Updated: Nov 1, 2022
October 28, 2022 | Updated | As we near day-30 since the close of the third quarter, the pain being felt across most markets is palpable and growing. Not a lot of fun for operators or analysts or even bank regulators. The FOMC is coming dangerously close to causing a repeat of the S&L crisis among smaller depositories. In this spirit, The Institutional Risk Analyst checks in on two important players in the world of mortgage and structured finance, PennyMac Financial (PFSI) and Credit Suisse AG (US).
Credit Suisse AG
Credit Suisse is a Zurich-based bank that does a global investment banking and wealth advisory business. CS is the final holdout among the Swiss private banks in terms of exiting the transactional world more than a decade since 2008. A decade ago this month, UBS AG (UBS) fired 10,000 investment bankers and exited the world of fixed income investment banking forever.
Today UBS is the largest private bank in Switzerland and by a wide margin, while CS is a laggard. In the wake of the $5.5 billion in losses and reputational damage caused by the hedge fund Archegos Capital Management, CS has decided to spin off the investment bank as a resurrected “First Boston.” CS also just settled a long-standing claim from the 2008 financial crisis to the tune of $500 million.
Bloomberg reports that Apollo Management (APO) and PIMCO are in negotiations for a club deal to finance the spin-out of the CS structured finance group. No sign of Citigroup (C) or the Fortress Investment unit of SoftBank. Did our friend Charles Gasparino of Fox Business really really, suggest TD Bank (TD) or Canadian Imperial Bank of Commerce (CM) as prospective buyers for the CS investment bank? We cannot imagine a more frightening possibility.
CS is a relatively small global bank, with roughly $700 billion in total assets and less than 50% deployed in loans. At the end of Q3 2022, the bank had 6.5% capital to assets and $370 billion in customer deposits. In the US, of note, CS operates as a broker-dealer rather than a commercial bank, a pattern followed by many EU names. The corporate taxonomy of the US operations of CS is below:
The bank is said to be raising an additional $500 million in equity to bolster its balance sheet, which is well-below required Basel III levels. As of the date of this report, CS was trading at 0.27x book value and + 250bp over the curve in credit default swaps, roughly mapping to a “BB-” ratings equivalent. CS is down 56% YTD while the close comparable, UBS AG, is down just 11% and is still trading above book value.
As we’ve documented over the years in The Institutional Risk Analyst, the asset gatherers tend to have higher market valuations and lower volatility than the universal banks with transactional risk. Thus CS trades on a beta of 1.5x the average market volatility vs 1.0x beta for UBS. End of story. We suspect that Swiss regulators and other private bankers will be very pleased to see CS exit the world of investment banking and structured finance for good.
PennyMac Financial Services (PSFI) reported earnings yesterday. Like COOP, volumes are down dramatically from 2021 but MSR values and cash flows from servicing are rising, providing collateral to fund advances or operations. The key caveat is that issuers must manage expenses very aggressively. In times of rising interest rates and falling lending volumes, lenders with substantial servicing books generally fare better than lenders that sell loans servicing released. The chart below is from the PFSI earnings release.
Like COOP, PFSI is well-above the capital requirements for the new risk-based capital regime from GNMA and had more than adequate access to liquidity. Both of these firms control a servicing book measured in the millions of loans to feed leads to a consumer direct lending platform, the lowest cost way to originate a new loan asset. The rising value of the MSR provides a natural hedge for the declining production income of the lending business.
While there have been some hyperbolic reports in the media about the impending collapse of PFSI and other large issuers, in fact the liquidity situation for the large players is improving even as loan delinquency rates return to pre-COVID levels. Note in the slide below the history of advances on PFSI’s half trillion dollar servicing book. How is this possible when aggregate advances in the industry are rising 30% YOY? Because mortgage lending remains a very fragmented business with wide dispersion in operating models.
The true situation at present with respect to liquidity for PFSI and other large GNMA issuers is that cash flow requirements are continuing to decline even as interest rates rise to 20-year highs. This is the lingering effect of the Fed’s QE, which drove loss given default (LGD) for conventional and bank-owned 1-4s negative over the past two years. How is this possible? Ask Fed Chairman Jerome Powell.
“Servicing advances outstanding decreased to approximately $397 million at September 30, 2022 from $506 million at June 30, 2022,” PFSI reports. “No P&I advances are outstanding, as prepayment activity continues to sufficiently cover remittance obligations.” In other words, PFSI has more than sufficient internal cash flow to finance any default advances without pulling on bank lines – a situation that has existed for several years, of note. Short-sellers drinking the tea of hyperbole beware.
The indicators of liquidity for a large seller/servicer such as PFSI are not immediately apparent to market observers, in part because large lenders with equally large servicing books generate enormous amounts of free cash flow. As volumes fall and issuers are able to recapture the equity component of advance lines, cash grows but uses for this cash in terms of lending are limited.
To paraphrase the exchange in the 1982 John Milius film “Conan the Barbarian,” what is best in life?
What is best in mortgage lending? Piles of ready cash and committed sources of liquidity from large banks. When PFSI CEO David Spector tells you he has not needed to draw on advance lines to pay principal and interest on defaulted loans, that is a good sign that belies the predictions of imminent disaster. Below is the table showing PFSI’s adjusted earnings before interest, taxes, depreciation and amortization (EBITDA).
Some readers have expressed confusion over our past warnings regarding mounting delinquent loans, particularly in the government sector, due to the high cost of default resolution. Those warnings remain very much in effect and, indeed, have been broadened. Fact is the total amount of cash advanced on delinquent loans (including COVID forbearance is still rising, but not apparently at PFSI.
Like any financial company, you cannot really tell what is going on inside a bank or nonbank based upon GAAP financials. The operating dynamics and financial flows inside a bank or a nonbank issuer with substantial owned or third-party servicing assets are far more complex than outside observers in the financial community appreciate. The cash flows generated by loan prepayments, for example, are largely invisible but very definitely an operating benefit.
So what is best in life when interest rates are rising? A big servicing book. Is future loan delinquency going to be a substantial expense for PFSI, COOP and the other leading government issuers in 2023 and beyond? Yes. But we worry more about the market risk facing lenders in the TBA markets. Our recent comments about future margins calls as and when interest rates fall are the real risk facing the industry as MSR valuations march ever higher. The table below shows the MSR disclosure from PFSI's Q3 earnings.
PennyMac Financial Services
The Fed, after all, is the single biggest risk to the world of bank or nonbank finance. But the destabilizing effect of mark-to-market losses on loans and MBS due to rising interest rates is front of mind for prudential regulators and the Federal Housing Finance Agency. We hear increasing concern about the Ginnie Mae risk-based capital rule from investors, lawyers and regulators as we head to the end of the year. Could Q1 2023 be the great flushing away of M2M losses by U.S. banks?
Indeed, we think there is a growing chance that prudential bank regulators, worried about already insolvent depositories and the prospect of a 20-30% markdown in $120 billion in MSRs in Q1 2023, will pressure HUD, Treasury Secretary Janet Yellen and the Biden Administration to withdraw the Ginnie Mae RBC rule entirely.
In any event, PFSI, COOP and other large issuers easily meet the Ginnie Mae RBC rule today, in fact, several times over. But they cannot control what happens to the MSR market. If Ginnie Mae’s astounding insensitivity to market risk and the rules of finance causes a wholesale markdown of MSR valuations, everyone loses. You might think the larger mortgage issuers would like to see many smaller players exit the market, but no. Only fools believe you can encourage an industry consolidation and reduction in leverage on MSRs in the current rate environment without courting disaster.
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