Interest Rates, MSRs, Mortgage Putbacks & FICO Scores

May 25, 2023 | Premium Service | In this issue of The Institutional Risk Analyst, we return to the world of credit and secured finance after spending two days at the Mortgage Bankers Association Secondary Conference in New York. Suffice to say that the area around Times Square and 8th Avenue in the lower forties is reverting to conditions circa the early 1970s. Commercial property values are soft, the smart money is long gone and vultures are gathering in great numbers. And yes, we've seen this movie before.

In residential mortgage land, the good news is that default rates are still running below prepayment rates, allowing servicers to float the cost of advances on delinquent loans. The bad news is that persistent talk about a 5.5% 30-year mortgage rate later this year is badly wrong as TBAs flip from 5.5% to 6% coupons for delivery in June. The industry is writing 7% mortgages as we enter the Memorial Day weekend.

The MBA Secondary was lightly attended, with the vast majority of industry executives focused on meetings with counterparties and regulators. News that Credit Suisse restarted the auction for Select Portfolio Servicing was welcomed, though it remains to be seen whether a deal gets done. We hear also that CS extended a long-term credit facility to Apollo Global Management (APO) portfolio company Atlas SPG as part of the deal to sell some investment banking businesses to APO.

Bidders in the SPS auction tell The IRA that the business and the MSR are being offered separately, but that still may not be a sufficient concession given the recent sale of HomePoint, which basically liquidated after a 2021 IPO. Our earlier report of the HomePoint mortgage servicing right going for just under 5x multiple may have been optimistic.

Several issuers argued that when boarding fees and other offsets are considered, the price paid falls below 3x vs a 6x mark by HomePoint at year-end. This does not give us great confidence in some of the other 6x MSR marks among public issuers. But let's recall that a continued move higher in the 10-year Treasury yield will also mean higher fair value marks for some MSRs, the ideal negative duration asset for a lender portfolio.

A number of comments were heard about the acquisition of Angelo Gordon by TPG (TPG), which will give the acquirer control of two public REITs: AG Mortgage (MITT), and TPG Real Estate Finance (TRTX). Eric Hagen at BTIG notes that both REITs have market caps below $1 billion, making us wonder about the play going forward. Of course, we'd be remiss not to mention that TPG was the investor in Washington Mutual a decade ago.

Other residential mortgage REITs are facing erosion of book value due to Fed interest rate tightening and difficult spreads. In the event of Fed ease, margin calls on suddenly disappearing MSRs become the new concern for investors. We exited Annaly Capital (NLY) when they began to buy MSR because of our long-held belief that only mortgage lenders should own servicing assets, especially Ginnie Mae servicing assets.

A number of attendees were concerned about the increasing tide of loan repurchase requests coming from the GSEs, Fannie Mae and Freddie Mac. One prominent industry CEO known for his ability to "see around corners" laughed at the fuss so far and told The IRA: “The GSEs are just practicing for the real push back. This is just a dress rehearsal.”

Federal Housing Finance Agency Director Sandra Thompson continued to hear criticism in private meetings about the changes in the loan level pricing adjustments (LLPAs) for the GSEs. As we noted in National Mortgage News (“FHFA Should Nix Its Credit Score Plan, Too”), there are few loans below 680 FICO scores going into conventional assets to move the needle for the White House. Thompson oversold the impact of the LLPA changes.

Several issuers tell The IRA that personnel at the GSEs are desperately, urgently asking lenders for “mission loans” – meaning loans to underserved and generally low-quality borrowers. Some issuers approaching the GSE cash windows have been told that they will not receive attractive pricing unless the pools include mission loans. But sadly, there are few cases where a lender could advise a consumer to take out a conventional loan vs FHA/VA.

Another telling comment from a top correspondent CEO: After more than a decade in conservatorship, the GSEs more and more resemble government agencies rather than private issuers. Any hope of ever taking Fannie Mae and Freddie Mac out of conservatorship is pretty much dead when the cultural changes made at the GSEs are taken into account.

The pricing of the GSE cash window, for example, is so bad that several large bank issuers have shifted conventional volumes to the Federal Home Loan Banks. The changes in GSE loan pricing and other policy changes reflect the FHFA’s focus on implementing the enterprise capital requirements put into place by Thompson. Consultant Garrett Hartzog, Principal of Fundamental Advisory and Consulting notes in a comment in NMN:

“The Enterprise Regulatory Capital Framework is going to dramatically transform GSE pricing in ways the industry hasn't begun to contemplate. Understanding the ERCF means being able to mentally reconcile increasing risk-based pricing (the DTI-based fee) and decreasing the level of risk-based pricing (the credit score/LTV matrices). What's more, people need only read Fannie Mae and Freddie Mac's comment letters during the rulemaking process to understand that g-fees will ultimately experience a dramatic increase as a result of the ERCF.”

