April 19, 2021 | In this issue of The Institutional Risk Analyst, we feature a discussion with Nom de Plumber, the pseudonym for a prominent Wall Street risk manager who is currently ensconced at a major bank. While it is generally our policy to avoid anonymity, the fact of employment in a large company or bank means that you have no First Amendment rights. As we learned the hard way many years ago, the only free press is the one that you own.
The IRA: Good to connect again after the year of COVID. You’ve made some interesting comments on how the Consumer Financial Protection Bureau and the Federal Housing Finance Agency, to name a couple, have been treating the independent mortgage banks (IMBs). When servicing was controlled by banks, you could impose stupidity like foreclosure moratoria and it did not really matter. Now that IMBs control two-thirds of the mortgage market, it kind of matters. Care to elaborate?
NDP: Sooner or later the delinquencies will really have to manifest as actual losses and defaults. Millions of people who’ve lost their jobs or their business are not paying their mortgages, so we have what is effectively a default in drag. Foreclosure moratoria and payment holidays do not fix the problem of unemployment and affordability. Sooner or later the python has to poop the pig. Someone has to eat those forgone cash flow losses.
The IRA: In a funny way, we’re right back to April 2020 in terms of the issues facing the IMBs. The Federal Open Market Committee bought us a year, correct? Now the mortgage market is reverting to the mean, as we discussed with John Dizard in The Financial Times over the weekend ("Easy money might be over in US mortgage banking boom").
NDP: A default is a default. You can modify the loan or put the arrears at the back of the loan, but from a present value (PV) perspective that is a huge hit. In the conventional market, the GSEs will eventually absorb the loss, but in the meantime the IMBs must finance this and also the expense of dealing with the delinquency. In the government market, the seller/servicers eat part of the loss. When we had banks as servicers, this was not a problem. You could use bank deposits to fund servicing advances. But IMBs don’t have much capital or excess liquidity. Had the GSEs finally not come forward last year to take responsibility for liquidity we might have seen some IMBs shutting down last summer.
The IRA: It took FHFA Director Mark Calabria some time to figure this out. We’re told that he basically makes decisions without consulting the career staff at FHFA or the GSEs. The decision last year to impose the 50bp tax on refinance transactions, for example, came with no warning to conventional issuers or the GSEs. He is at once the laughing stock of the housing finance community, but is also a huge problem. Look for loan repurchase demands from the GSEs as Mark's next big idea. To your point, the monoline servicers seem to be in the biggest trouble in terms of both liquidity and prepayments. Servicers face the cost of default mitigation, on the one hand, and prepays on the other. Is this a perfect storm for IMBs?
NDP: Servicers depend upon the stable world of notional amortization. Default based amortization where there is no fee recapture of any sort, meaning no payment for fixing COVID forbearance loans, is going to be brutal for the IMBs. The fundamental problem is that the politicians and consumers think that the servicers all have money set aside to pay for the CARES Act and other types of debt payment holidays. The regulators too at FHFA and FHA assume that there are piles of cash just sitting there ready to be tapped in time of emergency. But there is no cash. The disconnect in Washington comes from not understanding the difference between a bank and a finance company. IMBs don’t have internal deposit driven liquidity. Capital is an afterthought. They live on cash and available financing.
The IRA: The IMBs generally pledge net assets to back warehouse lines, gestation and TBA trading, all provided by the big banks, so the idea of a secret cash pile is pretty amusing. With the nice profits made in 2020, the industry grew book equity and AUM on net, but had to contend with severe prepayments, 30% or more in some cases. The whole US banking industry lost 20% of total loan balances and servicing in 1-4s net over the past four quarters. But you used the “f” word the other day, namely forbearance. How much forbearance is there in the US banking industry particularly for commercial real estate?
NDP: Some of the credit concerns are being addressed by an economic recovery, but many analysts including you have said it remains an open question as to the total credit cost of COVID. Commercial servicers, for example, were pretty lenient in 2020 but many have finally stopped providing forbearance to borrowers, which are mostly commercial buildings in this case. Even for deep pocketed landlords, will they have the capability to finance operating deficits for years to come?
The IRA: And the desire. There were many properties abandoned in NYC in the 1970s. We think this cycle could be worse because of the poisonous politics in the city. New York State and City need to start thinking about being competitive with other states instead of raising taxes.
NDP: The New York Times is writing very sobering reports about office space and the dynamics of making these properties profitable again. If we have major tenants shrinking their office footprint and also renegotiating terms on the space that they are willing to keep, that fundamentally changes the net operating income (NOI) assumptions behind the valuations for these assets. The buildings that are delinquent and want to recover cannot because falling NOI pulls out the ground beneath their feet. The property cannot be financed without significant new equity, cash the landlord does not have because his tenants are not paying him.
The IRA: We keep pointing this out to people in Washington. The crisis with COVID is about the bottom quartile of the economy, workers and small business that have been crushed by lockdowns. In aggregate, the credit numbers for consumers are fine. But the situation for commercial and multifamily real estate assets where the NOI has changed permanently is a very disruptive and destructive change, for REITs, bond investors and also municipal debt. Can we get people to focus on the coming bloodbath in moribund urban commercial real estate?
NDP: Reality will come back into sharp focus because there is no political support for helping commercial landlords or tenants. Like 2008, reality will hit first in commercial properties. Here’s the thing: After 2008, you really did not see office space utilization change that much, so pricing settled down pretty quickly. Now, we are talking about significant and permanent changes to utilization and the rate for space, both at once. Reality will be cushioned for consumers, but the delinquent borrowers will still be resolved. The impact on commercial real estate will be earlier and harder. What is interesting to think about is whether commercial servicers, which also advance and collect, will be impacted. Commercial servicing is chunkier, but in basic terms is the same as residential when it comes to paying the note holders.
The IRA: Isn’t is remarkable how low consumer loss rates remain, forbearance or not?
NDP: Consumers have become very adept at managing their credit. They keep up on credit cards and auto loans, for example, even subprime auto. But with each financial crisis, you see a tendency for people to game the system in terms of consumer relief programs. This time the cost has fallen upon the nonbank servicers and nobody in Congress knows or cares. But we may not be too far from the day when a large nonbank servicer turns to the FHFA and FHA, demands immediate assistance with the cost of consumer forbearance, and threatens to shut off the lights and walk away if the cry for help goes unanswered.
The IRA: Yeah, like we’ve said before. Be well.