August 23, 2021 | In this issue of The Institutional Risk Analyst, we feature a discussion with Lee M. Smith, Executive Vice President and President of Mortgage at Flagstar Bank, the main operating unit of Flagstar Bancorp (NYSE:FBC). As one of the leading originators, servicers and warehouse lenders in the industry, Lee and his team at FBC have an important perspective on the industry and what lies ahead in residential mortgages.
The IRA: Lee, thank you for taking the time. We’ve been through quite a year in the mortgage factory. Where are we now and what lies ahead for the residential mortgage business?
Smith: We always appreciate your perspective and insights on the industry, Chris. It was indeed a very interesting quarter and year in mortgage given COVID, the lockdowns and low interest rate environment creating a $4+ trillion mortgage market in 2020. And it’s likely going to get more interesting.
The IRA: Do tell. We’ve watched Rocket Companies (NYSE:RKT) guide to an up year on production if not profits. That suggests that they intend to take a lot of market share. It also suggests that the sharply lower projections for refinance volumes in the latest estimate from the Mortgage Bankers Association is a tad bearish.
Source: Mortgage Bankers Association
Smith: First of all, I think it’s important to differentiate between mortgage locks and closings when talking about share. Closings may be up in 2021 vs. 2020 but some of that is 2020 locks closing in 2021. It might not seem like a big deal, but some originators, like Flagstar, calculate gain on sale revenues off of locks while some calculate revenues off of closings. Just something to be aware of when comparing results.
The IRA: Good point. What does that suggest for the future?
Smith: A lot of mortgage companies that have gone public in the last year have talked about increasing market share and leveraging technology to do so. If you look at the MBA and agency projections, the mortgage market is forecast to get smaller in 2022 and beyond as the number of refinance mortgages in particular starts to decrease. So the question remains, is this technology real because not everyone is going to be able to grow market share in a declining market. As a result, I expect to see a lot more M&A activity over the next 12 – 18 months, as that’s the only way for some players to grow share.
The IRA: So, the promise of new technology somehow transforming the mortgage manufacturing and servicing business has not yet arrived?
Smith: I don’t think we’ve seen anybody really come to the fore in terms of growing market share based upon technology. That’s why mortgage remains such a fragmented industry. I think the top 25 originators account for approximately 37% of the market. Some platforms are more efficient than others, but we’ve not seen anything transformational as yet, like an “Uber” moment. It’s another reason, I think, that you’re going to see a lot of M&A activity in the mortgage space over the next 18 months.
The IRA: Good to sell at the top, right? Most of the stocks in this sector are down double digits for the year to date. There will be downward pressure on valuations, especially if Mike Fratantoni’s forward production numbers for the industry are correct.
Smith: Well, we are coming off the top now. That’s why a lot of mortgage companies executed on their IPOs six to nine months ago.
The IRA: And we may not see certain IPOs get done later in this year. The SoftBank-backed digital lender Better.com plans to go public in the fourth quarter of 2021 via a SPAC at some silly valuation. They talk a lot about technology. We cannot see how that offering gets done with the industry under selling pressure. A lot of retail investors on Reddit have been burned on mortgages. These new retail investors would rather trade crypto currency!
Smith: One of the primary objectives of any public, for-profit organization is to create shareholder value. It doesn’t have to occur immediately but it has to occur otherwise boards and shareholders will rightly start to ask questions of management and its strategy. Investors are looking at some of the mortgage companies that went public recently as benchmarks for further IPOs in the space. That’s why we like our diversified business model and the fact we’re a bank that is well capitalized. We have business lines that are complementary meaning we believe that we can generate strong and predictable earnings in any interest rate environment.
The IRA: To focus on the market, even with the benchmark 10-year Treasury moving lower, how do you see the rest of the year unfolding? You’ve been watching these markets for years, but the traditional linkages between mortgage rates and benchmarks have changed.
Smith: There are some interesting things going on in the market. The 10-year has recently moved lower after threatening to move higher, and a significant number of mortgages are still in the money from a refinance point of view. But 2020 was a huge year in terms of refinance activity making up two-thirds of total volume. At some point however, we’re going to see refi burnout, which explains the declining forecast numbers from the MBA and the agencies. But there are still a lot of mortgages in the money. With rates where they are today, purchase volumes should remain strong as low rates are helping affordability. And it seems the lack of housing inventory is starting to improve albeit slowly.
The IRA: So where do you see volumes in 2021?