If Garrett is right about FHFA raising guarantee fees for the GSEs in line with the capital rule, then Fannie Mae and Freddie Mac would no longer be competitive for larger, high-FICO loans and could price themselves out of existence.

FICO 10 & Vantage Score

The big news regarding FHFA and the GSEs was the back-peddling on the plan for using two credit scores for conventional loan approvals. "We're very aware of the many challenges out there," Federal Housing Commissioner Julia Gordon told attendees. As we noted in the NMN comment, using two different credit scores for a loan underwriting process is technically problematic and may create significant liability for issuers.

The ideal solution to this latest progressive initiative from FHFA is to let the lender pick which score to use in underwriting the loan. The lenders own the risk, after all, because the GSEs can put back the loans. If the GSEs want both scores delivered with the loan at sale, fine. But lenders cannot compare the two scores arithmetically, so let the market choose.

For rating agencies, bank regulators, institutional investors, et al this proposal is a huge mess (and prospective expense) because the century of consumer credit data that rests on the FICO classic model approach is useless for benchmarking FICO 10. All of the models and ratings criteria used in 1-4s must be recreated from scratch. There is no transition table between FICO 10 and Vantage Score. And there is no historical data for either score, a fact that may come to haunt Thompson and FHFA when they finally engage with federal banking regulators.

Amidst all of the fuss, Director Thompson and the Biden White House are missing a big opportunity to move the industry forward in terms of credit ratings and access to credit for the underserved. FICO 10 incorporates many qualitative factors used by Vantage Score and demanded by progressives. Problem solved. Let the lenders pick the score and the markets will quickly tell issuers which model works best. Merely requiring the conventional market to migrate to FICO 10 and allowing Vantage Score is a huge change that should satisfy the White House and consumer advocates.

Ginnie Mae Default Rates

One topic that many issuers mentioned again and again was the steady climb of default rates for FHA/VA/USDA loans in Ginnie Mae securities. Default rates are not yet near critical levels, but when prepayments are not well above default rates, liquidity becomes a concern. The table below shows the largest Ginnie Mae issuers with delinquency and prepayment rates (CPR).

Source: Ginnie Mae

The Ginnie Mae table above shows that many significant issuers are already at default rates where prepayments are insufficient to fund default advances. One reason that PennyMac Financial (PFSI) was able to report zero default advances was that prepayments were running high enough to finance the cash. Now, however, defaults at PFSI and other large issuers are moving higher as prepayments fall, thus utilization rates on advance lines should be up in Q2 2023.

Of note, the FHA is in the process of making changes to the rules for reimbursement to allow government issuers to make multiple partial claims on a delinquent loan. With interest rates rising, issuers are unwilling (or unable) to buy delinquent loans out of Ginnie Mae MBS pools, thus the favored approach now is to leave the loan in the pool and simply modify the note. This is why bank balances for early buyouts from Ginnie Mae MBS have been falling sharply, as shown in the chart below.

Source: FDIC

The fact that FHA is working at maximum speed to modify the rules for partial claims on delinquent loans should tell readers all they need to know about the outlook for credit in 1-4 family mortgages. This is perhaps why Ginnie Mae President Alanna McCargo and her team have been very accommodating to issuers in the past few months since the failure of Reverse Mortgage Funding in December.

During an MBA session, McCargo made positive comments about excess servicing strip (ESS) transactions in the context of the agency's Risk Based Capital rule, although no final statement has been forthcoming. Several issuers tell The IRA that Ginnie Mae officials have been very focused on understanding problems faced by issuers. There were also suggestions that Ginnie Mae would tailor the RBC framework to issuers by size and market footprint, a sensible change that would go a long way to addressing industry concerns

As the CEO of one veteran government issuer that focuses on underserved communities told us: "I think Ginnie Mae understands that they need to get out of the way and let us run our businesses as delinquency rates rise. Until interest rates fall and volumes improve, this is a war of attrition among lenders. The issuers that are hoping for lower rates and are dragging their feet on cost cutting will not survive. Hope is not a strategy."

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