not quite yet.

The good news, of sorts, is that Ginnie Mae staff do not seem able to discuss the risk based capital rule at all. We hear that risk function head Greg Keith, for example, told one issuer during an all hands meeting that "we don't have to discuss that now," this in response to a question about RBC. This seems a very odd comment for a senior official of Ginnie Mae. Even makes us wonder if this RBC proposal is more decorative than substantive.

Much of the joint-proposal between FHFA and Ginnie Mae is aligned, a big win for FHFA Director Sandra Thompson and Ginnie Mae President Alana McCargo. But the strange, Basel-style risk weighting for MSRs in the Ginnie Mae proposal makes no sense and requires a detailed explanation from McCargo. The RBC scheme doubtless will increase visitor traffic into the office of McCargo and HUD Secretary Marcia Louise Fudge.

Did anyone in the Ginnie Mae risk function, we wonder, review the proposal with McCargo? It appears that the answer is no. One MBA official noted: “The Ginnie RBC stuff is stupid. They are keeping an RBC standard for monoline institutions with a punitive risk weight on MSRs that has driven banks out of the servicing business. Dumb.”

Fortunately, the effective date of the yet-to-be-defined risk based capital rule is many months away. Many mortgage firms may simply go out of business due to horrendous market conditions, where most issuers are losing money on every loan they underwrite. The chart below contains data from the latest Mortgage Bankers Association performance survey:

Source: Mortgage Bankers Association

Suffice to say that the velocity of change in the money markets combined with the difficulty involved in reducing expenses as quickly as interest rates have risen has pushed many mortgage lenders into operating loss in Q2 2022. loanDepot (LDI), for example, reported a loss of $0.51 per share and a sharp decline in volume. As usual, bank consultant Joe Garrett puts it well in a client note:

“[S]ources of revenue are not steadily moving upward a little every year. So, what does this mean? It means that you have to be disciplined in managing your overhead. Period.”

LDI will exit the partner (wholesale / non-delegated correspondent) channel, but will fulfill the $1 billion still in pipeline by the end of October. We’ll see. The execution in the channel remains depressed due to the beggar-thy-neighbor approach taken by United Wholesale Mortgage (UWMC), which has already chased several weaker players out of the wholesale channel entirely.

According to the earnings disclosure, LDI expects to be run-rate profitable exiting 2022, but they are assuming continued slowdown in volume through 2023. We think many weakened firms will either be put up for sale of shut-down entirely. Inside Mortgage Finance writes:

“The word on the street is that loanDepot hired industry veteran Frank Martell early this spring to trim the fat at the nation’s seventh largest lender and make sure it survives. The end-game? A sale or merger perhaps…”

We agree. Martell better hurry. The interest rate rally since mid-June may help some lenders in Q3 2022, but we still think that pricing remains an issue due to industry overcapacity. And to address that very issue, UWMC is clearly preparing for a war of attrition in the wholesale channel: KBW featured this little financing note recently:

“United Wholesale Mortgage, LLC, which is indirectly minority owned by UWM Holdings Corporation (NYSE: UWMC), entered into a revolving credit agreement with SFS Corp. as the lender. The agreement provides for, among other things, a $500mm unsecured revolving credit facility with an initial maturity date of August 8, 2023. UWMC has an “Up-C” organizational structure whereby United Wholesale Mortgage, LLC is the operational subsidiary of UWM Holdings, LLC. As of June 30, 2022, UWM Holdings, LLC’s common units were 5.8% held by UWMC as Class A common units and 94.2% were held by SFS as Class B common units which are convertible into Class D common stock of UWMC, providing SFS with 79% of the voting power of UWMC’s common stock. Mat Ishbia, CEO and Chairman of UWMC, is President and sole director of SFS and indirectly controls all of its voting stock.”

You won't see a lot of other mortgage companies taking down unsecured financing this year. The cost of revolving bank lines for mortgage lenders and other non-bank finance companies is rising fast, putting additional pressure on an industry that is already operating in extremis.

The money market summary above from Bloomberg shows that 30-day benchmark rates are closing in on 2.5%, so figure that rates for most secured advance and warehouse lines for non-banks lenders is around 3.5% to 4%. Meanwhile, the total cost of funds for JPM is still inside 40bp vs average assets as of Q2 2022.

Source: FFIEC

Back in June we reviewed Upstart Holdings (UPST), the once high flying partner of Cross River Bank (“Update: Upstart Holdings & Cross River Bank”) that has lost 80% of its market value since last year. UPST was sued by the class action law firms after revelations about surreptitious warehousing of unsold loans shattered the company’s veneer of invincibility. A large group of hedge funds selling the stock short certainly helped in the devaluation process.

When banks and non-bank lenders like mortgage companies and UPST had a cost of funds approaching zero, then it was easy to pretend that non-banks could compete with insured depositories. Likewise, zero returns on risk-free assets made crypto tokens seem reasonable. But non-banks fund off the market, while banks have funding called deposits. Big difference, especially when the FOMC moves federal funds hundreds of basis points in a quarter.

Now that market interest rates are starting to become very positive, but bank deposit rates are barely moving, the pretense of fintech as bank killer is over. The rising real costs of funding for non-banks is the chief risk in 2022 and beyond, one reason that the Ginnie Mae proposal to increase the capital charge for government MSRs is so completely ridiculous.

As we move through 2022 and prepare for another year of down debt and equity markets, all of the market funded, market facing lenders in fintech, whether operating in mortgages, auto loans or unsecured IOUs, are going to be at the mercy of lender banks and an ABS market that has suddenly grown a good bit more picky. That is one reason why UPST is down 81% YTD, but they have a lot of company.

The Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.