Smith: Looking at the numbers from the GSEs, MBA and our own internal models, we should see a $3.9 trillion mortgage market this year after a $4 trillion market in 2020. We’re still forecasting over $2 trillion in mortgage volume in 2022 and 2023, which is very strong. Anytime you’re above $2 trillion, that’s a healthy mortgage market.
The IRA: We will eventually run out of customers. Does the sharp increase in home prices make you worry about the change in loan-to-value ratios?
Smith: No. There are a lot of buffers built into the QM rules, which is a good thing. The opportunity going forward may be that home equity lines will become more prevalent. If rates rise, then we could see consumers use HELOCs to tap into their home equity as a result of increases in house prices and valuations.
The IRA: The Fed is talking about tapering MBS purchases. Does a change in quantitative easing or QE by the Fed impact spreads or volumes? Do we see a sharp increase in pricing if the Fed steps back from the MBS markets?
Smith: I’m not sure that the Fed will start tapering just yet. The Fed defines “full employment” as unemployment being less than 4%. We’re not there yet. When the Fed does start tapering, it will likely move the long end of the curve higher. It remains to be seen what that does to margins. The primary secondary spread moved down quickly early in the year. It got to around 125 bps and has remained around that level for several weeks/months now.
The IRA: Yes, as we wrote recently, the great price war between Matt Ishiba at United Wholesale and Rocket Mortgage has ended.
Smith: I think we will remain in this general ZIP code in terms of secondary spreads for a period of time and perhaps remain here even regardless of what the Fed does in terms of tapering. We’ve found a level that seems to be working for a number of mortgage lenders.
The IRA: Talk a little about the merger with New York Community Bank (NYSE:NYCB). You are gaining a big multifamily book as part of the mortgage business and a lot of retails deposits. What can you say about the process and the days ahead?
Smith: Both companies now have shareholder approval for the deal. With the merger, we would be creating a $90 billion bank and there’s very little business overlap between the two organizations which makes this transaction even more complementary. From a mortgage and servicing point of view, we expect to use the bigger balance sheet to grow across all sales channels and further enhance our RMBS program. We believe that with a larger balance sheet we will be able to support more issuance inventory and continue to step into market segments where the GSEs have stepped back, such as non-owner-occupied mortgages.
The IRA: One area where we disagree with analysts is the likelihood of changes to the cash window. While the preferred stock purchase agreement (PSPA) with Treasury may be reopened at some point, we do not look for changes in the cash window or investor/NOO homes. We believe that the operational issues that led to the changes in the cash window make any reversal of the Calabria era policies unlikely. The Federal Housing Finance Agency under Mark Calabria clearly wanted to take most cash window pricing discretion away from the GSEs, period.
Smith: Regardless of what happens with the GSEs, we see a lot of opportunity ahead. With a bigger balance sheet from the merger, we can hold a bigger inventory of loans to support our own RMBS program or portfolio more products and generate interest income. We can also support holding more MSRs if we choose to do so. New York Community Bank has 238 bank branches that haven’t had the benefit of a mortgage platform like ours supporting them and their customers. And we’ll be able to grow our warehouse business to support our existing and new correspondents. There is very little overlap between the two banks, so this is a growth story with plenty of asset and liability synergies created by merging the two organizations.
The IRA: You have built a nice model at FBC where you have rather adroitly sold some of your servicing assets and embracing a sub-servicer model. This is the optimal economic model, selling the MSR but retaining the servicing and the escrows, as we’ve long argued. Look at AmeriHome, where they closed with Western Alliance (NYSE:WAB) and then sold the MSR and took back the financing for the bank! Sweet, low risk trade for WAB. We’ve been trying to gently tell our friends at Ginnie Mae that everyone is leaving the government servicing market. Are we wrong? Is the servicing asset in the government loan market going to be owned by independent mortgage banks and REITs?
Smith: We like our mortgage business model a lot. We’re a bank. We originate in all six sales channels, including bulk, delegated correspondent, non-delegated correspondent, broker, retail and direct-to-consumer. We have a balance sheet and an RMBS program that gives us execution optionality, and we have a servicing and sub-servicing business that generates good fee income. We’re also a lender and provide financing to IMBs via warehouse, MSR, servicing advance and EBO facilities. We were the third largest RMBS issuer behind JPMorgan Chase (NYSE:JPM) and Goldman Sachs (NYSE:GS) in Q2 2021 and are the second biggest warehouse lender in the country. Coupled with being the sixth largest bank originator of mortgages and sixth largest sub-servicer in the country, it’s a powerful combination. We’ve also been a mainstay of the mortgage business for almost 35 years and are experienced navigating through all cycles.
The IRA: It’s a great story. Thanks Lee.