The Bear Case for Mortgage Lenders

New York | This week in The Institutional Risk Analyst, we make the bear case for the housing sector as several more large mortgage issuers have announced public share offerings, joining LoanDepot and United Wholesale Mortgage. Caliber Home Loans and AmeriHome, Inc., two very different mortgage issuers that are benefitting from the low interest rates environment, each filed IPOs last week.

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Mortgage Group: ACGL, AGNC, AI, BKI, BXMT, CIM, CLGX, COOP, ESNT, FAF, FBC, FMCC, FNF, FNMA, IMH, LADR, MFA, NLY, NRZ, NYMT, OCN, PFSI, PMT, RKT, RWT, STWD, TWO

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Caliber Home Loans is a portfolio company of Lone Star, which formed Caliber in 2013 from bits and pieces of business left over from the 2008 mortgage crisis. Under CEO Sanjiv Das, who formerly triaged and repaired the correspondent mortgage operation at Citigroup (NYSE:C), Caliber has developed a high-touch, largely purchase mortgage business that is the antithesis of firms like Rocket Mortgage (NYSE:RKT) and AmeriHome.

Most recently, Caliber has also seen an increase in refinance volumes, but the core business remains purchase loans sourced via retail branches. See our previous discussions of Ally Financial (NASDAQ:ALLY) and Citigroup for further background.

AmeriHome is one of the most efficient platforms in the industry and boasts a veteran team of operators. The firm is a subsidiary of insurer Athene Holding (NYSE:ATH), which in turn is controlled by Apollo Global Management (NYSE:APO).

Unlike Caliber which focuses on purchase business and is a large GNMA issuer, AmeriHome focuses on both purchase and refi loans predominantly in the conventional loan market. AmeriHome is an important part of the success of ATH and APO.

The extraordinary boom in the US residential mortgage market has pushed up volumes for new issuance of mortgage backed securities to over $440 billion per month through August. Even as commercial banks face years of uncertainty due to the credit cost of COVID and its aftermath, nonbank mortgage lenders are today's golden children for Wall Street – at least for now.

In an existential sense, the rise of the mortgage lenders and servicers since March provides a counterpoint to the travails of the commercial banks and, in particular, the mortgage REITs and funds. This latter group purchased MBS, loans and/or servicing, all with ample leverage, over the past 7 years. More recently, these firms have seen their equity market valuations crushed as the FOMC drove interest rates down.

We noted in National Mortgage News (“Banks Retreat Again from Residential Servicing”) that simply owning mortgage assets w/o also having the ability to lend and recapture refinance events is no longer a viable trade. This is a direct reference to the entire hybrid REIT space led by the likes of New Residential (NYSE:NRZ) as well as some specialized private servicers such as Lakeview Loan Servicing. But there is even more to the risk story. The table below shows some of the largest servicers in the $1.9 trillion Ginnie Mae market.

Source: Ginnie Mae

There are many REITs and also some large non-bank servicers most people have never heard of that presently face massive risk in terms of prepayments and also the cost of default resolution. These REITs and servicers are mostly weak lenders and have significant leverage. COVID has further increased the risk to some participants in the mortgage market and also decreased the visibility into how loans currently in forbearance under the CARES Act will be resolved.

Time and cost to resolution of delinquent loans = expense and risk for servicers. These risks are different depending upon whether we look at the conventional market build around Fannie Mae and Freddie Mac or the government market built around the FHA and Ginnie Mae. Below we outline some of the obvious risks facing investors, some of which are mentioned in the public filings of several independent mortgage banks. Other risks are not yet mentioned in public disclosure.

Prepayments

As we have discussed previously in The Institutional Risk Analyst and also in National Mortgage News, the rate of mortgage loan prepayments in conventional and government loans are at levels not seen since the early 2000s. The sharp decrease in interest rates two decades ago set off a bull market in residential lending in the early 2000s that is very similar to today’s market. The major differences are the lack of a private label loan market and COVID. But the risk to issuers in terms of prepayments and, as discussed below, default resolution is the same.

We wrote last month in NMN:

“Simply stated, banks and REITs buy loans, IMBs make loans. Holding MSRs when you cannot defend the asset by recapturing the refinance event is a losing trade. This is why, for example, that early buyouts of government loans is such a popular strategy with large banks. Buy the delinquent asset, modify or refinance the loan, and sell it into a new MBS pool or just hold the loan in portfolio.”

