New York | As we head into the bottom of Q3 2020, risk managers and investors face a tough puzzle. Financial markets have rebounded to the point where all-time highs are within reach for some equity market benchmarks, but fundamentals like earnings and lending volumes are weakening in most of the financial sector. And even with the record volumes of mortgage loans sold in June and July, risk remains a large factor for bond investors due to torrential flows of loan prepayments.
Mortgage Sector
We’ve noted that the sector known as Mortgage Originators and Servicers outperformed most major indices in July, this according to a note by KBW. This was in part due to the successful IPO by Rocket Companies (NYSE:RKT). But more to the point, interest rates are low and likely to stay that way for years to come, at least listening to the statements coming from the FOMC. We look for continued strong volumes and earnings from nonbank mortgage issuers.
Lending has started to decelerate slightly from the torrid levels of June and July, when total issuance of mortgage-backed securities exceeded $350 billion, a record going back more than a decade to the mid-2000s. The chart below shows the latest data from the Federal Reserve on bank lending. Notice that nonbanks, which are driving much of the growth in mortgage lending, are not included.
Source: Federal Reserve
Mortgage lending by commercial banks actually fell in June overall, but nonbank production surged. Bulging new issue pipelines of nonbanks kept the issuance side of the equation humming along even as commercial banks have stepped back from correspondent channels. The chart below shows total debt issuance by SIFMA, which includes non-bank production in the total mortgage issuance (green line).
Yes, in July 2020 the US mortgage industry printed $350 billion in new MBS. The only negative in the first half of August 2020 was the bad decision by Federal Housing Finance Agency Director Mark Calabria to impose a 50bp fee on loans purchased by Fannie Mae and Freddie Mac, this to offset the supposed risk posed by mortgage refinance loans. The Trump White House immediately criticized the action as being "bad for consumers."
“The mortgage industry exploded with outrage late Thursday night after being greeted with the news that Fannie Mae and Freddie Mac, come Sept. 1, would begin charging their seller/servicers a 50 basis point 'market condition credit fee' on most refi products,” reported Inside Mortgage Finance.
Think of the change that takes effect September 1st as a tax. FHFA chief Mark Calabria is effectively confiscating 1/3 of the 150bp or so in net profit on retail mortgage business, but most of the 70bps or so on correspondent. Indeed, some smaller conventional lenders will lose money on every correspondent loan.
As market participants know very well, refinanced loans tend to perform better, especially when LTVs are falling due to strong home price appreciation. Indeed, we suspect that strong home prices are one reason that default rates are running below our worst-case scenario. When borrowers get into trouble, they simply sell the house and take the net equity off the table.
The FHA change will severely impact the correspondent business needless to say, because a 50bp tax pushes many correspondent lenders out of the market entirely. One wonders if the FHFA considered the economic impact of their actions. We suspect that Calabria's hasty action was driven by a need for cash.
“Housing… may be the most government owned and controlled of any industry in the country or even the world,” notes Dick Bove at Odeon. “This system is now running into difficulty. The recent increase in a GSE refi fee indicates this. It is my belief that this fee is being levied to cover loan losses and, therefore, it will not go away. It is unlikely to result in big profit gains that are not offset by other costs.”
We concur with Bove’s analysis and believe that the government-controlled GSEs, Fannie Mae and Freddie Mac, face a capital squeeze in 2021 as they are forced to finance COVID-19 related forbearance and also actual default activity. You won't find any conventional collateral in most commercial bank warehouse lines or repo programs, and for a reason. But in the event that Joe Biden wins in November, the privatization of the GSEs will be off the table.
The fact remains that interest rates will continue to drive strong mortgage lending volumes, helping banks, independent mortgage banks and the GSEs offset pandemic related operating costs. If you look at the mortgage sector, the exemplars such as Mr. Cooper (NASDAQ:COOP) and Penny Mac Financial (NASDAQ:PFSI) are up 100% over the past year and mid-double digits over the past month.
Add RKT to the leadership group in mortgage finance in terms of lending and also operational efficiency. RKT Friday released an estimate of the firm’s second quarter earnings number at $3.46 billion. The largest non-bank issuer of residential mortgages in the US disclosed an extraordinary gain-on-sale margin of 519 basis points for Q2 2020.
Private issuers such as Amerihome, a unit of Athene (NYSE:ATH), Caliber, and Freedom will also benefit from continued low MBS yields and wide primary/secondary spreads.
After these hyper-efficient issuers in the mortgage space come data providers CoreLogic (NASDAQ:CLGX) and BlackKnight (NYSE:BKI). Both of these quasi-monopoly providers of mortgage data and servicing tools give investors exposure to the mortgage sector, but with less cyclicality in terms of credit.
