Update: Rising Interest Rates & Mortgage Servicing

May 25, 2021 | In this issue of The Institutional Risk Analyst Premium Service, we talk about the outlook for interest rates and the impact on banks and other financial intermediaries of the structural market changes that we described in our last issue. We start our comment today, however, with the increasingly manic behavior of the market for mortgage servicing rights, a negative duration asset that performs the opposite of a bond.

The competition for assets in the financial markets has reached a fever pitch, not just for stock and bonds. Yesterday Ocwen Financial (NYSE:OCN) disclosed that it has agreed to acquire significant conventional MSRs from AmeriHome, which was just acquired by Western Alliance Bancorp (NYSE:WAL). Significantly, WAL is selling the AH MSRs to OCN and is acquiring a financing asset, a good trade in a market that already sees late vintage servicing changing hands at 5x cash flow.

With the on-the-run MBS spread to Treasuries headed to 0.5% vs almost 2% last summer, the market conditions facing mortgage issuers and investors alike are increasingly difficult. Less efficient lenders are already losing money on most loans at close, thus selling the MSR along with or separately from the sale of the mortgage note into an MBS is increasingly attractive – even mandatory. Of note, MSRs on FNMA 3% coupons are trading north of 5x annual cash flow.

It is important to remember that in most “normal” markets, lenders are down cash at the close of a loan but make up the difference by retaining the servicing asset. For banks with diversified balance sheets, the decision to retain the MSR is relatively easy. But for independent mortgage banks (IMBs), the need for cash is intense and growing as primary-secondary market spreads fall.

Issuers are anxiously awaiting the replacement of FHFA Director Mark Calabria by the Biden Administration, but the pain inflicted by the changes made to the conventional market may persist all summer. The latest version of the Preferred Stock Purchase Agreement between the Treasury and the GSEs included changes to the cash window purchases by Fannie Mae and Freddie Mac, changes that are forcing large issuers to look for alternative channels for selling loans.

For example, United Wholesale Mortgage Corp (NYSE:UWMC) just priced a private MBS comprised 100% of QM loans. Several market participants remarked on the tight terms for the deal, but spreads are likely to continue to tighten. The 2.5% coupon for the senior tranches of the MBS are likely to tighten further. Note that the CLTV is only 65% for this prime jumbo deal, a reflection of the steady increase in home prices.

Of note, the UWMC deal uses variable servicing fees depending upon the degree of delinquency in the deal. KBRA notes:

“Under a variable servicing fee framework, mortgages incur servicing fees that, in aggregate, increase as loan performance worsens and/or loss mitigation activity increases. Not all prime transactions use this servicing framework, more often using fixed servicing fee rates, though the use of variable servicing fee frameworks has been a growing trend. For the subject securitization, we expect the all-in servicing fees over the transaction’s life will be less than the total fees for comparable transactions with fixed servicing fee rates for all loans.”

Call us in 2025, when the market for 1-4 family homes is likely in the midst of a significant price correction, to talk about the servicing fees in this and other “variable” servicing fee deals. In good times, servicing a 1-4 family loan only costs a couple of basis points. But as soon as the loan becomes distressed, the cost of servicing can increase by 10x or more. Issuers such as UWMC and New Residential (NYSE:NRZ) that use variable cost servicing contracts are betting that home prices will not correct – ever.

Meanwhile in the world of commercial banking, the movement of cash out of the Treasury’s General Account (TGA) into the banking system is causing a great deal of pain for depositories. Already awash in cash due to QE, the banks are now being inundated with additional unwanted liquidity that is likely to further depress asset returns. To this point, the $351 billion in reverse repurchase agreements (RRPs) priced last week represents a belated effort by the FOMC to manage this massive cascade of cash.

Not only do we expect to see the Fed make permanent facilities for adding cash and/or collateral to the markets, but we further anticipate that between now and year end, the Fed and Treasury will make structural changes to the markets that allow the US central bank to taper QE and even raise target interest rates without another “taper tantrum.” This includes imposing circuit breakers on money market and other funds to suspend redemptions in times of market stress.

Simply stated, the FOMC does not want to be in a position where it needs to provide liquidity support for money market and other funds should rates need to rise. Indeed, we believe that the central bank, having badly mismanaged the US interest rate equation since last April, will 0be forced to change its monetary policy stance much sooner than the consensus anticipates.

While a change in interest rates will be a positive for the banking sector, the next shoe to drop after the creation of permanent RP and RRP facilities by the Fed will be a Treasury initiative to force all counterparties to clear trades via the clearinghouse. The quid pro quo of providing standing RP and RRP facilities that are open to all banks, dealers and REITs, for example, will be centralized clearing of Treasury debt and agency MBS.

We agree with the views of our colleague Ralph Delguidice at Pavilion Global Markets that this change will essentially bring an end to bilateral trading in Treasury debt, with the attendant decrease in leverage available to dealer banks and their prime brokerage customers. Smaller dealers and investors will benefit, but the market monopoly of the primary dealers will end.

If we think of the RRPs last week by the Fed as the beginning of tapering, then the imposition of centralized clearing will be the death knell for the Anglo-American model of finance, where 80% of trading today is conducted bilaterally. In its place, the US will adopt a European-style model with the central bank at the center and all leverage entirely visible to the clearing house, where the members are joint and severally liable for all trades. Just as we learned in Frankfurt years ago trading for Bear, Stearns & Co, the Bundesbank has a front row seat on the exchange floor.

Source: FDIC

In the 1980s, regulators such as Paul Volcker and William Taylor allowed the largest banks to increase leverage via off-balance sheet financing. As Volcker told us in 2017: "The banks were broke. What else could we do?" The change to centralized clearing of Treasury collateral, however, will reduce leverage and future earnings power for the largest banks. The 100:1 leverage available offshore using Treasury collateral as the catalyst for highly levered trades (as illustrated by the Archegos disaster) will not be tolerated in future.

While some observers doubt such changes will actually occur, we remind one and all that the Fed’s chief concern is keeping the Treasury debt market open and functional. The corollary to this rule is that liquidity stress includes both cash and risk-free collateral, meaning that the Fed will be ready to provide either to the markets in order to keep visible volatility firmly under control. A

Whether interest rates need to rise or fall in the future, the FOMC intends to cut the ends off the risk curve in order to ensure the Treasury’s uninterrupted access to the global capital markets. These changes may seem expedient from the perspective of the Fed in Washington, but have no doubt that the end of bilateral trading in Treasury collateral will negatively impact the US capital markets and particularly bank earnings for years to come.