Debt Deflation in CRE? PFSI, COOP & RKT

May 6, 2024  | Premium Service | We completed the rebalancing of the WGA Bank Indices last week, including adding Zions Bancorp (ZION) and dropping two outliers, Hawaiian Electric (HE) and First American Financial (FAF), the giant title insurance underwriter and grandfathered thrift holding company. There are a lot of folks in the mortgage industry who don’t know that First American is a 125 year old savings bank.

The WGA Bank Top 10 Index is shown below, including the new weighting, methodology and test score changes. The top ten group in particular shows the power of the score-weighted methodology. Big h/t to our friends at Thematic in Menlo Park.

WGA Bank Top 10 Index (WBXSW)

The big takeaway from Q1 2024 earnings is that credit pain in commercial exposures is rising fast, but we see no special concern coming from the Fed, Treasury or other regulators. Bloomberg reports that "Distress in CRE CLO Loans Jumps Back Up to Record." Yeah. And the stated, accrual accounting CRE loss numbers are way, way behind the cash reality.

A reader named Burke sent us this little missive he penned for his banking team earlier in the week:

"Pound-for-pound the failure of Philly’s Republic First should have been bigger news (like Rocky Balboa on the top of the museum steps). In this day and age of $1T forgiveness on a range of debts and deficit spending—a mere $667mm fairway 'divot' taken by the FDIC (ultimately you and me) on a Saturday morning when Campus Protests and Spring Golf weather distract us, was a perfect 'nothing to see, move along' moment for the FDIC. Yet, minus $667mm on a $4B loan and securities pool— in supposedly a good economy on some random local bank, should wake up some boards and accountants. But no one seems to want to connect the dots. I was on CNBC in ’23 before and during the Silicon Valley/First Republic/Signature dam breaking 'surprise', trying to hint at this upside-down MtM risk and boards needing to wake up. Banks carry about 8% common. If the run-of-the-mill Republic First interest rate mark on the loans is 13.3% that is not just wiping out one bank’s 8%, it is as though an invisible bank got wiped out too—that invisible bank is the FDIC."

Ditto. The degree of blithe presumption in the financial markets as the bad debt accumulates is astounding. Below we do a “lighting round” a la CNBC's Jim Cramer through earnings in the mortgage finance ghetto. Note that the volatility in key asset values like mortgage servicing rights (MSRs) is a function of the uncertainty swirling around the direction of interest rates at the US central bank.

How is the cacophony of confusion now pouring from Chairman Powell and other FOMC members in public commentary helpful to confidence or the Fed’s standing as an institution? The media circus surrounding the FOMC is ridiculous and unseemly, and increases market volatility and hedge losses for financial institutions. One member of the FOMC ought to be deputized each month to carry the message that represents the majority view. The rest of the members of the Committee should be quiet.

Speaking of economists, we had a lovely conversation with Jan Hatzius of Goldman Sachs (GS), Gennaro Zezza of the Levy Institute & University of Cassino, Italy, and Harriet Torry of the Wall Street Journal at the Levy Institute event last week. Notably, GS Chief Economist Hatzius was calling for a Fed rate cut two months hence in July.

We think the proximity to the November election makes a rate cut before December pretty unlikely. And all of the participants in the Levy event should reconsider their assumption that the market for Treasury and agency debt is continuous and always functioning. Again, Menand & Younger (2023) note:

"American public finance has long been closely intertwined with the American monetary framework and that deep and liquid Treasury markets are, in large part, a legal phenomenon. Treasury market liquidity, in other words, did not arise organically as a product primarily of private ordering. Instead, it was actively constructed by government officials. The high degree of convertibility between Treasury securities and cash—the market’s “liquidity”—depends upon entities that can create new, money-like claims to buy Treasuries."

We clearly surprised the crowd when we said that there is a “debt deflation” underway in commercial real estate in the US and invoked Irving Fisher. But even with the wheels falling off the economic cart in cities such as New York and Los Angeles, commercial developers are still scrambling to buy these suspect assets.  And in yet another post-COVID change datapoint, Sam Ash, the century-old music retailer founded in Brooklyn, announced the closure of its 42 retail locations because of competition from online sellers. 

Whether we speak of legacy content, cars or many other products, the great aggregation of demand and fulfillment is continuing apace, with Alphabet (GOOG) unit Google and Amazon (AMZN) leading the way. The surveillance and monetization of all online activity is about processing capacity and money, just as in payments or program trading. Big is better. And even some very big players, like Microsoft (MSFT), are marginalized in the fight for eyeballs. Does MSFT really need to surreptitiously change the default browser setting in millions of Windows 11 installs with each software update? Really?

Some readers were a bit taken aback when our bro Michael Whalen predicted in our last issue (“Then Old Media Became Redunzl”) that all of the existing media conglomerates would eventually be pushed out of content entirely by the great eyeball aggregators led by GOOG. But Michael may be correct. He works in the trenches of modern music and has a bad habit of being right when it comes to money and the world of content. And Michael has a new album out with Mark Isham et al: "Watercolor Sky"

Hedge the MSR?

PennyMac Financial (PFSI) reported results for Q1 2024 with the non-cash gain-on-sale results from correspondents up significantly from a year ago. To give you some context, two-thirds of the mortgage industry lost money in 2023. PFSI reported $39 million in GAAP net income, and had a small non-cash down mark on its mortgage servicing rights (MSR), but also took a nearly $300 million non-cash loss on MSR hedging.  A lot of private issuers do not hedge the MSR at all.

