A number of analysts have speculated on whether the upcoming IPOs for a number of mortgage lenders will be completed. The good news is that business volume across the industry is excellent and is expected to continue at least through 2021, albeit with falling spreads.
The bad news is that the Federal Open Market Committee is stepping on the gas on market intervention, which means prepayment rates are likely to remain elevated. As Rocket Cos. Reported profits, they found that the fair value of the company's mortgage service rights had actually declined slightly over the past nine months despite the record loan volumes.
"In the third quarter, we achieved a record $ 89 billion in closed-end credit, up 122% year over year," said Jay Farner, CEO of Rocket, to investors. "The growth we are seeing is unmatched in the third quarter. We added nearly $ 50 billion in closed-ended loan volume year over year. Keep in mind that our incremental volume in the third quarter is so large that we alone are the second largest mortgage lender for private customers in the nation. "
During the monthly call to discuss the secondary market for MSRs, the SitusAMC staff noted that the Fed has been buying 1.5% coupon bonds from Ginnie Mae and USB for several weeks. Since most lenders are still delivering new loans in pools with 2% or even 2.5% coupons, this suggests that many of these loans will be prepaid again over the next 12 to 24 months.
For mortgage lenders like Rocket, who brag about customer retention rates in excess of 80%, high prepayment rates are a way to increase revenue, and especially revenue from sales. As we wrote in NMN in September ("Banks are withdrawing from the housing service"):
“The only sensible strategy for holding MSRs is to be very aggressive in protecting service assets by withdrawing credit. This is one of the main reasons banks have been willing to give up their stake in lending and services as they resort to retail lending-only strategies. "
When Rocket was forced in the markets to drop its share price from $ 22 per share to $ 18 in August, it was the first indication that the independent mortgage lenders with stock managers were facing a tough sledge. IMBs are pretty much fixed income stories, after all, best used to raise long-term capital in the debt markets.
The fact is, IMBs like Rocket, PennyMac, and Mr. Cooper are good enough to defend the value of the MSR by replacing it with new service assets. For other MSR holders, including IMBs, commercial banks and REITs, the FOMC’s recent moves to further juicing volume in the housing sector pose a serious threat to the return on investment in whole loans, MBS and MSRs.
But of course the FOMC isn't the only problem for these investors. Ginnie Mae 3% Coupon MSRs with a 5-fold annual cash flow or around 150 basis points (32 basis points per year x 5) were already activated in October 2019. Today, those same 3% coupon MSRs are capitalized by Ginnie Mae with 3 times the annual cash flow (or 90 basis points), and that figure is still too high given the apparent prepayment speeds.
"The price multiples are too high compared to the current environment," says one of the most respected CIOs in the mortgage industry on Ginnie Mae MSRs. “The risk has increased much faster than the risk-free rate. It is possible to lose MORE than investing in a Ginnie Mae MSR. "
The mortgage lender tells NMN that expected default rates, especially for low FICO borrowers, are well below realistic levels. Most of the time, he claims, MSR brokers ignore FICO scores on government loans and seem to accept a borrower of a much higher quality for FHA than actually exist.
In theory, the fair value of the remaining portfolio can increase ahead of time over time as MSRs with higher coupons and faster rates pay up front as the portfolio has a larger percentage of lower coupon assets left. At the same time, the measures taken by the FOMC and the increasingly competitive environment for credit are leading to prepayments across the range of coupons.
For investors like banks, REITs, central banks, and mutual funds, the prospect of continued high loan prepayment is a major concern. Just as some investors take losses on MSRs purchased 3 and 4 times a year ago, government MBS holders are seeing negative net returns on their investments. The screaming you hear in the distance is the Bank of Japan calling Fed Chairman Jerome Powell.
Various media have described the delay in IPOs by mortgage banks as a result of "market volatility". In reality, however, investment managers are smarter than investment bankers claim. If you look at the fact that coupon spreads have narrowed by 25 basis points in the last month, you'll find that profits per new loan decrease as industrial capacity catches up with demand. Remember, when it comes to profits for IMBs, REITs, or commercial banks, it is all about spreads over funding, not interest rates.
It doesn't take a genius to realize that the boom in mortgage lending is due to low interest rates and aggressive asset purchases by the FOMC. These purchases will continue to support record new loan volumes, but with declining profits and overall declining credit quality. And if the new volume of credit declines despite the FOMC's actions, the swarms of credit and operational risk lurking just below the surface will emerge.
As all mortgage lenders know very well, the good times end after all.