Update: Mortgage Lenders, TBA Contango & MSRs

June 26, 2023 | Premium Service | Developing a forward investment thesis for the world of housing credit requires first that we recognize the impact of monetary policy on both asset returns and the apparent cost of credit. Asset returns were boosted by low interest rates, while soaring asset valuations muted or even turned negative the apparent cost of credit.

In January 2022, the Congressional Research Service published a handy history of the Fed’s monetary machinations, “Federal Reseve: Tapering of Asset Purchases,” focusing on the resumption of Fed asset purchases in 2019:

“In the fall of 2019, a liquidity shortage caused repo market turmoil, prompting the Fed to begin purchasing Treasuries again. Asset purchases rapidly increased in response to financial unrest caused by the pandemic’s onset in the spring of 2020, with securities holdings increasing by about $2 trillion in two months. MBS purchases resumed then, and for the first time the Fed purchased agency CMBS (MBS backed by commercial mortgages) in relatively small amounts. Beginning in June 2020, the Fed purchased $120 billion of securities per month—a faster rate than the rounds of QE following the financial crisis. In December 2020, it pledged to continue purchases at this rate “until substantial further progress has been made toward its maximum employment and price stability goals.” When tapering was first announced, the unemployment rate had fallen from 6.7% to 4.8% and the Fed’s targeted inflation measure had risen from 1.3% to 4.3%. Since March 2020, the Fed’s securities holdings have doubled to $8.9 trillion.”

The immediate impact of the asset purchases was to push down interest rates across the board, the obvious impact of the FOMC removing almost $9 trillion in securities from the Treasury and mortgage markets. Our discussion of the FOMC meeting last week with Bloomberg Television is below.

Since 2022, as the FOMC raised the target rate for federal funds, the rest of the yield curve has remained suppressed while short-term interest rates have returned to something closer to normal. The chart below shows dollar swaps from the Friday close (green line) and some 15 years ago in June of 2008 (yellow line) with the spread shown below.

Source: Bloomberg

Since 2008, the market for dollar swaps has traded through Treasury yields, again reflecting the change in US monetary policy since the FOMC under Chairman Ben Bernanke embraced QE. Today dollar fixed/floating rate swaps (blue line) trade through Treasury yields (green line) outside of ten years, as shown in the chart below. If we look at the rate and the shape of the swaps curve, it seems to reflect the fact that the Fed still owns over $8 trillion in securities in the System Open Market Account (SOMA).

Is the inverted yield curve a bad thing? And does it predict a future recession? Our answer is that the distortions in the term structure of interest rates caused by Fed open market operations and, now, no sales of securities, are bad for the economy and very bad for lenders.

Erica Adelberg of Bloomberg Intelligence describes how lenders are facing absurd conditions in the bond markets, with forward contracts for mortgage backed securities trading above current spot prices. This classic “contango” market means that lenders do not earn any float on their assets and, in fact, lose money on loans as they move through the manufacturing process. She writes:

"With the fed funds rate higher than the yield of most agency mortgage-backed securities (MBS) coupons, it's become cheaper to hold cash than MBS in the near term, as dollar-roll financing for TBA issues has fallen deeper into negative territory. The Federal Reserve's indications that more hikes may be on tap for 2023 could lead to persistent carry challenges for MBS."

Simply stated, most mortgages backed securities are trading on yields well-below funding costs for lenders. Let’s say you are writing 7% loans this week, which you are going to deliver into a Fannie Mae 6% MBS in July, which yields in the high five percent range. Or to put it in basic terms, you are short the MBS for July and prices are rising. But for investors looking to pick the next strategy in mortgage land, some thoughts.

The first obvious statement is that those 2% MBS that are causing everyone indigestion are also one of the big trades in prospect. The question, of course, is when to actually put on a trade that is 5 points underwater on funding. But as the Fed’s portfolio runs off and rates do eventually fall, the long duration Ginnie Mae MBS kamikaze trade will beckon to the wild of heart.

Let’s say that the FOMC does eventually start to sell MBS or at least ensure that the portfolio runs off $35 billion each month. Does that help MBS prices? In the current low production environment, that incremental selling may not result in higher mortgage rates or MBS yields. That is bad news for lenders seeking profitability, but good news for financial investors with cash and a strong constitution.

The second observation is that with credit costs starting to rebound from the torpor of QE, valuations on certain mortgage portfolios and servicing strips will come into question. We’ve already seen a huge chasm emerge in recent months between buyers and sellers of mortgage servicing rights. Higher credit costs means lower net operating income and MSR multiples, but sellers are refusing to capitulate -- yet.

