Washington Trip Notes; Mr. Cooper & PennyMac Financial

July 28, 2023 | Premium Service | This past week The Institutional Risk Analyst was in Washington, D.C. for meetings in the mortgage and banking channels. Suffice to say that with interest rates rising, career officials in the Executive Branch are preparing for an eventual market break as the federal deficit explodes.

“The last Treasury Secretary that tried to extend the maturities of government debt was Jack Lew (2013-2017), but Secretary Janet Yellen missed a big opportunity,” says a senior career official. The chart below shows the interest expense for the federal government.

The official reckons that the FOMC has perhaps a year to finish its inflation fight before rising funding costs become a critical issue for the Treasury. Sources at UST worry that ability to extend maturities at current yields is limited and that short-term funding strategy could "break" forcing longer yields higher.

Meanwhile, a number of investors have been concerned that the Financial Stability Oversight Council (FSOC) might designate large fund managers or mortgage servicers as "systemically significant."

Our sources at UST and OMB say there is no initiative for a SIFI designation on IMBs and/or funds coming from Secretary Yellen. UST staff are protective of the agency's authority in this area and do not see any request coming from Fed or OCC at this time.

CFPB's Rohit Chopra has been most vocal on the issue of systemic risk and could float a proposal to name nonbanks as “systemically significant," but Yellen Fed, OCC, FDIC must support.

As we noted previously, FSOC like the FOMC is not a policy making body. Unless the head of a member agency with purview over systemic risk makes a request for action, nothing is going to happen. The WH has shown zero support for or interest in FSOC action on IMBs, a necessary precursor. The WH (Lael Brainard) is not even engaged on Basel bank proposal or housing.

Mr. Cooper

This week a number of nonbank mortgage firms reported financial results. Mr. Cooper (COOP) reported strong earnings driven by rising servicing revenue, even as lending volumes surprised on the upside. COOP is approaching $1 trillion in mortgage servicing, placing them just behind JPMorgan (JPM). COOP’s origination’s generated positive income, illustrating the low cost of the direct-to-consumer channel at COOP. The graphic below is from the Q2 2023 presentation from COOP.

We have written positively about COOP in the past, but don’t own the stock because WGA acts as an advisor currently. We view COOP as one of the best managed firms in the world of mortgage finance. We like the superior operating efficiency and the focus on direct to consumer (DTC), which allows COOP to control the cost of loan acquisition. Our current portfolio is shown below.

A number of issuers had relatively good volumes in Q2 2023, pushing up net issuance of MBS above Street estimates. “June’s pickup in net MBS issuance — at $30.3 billion — was a “bit surprising” and as that supply is historically back-loaded, is a negative when it comes to the supply and demand picture for mortgages, Morgan Stanley (MS) analysts Jay Bacow, Zuri Zhao and Janie Xue wrote, Bloomberg reports.

PennyMac Financial Services

PennyMac Financial Services (PFSI) also reported earnings, with positive results in lending and servicing. PFSI’s servicing book is only half the size of COOP, a significant point of differentiation between two market leaders. PFSI reported that production revenue margins were higher in all three channels, but PFSI saw correspondent volumes and related decrease in PMT correspondent volumes from the prior quarter due to a higher proportion of conventional loans sold to PFSI by its companion REIT, PennyMac Mortgage Trust (PMT).

Of course, many large issuers are deliberately reducing conventional production because of fear of putback claims from the GSEs, but with loan delinquency still falling PSFI is taking all of the volume that it can. PFSI took a $118.9 positive non-cash mark on its MSR, but reported a large, $155 million in cash loss on the interest rate hedge. The graphic below is from the Q2 2023 PFSI presentation.

Looking at PFSI, the firm has only reduced operating expenses by about 7% over the past year. PFSI's benefits from the fact that correspondent volumes are growing as an overall percentage of industry volumes. But the fact remains that net revenues are down and, like many lenders, PFSI is betting that delinquency rates and related expenses will remain low and that the Fed will reduce interest rates sooner rather than later.

A careful examination of the balance sheet of PFSI shows a sharp increase in liabilities for loans eligible for repurchase since Q2 2022, part of a larger industry trend of allowing delinquent loans to remain in MBS pools for extended periods. An increase in loan delinquency could impose sharply higher expenses on PFSI and other large Ginnie Mae issuers.

As one reader commented earlier: "The irony of the Fed increasing capital requirements on banks well north of ten percent the same day that PFSI demonstrates you don’t need capital for a $260 billion loan portfolio is killing me."

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