COVID & Liquidity Risk

Earlier this year, there was considerable concern about the ability of independent mortgage banks (IMBs) to finance advances of principal and interest (P&I), and taxes and insurance (T&I) on loans that have 1) received forbearance pursuant to the CARES Act or 2) are simply delinquent. Significantly, residential mortgage loans in forbearance and actual defaults are not eligible for pooling and cannot be financed, thus the servicer must bear the cost of financing both the mortgage note and the advances.

The GSEs recently issued guidance limiting the number of payments a servicer must advance in the case of a forbearance, but most issuers expect that a borrower who has experienced a loss of employment or a reduction of income may not repay the missed payments at the end of the forbearance period. These loans will likely result in a default and foreclosure, resulting in an expense to the GSEs.

All servicers generally have a month between the receipt of the loan payoff and the principal payment to the MBS investors. Most servicers so far successfully utilized the float from prepayments and mortgage payoffs to fund P&I advances relating to forborne loans, and have not yet advanced material amounts of associated with CARES Act forbearances.

So long as the volume of mortgage refinance volumes remains strong, the industry will continue to use the float from mortgage prepayments and payoffs to finance COVID advances. This money, however, belongs to bond holders. Issuers will ultimately need to replace such escrowed funds to make payments to bond holders in respect of such prepayments and mortgage payoffs.

As a result, issuers may need to use cash, including borrowings under warehouse lines and bond debt, to make the payments required under servicing operations.

There is no assurance as to how long the bull market in mortgage lending and specifically mortgage refinance lending will continue. Thus the availability of this float to finance forbearance and default advances is uncertain. More, the ongoing funding burden will increase as servicers and the GSEs are compelled to advance T&I as well as P&I.

Also, due to the likely increase in unemployment in Q4 and 2021 due to a lack of additional stimulus spending, we expect to see loan defaults climb even as new loan volumes remain strong. In many cases, we expect that strong prices for existing homes will keep loss-given default (LGD) low or even negative, as is the case for bank owned 1-4s. Many defaults will be avoided with short-sales and other mechanisms because the home is often worth more than the unpaid principal balance (UPB) of the delinquent loan.

Source: FDIC/WGA LLC

Loss Mitigation

As the current bull market matures, loss rates will inevitably rise even as volumes and prepayments continue to run at record levels. The added risk of COVID and related unemployment and economic dislocation must be considered as well when considering the likely future cost of loss mitigation. The most recent quarterly data for loan delinquency is shown below:

Sources: MBA, FDIC

In the conventional market, the major risk facing issuers and particularly IMBs is repurchase demands from the GSEs. Historically going back to the 1980s, when defaults rise in conventional loans, Fannie Mae and Freddie Mac first seek payment from the private mortgage insurers, if applicable, and then seek to force the aggregator to repurchase the “defective” loan. The aggregator then typically seeks reimbursement from the correspondent lender.

As default rates rise in the conventional market, those loans that are judged to be adequately underwritten and documented will be covered by the GSE guarantee. Those loans considered to be defective, on the other hand, could become a significant expense to conventional issuers and particularly IMBs.

Commercial banks will have a significant advantage in terms of liquidity and funding for loss mitigation activities, but all issuers will face significant costs, both for loan repurchases and foreclosures. Again, the fact of strong home prices is the key factor that will impact LGD for all loans.

In the government market, the situation is even more complicated. First, there is limited funding available to government issuers due to the fact that Ginnie Mae is only a guarantor and has no balance sheet to use in providing liquidity to government issuers.

Ginnie Mae must operate through its seller/servicers, meaning that in the event of default, Ginnie Mae must transfer the servicing (and with it the obligation to pay bold holders) to another servicer. At present, none of the large banks are willing to accept large servicing transfers of Ginnie Mae assets.

In some cases, the FHA has indicated that it will allow issuers to make partial claims to offset the cost of forbearance loans. But for those loans which default and go into foreclosure, the impact on issuers and particularly IMBs could be severe. Again, the funding advantage of commercial banks is a significant factor in the world of default resolution for government loans, one reason why issuers such as Wells Fargo (NYSE:WFC) have been aggressively buying early buyouts (EBOs).

