January 19, 2023 | In this issue of The Institutional Risk Analyst, we speak to Mike Patterson, COO of Freedom Mortgage. Mike joined Freedom in 2006 when the firm acquired Irwin Mortgage and thereby became a government lender and Ginnie Mae issuer. Over the next two decades, Mike and other members of the Freedom Mortgage team have built one of the largest lenders and loan servicers in the US.
The IRA: Mike, thank you for taking time to speak to us about market conditions. There are a lot of people predicting the apocalypse in the residential mortgage market in 2023. What do you say to investors and policy makers who ask about market conditions now, some nine months into a rising interest rate cycle from the FOMC?
Patterson: We’ve been through these cycles before. This is nothing new. We went through this in 2008 and 2009. We went through this in the 1990s. We even went through this to some degree in 2018. For a while, we are going to have a period where if the loan is not a purchase, then there are simply very few transactions out there. I would want to be set up for this period the way we are here at Freedom, and this is not as a matter of self-promotion. If you don’t have a substantial servicing book that is going to provide consistent cash flows, then this is a very tough production environment for any mortgage bank.
Leaders from ESGR-NJ presented the prestigious Seven Seals Award to Mike Patterson, Chief Operating Officer of Freedom Mortgage, and fellow employees and reservists.
The IRA: Precisely. We have looked at a number of businesses in the past year. Most of them have good people but no servicing asset, so there really is no value in the business with volumes this low. All the consultants have the same message to smaller issuers: downsize to survival mode or simply shut down entirely. Is this market correction that severe for the industry?
Patterson: If you are only an originator and not a servicer, in the next 12 to 24 months you risk giving back all of the profit made during COVID if you don’t have a servicing book to help from a cash flow perspective.
The IRA: How does this period differ from 2008? You joined Freedom just before the wheels came off the cart in 2007 in private label mortgages. How is this correction different from 12 years ago?
Patterson: In 2008, we saw a contracting credit market where LTVs and FICO scores were tightening. Now we see an opening of the credit box to some degree, where FICOs are going a little deeper into the 600s and LTVs are going higher. The box is widening a little bit instead of contracting dramatically. Debt-to-income (DTIs) are a little higher. You also see lenders originating loans that they usually don’t pursue, meaning that they are not proficient at it. These trends could end up being concerns down the road.
The IRA: We know a guy named Stan Middleman who told us a while back that loans originated from now until the correction later in the decade will retrace in terms of home prices back to 2020 levels and be underwater for a while.
Patterson: The loans will be underwater or the originators operating in unfamiliar territory will make these higher LTV, lower FICO loans until the music stops and there is nobody left to buy the loans.
The IRA: The FOMC has moved mortgage rates 500bp or more in the past year. Most small issuers have given up on creating pools and are simply selling the loans on a best-efforts basis. How do you get people to think rationally about credit or loan pricing when they are literally fighting to keep the doors open?
Patterson: One of the opportunities that an environment like this creates is that more and more flow deals will get set up between larger issuers, such as Freedom, and smaller lenders that are having trouble dealing with these volatile market conditions. To get long-term stability at issuers that do not retain loans or servicing, flow deals help to provide some measure of certainty. You help the small issuer preserve their operations and they give us more volume as an issuer of MBS.
The IRA: How do you see the market for mortgage servicing rights (MSRs) in 2023. There are still some concerns about the Ginnie Mae risk-based capital rule. The tenor of the conversations at the IMN MSR conference at the end of last year were subdued, yet this is a market with shrinking supplies of new securities and extending durations. Most recently Wells Fargo (WFC) has announced an exit from all correspondent lending.
Patterson: The MSR market is still very healthy, despite the attempts by some observers to paint the market as a problem. There is now a lot of supply out there that people were holding through year-end in order to get better pricing in the first quarter. They wanted to get through a strong 2022, but they are going to need cash in Q1 and this will bring out new bulk deals.
The IRA: One of the interesting comments we’ve heard from a number of players is that the funds and banks essentially exhausted their cash in Q3 this year, leaving the room essentially empty in Q4 2022. With the start of Q1, however, new allocations will be available and the assumption is that volumes for bulk sales will pick up.
Patterson: We think there will be a lot of GSE and GNMA MSR deals in Q1 that will give the industry an opportunity to continue to grow servicing AUM or raise cash. The conventional market has hovered in the 5-6x cash flow price multiple range and the government assets are also strong with a smaller number of buyers.
Source: FDIC/WGA LLC
The IRA: A number of regulators in Washington have made a great fuss about the risk from MSRs, but the defaults this year have come from non-agency exposures in non-QM forwards and private reverse mortgages in the case of Reverse Mortgage Funding. Some regulators like to make a great fuss about the fact that MSRs are often booked above the cash value in the secondary market, but these assets generally only trade once.