PFSI had $5.4 billion in advances with an average tenor of 3.5 months at the end of Q1 as shown in the table below. Notice that the only depository in the main, 364-day PFSI MSR lending group is Citibank.

PFSI has $4.5 billion in term debt, mostly secured by the MSR. PSFI has arguably the best developed debt strategy in the industry for funding servicing assets, but remains heavily dependent upon Apollo (APO) portfolio company Atlas SPG, Goldman Sachs (GS) and other dealers for funding. Atlas SPG is the replacement for Credit Suisse, for new readers of The IRA. Note that the commitments from commercial banks are tiny compared with the Atlas-led group with GS, Citibank NA, Nomura (NMR). The table below shows the aging of PFSI's medium-term debt.

Mr. Cooper (COOP) reported first quarter income before income tax expense of $232 and net income of $181 million. Excluding other mark-to-market and other adjustments, the Company reported pretax operating income of $199 million. COOP’s owned MSR increased to $631 million and third-party servicing assets likewise increased to a total of $1.1 trillion in servicing. 

COOP issued $1 billion in HY debt at a cost of just 7.25% and increased the size of its bank lines, even as credit utilization levels were flat to down. Of note, default levels on the COOP portfolio and particularly FHA were down YOY, something that CFO Kurt Johnson attributed to the post-COVID credit waterfalls adopted by the industry. Johnson:

“FHA has done a really great job from a modification standpoint of just putting programs in place that are easy for the servicer to implement and really attractive for the customer as well. So they have programs that allow the customer to stay in their low rate mortgages and capitalize part or all of their arrears on the back end of the mortgage.”

Both COOP and PFSI are well-positioned going into Q2 and the rest of 2024, but we do not expect much relief in terms of lending volumes. Rates have been backing up since the end of March, but volatility is also a big concern for lenders that have recently seen higher volumes and thus have higher interest rate risk. But if rates rally, then lending volumes will rise as MSRs run off.  Yet most of the profit given current market conditions comes from the MSR over time.

Both PFSI and COOP can generate significant upside earnings and volumes from current levels and without big increases in cost. In this age of low volumes and negative lender spreads, much of the industry is migrating to a twin model for acquiring loans of 1) correspondent and 2) direct-to-consumer (DTC). Being able to grow volumes without a significant increase in expenses is a key goal. Again Johnson answering a questions from Eric Hagen at BTIG:

“The focus is on the balanced business model and we do think that these returns are really interest rate agnostic and that where you see a drop off in servicing because of a rate rally, you'll see an increase in our DTC channel.”

Rocket Companies (RKT) reported net income of $290 million in Q1 2024 vs a $411 million loss a year ago. The fair value of the MSR fell $220 million, but strong revenue more than offset the non-cash adjustment to the servicing. In Q1 of 2021, RKT reported $2.7 billion in GAAP net income and that was below the levels of the year before. The table below shows the quarterly financials for RKT going back to 2020 from the earnings release. 

RKT Q1 2024

Notice how the change in interest rates in Q1 2024 caused the FV of the RKT MSR to fall, generating a non-cash expense that hits GAAP earnings, but is added back to cash flow and calculations such as EBITDA. The MSR is recognized in full at the point of sale of the mortgage note, then deteriorates over time with the receipt of servicing fees and prepayment experience.

The change in income from 2020 through to Q1 2024 illustrates the 75% drop in loan volumes since the end of the COVID boom in home lending. Below we show a snapshot of the RKT income statement, which highlights some of the moving parts in the world of mortgage lending.

On line 6 of the RKT spreadsheet, we see the gain-on-sale (GOS) for loans sold followed on the next line by the FV of the MSR retained when the note is sold into an MBS. Notice that the FV of the MSR was bigger than the GOS for loans in 2023, a striking commentary on the pricing for RKT MSRs.

The GOS, net of the FV of the MSR, is a non-cash item that is subtracted from cash flow (See Page 80 of the RKT 10-K). The cost of creating the MSR is also subtracted from cash flow. Mortgage firms are able to borrow against the FV of the MSR to fund their operations in times of low lending volumes.

On line 12, we see the positive adjustment for MSR model assumptions, followed by the debit representing the amortization of the MSR on line 13 -- one of the more important line items for any mortgage bank. Since the full value of the MSR is recognized up front, at the point of sale of the mortgage note, the asset is amortized each quarter to reflect the receipt of loan servicing fees and prepayments. The net of these two figures is the change in the FV of the MSR on line 14. Now your understand mortgage banking.

Sources: MBA, FDIC

All of these large mortgage firms are doing fine at present, but largely because default rates on 1-4 family mortgages remain very low, well-below LT historical averages. As and when default rates rise into 2025, however, we expect the pain points in terms of funding and operational expenses related to loss mitigation to intensify. The low coupons of existing loans and high home prices offset other factors that would normally lead to higher levels of delinquency.

Source: GNMA

The table is pretty much set for the mortgage industry over the next several years, however, because even a 100bp drop in short-term interest rates by the FOMC may not result in a significant increase in lending volumes. As the table above from the latest GNMA capital markets report shows, the average coupon on GNMA MBS is barely above 3.5% and the loans in those MBS have coupons roughly a point higher, so mid-4% range or 300bp out of the money for refinance.

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