The higher credit costs that make MSRs and loans unattractive to some buyers will provide great value for others. Scores of investors are preparing for an increase in delinquency after a decade of QE. The increase in operating costs, however, could make some servicing portfolios unstable, leading to significant losses for investors. The cost of servicing a 1-4 family loan has trebled since 2008 and that cost increase makes mortgage servicers vulnerable to default.

In a comment article published in Reuters ("Don't go chasing waterfalls: intercreditor agreements in the context of agency mortgage servicing rights"), Michelle Maman and colleagues from Cadwalader, Wickersham & Taft LLP in New York note that mortgage servicing assets depend upon intercreditor agreements that contain two key provisions: (i) "waterfall" provisions that govern the application of collateral proceeds; and (ii) "turnover" provisions that require creditors to hold proceeds in trust and then remit excess proceeds they have received in violation of the applicable waterfall provision.

Maman opines: “Notably, however, the enforceability of these agreements could be called into question if the collateral at issue is insufficient to pay the secured debts of the servicer.”

Translated into plain language, if the expenses of the servicing portfolio rise and it cannot meet all of its legal obligations under the waterfall, then the intercreditor agreement fails and the secured debts become general claims on the bankruptcy estate. Or if a mortgage servicer tips over and cannot pay its secured debts covered by the waterfall, upon filing bankruptcy the MSR vanishes.

Laurie Goodman and Ted Tozer published a comment last week for Urban Institute (“The Payment Supplement Partial Claim Offers a Great Vision but Is Operationally Burdensome”) where the authors discuss efforts to expand liquidity for government issuers to support loss mitigation activities. Without expanded access to liquidity to fund loss mitigation activities, we believe that smaller government issuers are likely to fail. Larger government issuers are already under stress, as evidenced by the number of firms that have slashed dividends and other expenses.

Names such as Two Harbors (TWO) have been forced to cut dividends to finance rising expenses and capital losses due to MBS spread widening. Bill Greenberg, Two Harbors’ president and chief executive officer, remarked: “The decision to reduce the dividend this quarter was not a function of downward pressure on earnings, but rather a strategic focus on enhancing book value and further investing capital into a positive Agency MSR and MBS environment.”

Some REITs are migrating toward the floating phase of fixed/floating preferred instruments, one of the dumber ideas we can recall but typical of the predatory behavior of Sell Side investment banks, particularly given the amount of confusion in markets today. Preferred equity issued by Annaly (NLY) is already floating and several other REITs will soon be paying floating spreads (+500bp) over SOFR. What a great trade. H/T to Ed Groshans at BTIG. Oh, and let’s not forget the NLY reverse stock split of last year, never a bullish sign.

The big picture message for our readers is that there are some compelling opportunities in fixed income securities, MSRs and operating assets. We view MBS as a potential long-trade to benefit from a Fed easing in 2024, but MSRs, levered investors such as REITs, and operating assets are likely to be trading at discounts to current marks. As we noted recently, the MSR of the lender f/k/a HomePoint were marked at 6x cash flow at year end 2022, but were sold for total consideration closer to 3x.

As Q2 2023 comes to an end, we are bracing for some really astounding earnings results from banks and nonbanks alike. The distortions inserted into the money markets by the FOMC since 2019 are still not well-understood by most investors. In particular, the contango trade in the mortgage markets is profound and will continue to impact the performance of loans, MSRs and lenders. The negative economics in the loan market will drive further consolidation among lenders as the strong absorb the weaker operators.

When we saw Rocket Mortgage (RKT) selling $200 million in MSRs to JPMorganChase (JPM), we recalled the words of RKT CFO Brian Brown. “The buyers in that space, though they are big buyers, they are limited buyers,” Brown said in January, Inside Mortgage Finance reported. “It doesn’t take much pullback from an institutional buyer to all of a sudden have more supply than demand.”

If we think of the first half of 2023 as the Street getting comfortable with higher interest rates for longer through 2023 and beyond, the second half of 2023 will be about business operators adjusting accordingly. Many lenders and investors that thought the Fed would relent and drop interest rates before the end of the year must now make tough choices about selling money-losing assets and reducing headcount. We look for lower prices for legacy MBS and MSRs as new allocations are used up and P&Ls sink deeper into the red under mounting financing losses and credit mitigation expenses.

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