Patterson: Some issuers carry their MSRs at a higher price than they can sell it today, but the premium is relatively small. We are in the market every day and the mark-down from carry value for a secondary sale is usually a good bit less than 10%. Some issuers that want to sell will take their losses from carry value in Q1 and then position for a good year. Maybe they booked the asset in the 150bp range but have to sell at 145bp. That is a completely normal and acceptable practice as the market adjusts.
The IRA: So, come the end of January, we’ll have full numbers for the year and then look to sell the servicing asset at or near book value. A 5% discount is hardly a disaster. You book the GAAP loss and put the cash in the bank. Yet there are some folks at Ginnie Mae that are on a mission to prove that the government MSR is grossly overvalued by issuers, but the public record seems to suggest another conclusion. And, again, most MSRs trade once, if at all. Even if these were Level 2 assets instead of Level 3 under GAAP, there would still be a good bit of wiggle room in valuations depending on your interest rate outlook.
Patterson: We were at a 6.75% loan market for a few weeks, then the market rallied and now we are down to a mid 5% market more or less. So, now we have an opportunity for home buyers to save a money on their mortgage payment. What is interesting is how adept consumers have become at judging market swings and timing purchases to maximize savings. People were closing on 6.75% loans a month ago and now they are going to make the call today when they see a 6% or lower and ask if they can refinance. There are many refinance opportunities that are created because of short-term market moves. We often forget that dynamic. The borrower always wants the lowest payment. That is the one rule that does not change in our industry.
The IRA: Ginnie Mae is starting to get concerned about prepayments, an issue that goes back to the era of former Ginnie Mae President Michael Bright. Do you think that the industry has gotten religion when it comes to providing the maximum benefit to the consumer the first time around so that Ginnie Mae will not feel the need to penalize issuers for prepayments when interest rates eventually fall? There are a lot of Bright-era rules that were entirely focused on protecting the investor in the Ginnie Mae MBS from loan churning. Has the industry learned its lesson?
Patterson: Those rules are a problem because they effectively deny the consumer their legal right to prepay the mortgage at any time without penalty. That family that closed on a 6.75% mortgage in September cannot get a refinance today into a 5.75% mortgage because of the seasoning rules. There is no question that responsible lenders need to make sure that they provide maximum benefit to the consumer and thereby manage the issue. But what does not get nearly enough attention is the ability of consumers to seek lower mortgage payments as soon as the market moves, within even hours or days.
The IRA: It sounds like the winning strategy in the post-COVID world is to provide the maximum benefit to the consumer in a refinance the first time around and then retain the asset in portfolio. Instead of going for multiple bites at the apple in terms of refinancing the same loan over and over again, the responsible issuer will seek to provide maximum benefit the first time. Is that fair?
Patterson: We have always sought to provide the maximum benefit to the consumer and then retain the asset. The reality, however, is that servicers have a limited ability to manage prepayments. Brokers and other parties are contacting that consumer constantly and especially if interest rates move lower. People used to manage portfolios based upon assets, but now we manage our portfolio based upon the customer.
The IRA: Given the change in the market since 2020 and the number of loans that may not be in the money again for refinance, isn’t the competition for refinance loans going to be intense? How can issuers and regulators hope to have any impact on prepayments given the structure of coupons in the mortgage industry today?
Patterson: It is not just a question of competing for the few loans available for refinance, but there is also a limited spread in terms of profitability. I am looking at the TBA market right now and 102.50 is the top bid shown on the screen. The premium pricing that was available in 2020 and 2021 has changed dramatically.
CNBC Worldwide Exchange 1/17/2023
The IRA: There are some issuers based in Detroit that believe that they can drive everyone out of the wholesale market by overpaying for loans. How long does it take before we start to see rational pricing in the industry? Isn’t what United Wholesale Mortgage (UWMC) is doing today in wholesale just a repeat of what Provident and Countrywide did in the past? This is not a new story. When do we start to see rational pricing in the secondary market for residential loans?
Patterson: We will see some rationalization in Q2 of this year. In Q1, people are going to slowly see spreads improve. Better execution will allow some of the more aggressive issuers to pull back, but this just means that the other issuers will come back into channels like wholesale. Every month, we have seen gain-on-sale getting better for the public companies. By Q2, things will improve enough that I think some of the more aggressive players will start to relax and you’ll see the other wholesale players back in the game. Again, remember the golden rule: the consumer does not know names or brands, they know payments. Give them a lower payment and good service, and you’ll win their business. Is market share or best execution and service the most important thing? I will tell you it is the latter every time.
The IRA: Thanks Mike.
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