Looking at the rest of the group, REITs such as New Residential (NYSE:NRZ) and Two Harbors (NYSE:TWO) have rebounded, but still trade at significant discounts to book value – and for a very good reason.
We continue to be concerned about the effect of strong MBS prepayments on investors such as NRZ, who have abysmal rates of retention on their servicing portfolios. The FHFA change regarding refinancing will hurt NRZ and conventional correspondent issuers like Penny Mac and Amerihome. As we’ve noted previously, we expect primary-secondary market spreads for residential mortgages to remain very attractive for issuers like RKT, COOP and PFSI.
As one leading industry MSR manager told us last week, the rich primary secondary spread (consumer loan coupon minus the MBS debenture rate) ensures that most of pre-2020 MBS vintages will prepay. "We'll see 2.5% loan coupons," the manager continues with considerable amusement. He reckons that 2.5x multiples are reasonable for new MSRs, but worries that holders of legacy product will take losses on soaring prepayments.
This view suggests to us that holders of MSRs that lack the ability to generate new assets vs retention are in big trouble. We expect to see lending volumes slow somewhat for the balance of 2020, but we note that the MBS volumes through July put the US mortgage market on a run rate to exceed $3 trillion in production in 2020.
Mortgage Group: ACGL, AGNC, AI, BKI, BXMT, CIM, CLGX, COOP, ESNT, FAF, FBC, FMCC, FNF, FNMA, IMH, LADR, MFA, NLY, NRZ, NYMT, OCN, PFSI, PMT, RKT, RWT, STWD, TWO
Please email info@rcwhalen.com if you have questions.
Banking Sector
The US banking sector has rebounded since the end of May, but has recently given back some ground as analysts reluctantly start to focus on the fundamentals. Many banks are raising overhead and headcount even as lending volumes and liquidity falls. We look for a general increase in efficiency ratios, meaning less operating leverage, in coming quarters.
In June, the Federal Reserve reported that bank lending overall fell by double digits compared with May. Bank liquidity also fell sharply as the deposits created by the open market intervention by the Federal Reserve Board have begun to run off. The cost of funding has fallen sharply since the start of Q2 2020, but we worry that the decrease in asset returns and increase in credit expenses will start to take its toll on investor perceptions.
Source: FFIEC
The bank group tracked by The IRA is up for the past month, but mostly down double digits for the year so far. Some of the exemplars in the group are shown below with price to book value (P/B) and % change year-to-date (YTD):
Source: Bloomberg
At present, the financials group is being supported by investor appetite for assets and the fact that the FOMC is purchasing all of the Treasury’s net issuance and a large portion of the agency MBS issuance. We note that bank valuations were significantly higher at the end of 2019. Once worries about earnings and dividends subside, look for bank valuations to rise.
The resulting dearth of quality assets is driving liquidity into stocks, even stocks that have weak or no outlooks for earnings. The proliferation of story-company, zero revenue SPACs is a cautionary sign. There seems to be little connection between earnings estimates, which are pretty dreadful for the entire group, and current market valuations and credit spreads.
The situation facing many large banks, for example, is rising operating expenses and falling revenue. As a result, we have sold all of our common equity exposure in banks and have increased our preferred holdings.
The good news is that the outlook for defaults in areas such as residential mortgages is improving, but there is still precious little visibility on credit expenses for the rest of the banking industry balance sheet. Commercial foreclosures in hospitality and retail assets will be accelerating as the year progresses.
As the year moves forward to a close, we expect that institutional investors will continue to hold bank stocks in the hope that they will be positioned to enjoy the inevitable return to pre-2020 valuations. There will be little comfort for investors coming from actual earnings, however.
We expect bank earnings to significantly under-perform the Street’s admittedly rosy assessment. JPMorgan (NYSE:JPM), for example, is estimated to see revenue down single digits in 2020, but the Street still has earnings up in 2021.
Bank stock valuations may move higher in the near-term. But common stock dividends are in increasing danger in several cases due to rising credit costs as the industry heads for a significant credit loss event in the fourth quarter of 2020. Then comes 2021, which could actually be worse in terms of absolute dollar loss and also loss given default (LGD). We expect LGD for total loans to turn sharply higher as the year grinds to a finish.
Source: FDIC/WGA LLC
Bank Group: AXP, BAC, BK, C, COF, DB, DFS, FRC, GS, HSBA, JPM, MS, OZK, PNC, SCHW, TD, TFC, USB, WFC
Please email info@rcwhalen.com if you have questions.
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