Kaul, Goodman, McCargo, and Hill (2018) wrote an excellent monograph on these costs for Urban Institute. “Servicing FHA Nonperforming Loans Costs Three Times More Than GSE Nonperforming Loans,” they found. This why the FHA lenders receive 44bp for servicing vs. 25bp for conventional loans. But even the higher servicing fee does not cover all of the expense of Ginnie Mae default servicing.

All Ginnie Mae issuers face a substantial cash loss for every FHA, VA and USDA loan that goes into foreclosure, a loss that can range between $5,000 to $25,000 per loan or more. A lot depends on geography -- how much property preservation expense you have to eat, any damage to the REO house, health and safety issues, city fines, if you miss "first day" legal filings under FHA rules. The list is long and the operational complexity is high.

The fact that FHA lenders are reimbursed for interest expenses at the debenture rate but must advance cash for P&I at the coupon rate of the loan is another big factor. Also, foreclosures in “progressive states” such as New York, New Jersey and Massachusetts can take up to five years, greatly increasing the cost of default resolution. Nationally, foreclosures can take up to three years on average even before we talk about forbearance due to COVID.

There are many variables in managing FHA loans to conveyance and final resolution, making the expense and risk difficult to define measure. Ginnie Mae issuers must also finance the entire resolution process. While banks can easily purchase EBOs using their deposits for funding, IMBs lack the cash to finance buyouts of defaulted loans from Ginnie Mae MBS. The key determinants of the issuer risk here are:

• The geographic location of the defaulted assets,

• The rate of cure, short-sale or modification for each portfolio controlled by the issuer, and

• The average timeline for resolution across the portfolio

In recent meetings with officials at the Department of Housing and Urban Development, the top Ginnie Mae issuers were asked to model the rate of successful exit from COVID forbearance. Today FHA has an estimated 650,000 loans in forbearance and another 325,000 that are seriously delinquent (SDQ) but not in forbearance. That is $160 billion in UPB that is SDQ as of August, a figure that likely will rise.

Looking at the largest Ginnie Mae loan servicer Lakeview, which services 1.3 million loans with $224 billion in UPB, we can see why the rate of successful exit is absolutely crucial. Of the 15% of Lakeview loans that are non-current either due to COVID forbearance or actual delinquency, that comes to roughly 195,000 loans that are possibly SDQ.

Let’s say that half of non-current Lakeview loans exit forbearance successfully and another quarter get current and are then refinanced or modified. If a quarter of these non-current loans go through to foreclosure, that could in theory result in total unreimbursed expenses averaging approximately $12,000 per loan or $570 million in cash expenses to Lakeview. Under the same scenario, Penny Mac Financial Services (NYSE:PFSI) would face almost $500 million in cash expenses due to foreclosure.

On an industry level, if you figure Lakeview has about 11% market share in Ginnie Mae servicing, if one quarter of SDQ loans go through to foreclosure and REO, that suggests a roughly $4-5 billion loss spread across all Ginnie Mae issuers. Wells Fargo and Truist Financial (NYSE:TFC), on the other hand, will see far lower default resolution losses because their delinquency rate is far lower than the IMBs.

The table below shows the projected cash loss upon foreclosure for the top Ginnie Mae issuers, assuming that 25% of non-current loans today eventually go to foreclosure and a $12,000 non-reimbursed expense per foreclosure. Keep in mind that both the total number of loans outstanding and the rate of delinquency is likely to grow, this even as overall volumes also climb.

Sources: Ginnie Mae/WGA LLC

While some of the more efficient issuers in this group may be able to use profits from strong new loan origination volumes to offset cash losses on delinquent loan resolutions, less efficient players are facing a double whammy. High prepayments are destroying the value of MBS, whole loan portfolios and MSRs. Meanwhile, rising credit and servicing costs are consuming cash.

For both investors and risk professionals operating in the secondary mortgage market, the next several years contain both great opportunities and considerable risks. We look for the top lenders and servicers to survive the coming winter of default resolution that must inevitably follow a period of low interest rates by the FOMC. The result of the inevitable consolidation will be fewer, larger IMBs.

But we also look for some significant business failures over the next several year from those owners of Ginnie Mae and conventional assets that are weak lenders and servicers. We've said it before and we'll say it again, if you as a lender don't have retention rates for refinance events well above 50% and default resolution costs in the bottom quartile of the MBA survey, then you need to sell your MSRs and get out the the kitchen before you get burned.

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