Mortgage industry liquidity risk returns

By any measure, the past 24 months have been a roller coaster for the residential mortgage industry. In June 2020, the Fed was buying billions of dollars per day in Treasury debt and mortgage-backed securities, driving rates below 3% and pushing lending volumes for the year to record levels. Two years later, those rates touched above 6% and issuance of all new mortgage paper is now at a run rate half of 2020’s or below $200 billion per month.

A year ago, the industry was concerned with mopping up most of the remaining mortgage loans in COVID forbearance. It was unconcerned with liquidity because prepayments on refinanced loans were still floating the cost of financing COVID on a sea of interest-free money. Today warehouse and advance lines are a real and growing expense to issuers.

Two years ago, loans were profitable when they closed and were earning gain on sales margins of three and even four percentage points, a bonanza that helped to offset the cost of helping consumers hurt by COVID. While this is unfair to lenders and servicers, it is better than not having a COVID payment moratorium and instead having a 2008 foreclosure explosion on government-insured loans.

A year ago, issuers and funds were buying up delinquent loans out of Ginnie Mae pools (also known as early buyouts) to reap the same fat GOS margins on reperforming or modified loans. Today many issuers that were too slow on the sales trigger are sitting on delinquent loan positions that could result in significant losses.  

Likewise, the prospect of modifying EBOs into 40-year terms promises big losses to government servicers. Overall, the EBO trade could cost the mortgage sector billions in losses in the second quarter with Ginnie Mae 2.5s mortgage-backed securities trading at 90 and change in the To Be Announced market. One prominent banker told NMN: “What do we do with a delinquent FHA loan modified into 40 years? We keep it.” 

With the cost of servicing rising and profits from lending falling, the mortgage industry is caught in a very bad place. Credit spreads on bonds issued by the larger independent mortgage banks are back to high-yield levels after improving dramatically during 2020 and 2021. The magnitude and speed of the move in interest rates since January has the industry back on its heels.

“Originations drove earnings, then servicing markup, now what?” asked Kevin Barker of Piper Sandler in a research note about New Residential Investment. “Over the past several quarters prior to 1Q22, [tangible book value] declined $0.27/share and then popped $1.11 as New Residential marked up the MSR. Going forward, New Residential will see some tailwinds from lower [MSR] amortization expense, but we do not anticipate it will be enough to offset the large drop-off in origination earnings.”

Barker’s assessment of the largest IMB owner of mortgage servicing assets could be applied equally to the rest of the industry, who have gone from a feast of nearly unimaginable proportions back to a Darwinian market. The conventional loan market is characterized by overcapacity and loss-leader pricing behavior by inferior lenders that have not yet shut off the lights. Until capacity and demand come back into balance, profits in conventional mortgages will be difficult. 

The speed of the change in market perception of trends in interest rates has translated into increased volatility in the loan market and for MBS and servicing rights. Bids for lower coupon distressed loans have fallen, making hedging these assets expensive and often ineffective. NMN’s Bonnie Sinnock reported on the growing trend of passive investors participating in MSRs, but notes that there is considerable risk involved. 

Unlike two years ago, when the surge of refinance loans created a vast pool of free financing for the industry to use, today lenders must pay for liquidity by the drink. To the extent that delinquent loans or troubled servicing books require liquidity support, particularly in the Ginnie Mae market, the demand for cash may start to consume the available resources of many issuers.

While the industry watches production margins fall into low double digits, it is notable that many of the more aggressive buyers of MSRs in 2021 are now looking to sell. That includes a number of banks that have seen the marks for servicing push them near the limit for MSR holdings under Basel III.  

It is fair to say that those community banks and credit unions that paid up for Ginnie Mae servicing in the second half of 2021 could not sell those assets at the current fair-value mark today. Some analysts say that prepayment rates on vintage Ginnie Mae MBS 2% and 2.5% coupons will fall into low single digits, but the actual experience is likely to be closer to 10%, says one third-party advisory firm.

A difference of a few percentage points in prepayment speeds can mean the difference between profit and loss on a Ginnie Mae servicing asset. The truth is that astute buyers of MSRs that are lenders can make money in this environment, but investors less so. The service providers are under intense operational and financial stress and will likely see these levels of pressure only increase. 

In an effort to find reasons to further boost MSR value, a number of issuers and funds are reportedly using assumed revenue from cross-selling opportunities to customers acquired via MSR purchases. A number of other banks have been purchasing conventional MSRs at multiples approaching 6 times and, again, are referring to cross-selling opportunities to justify MSR valuations. 

These reports are troubling but not surprising. The flow of credit into MSRs is only increasing marginal demand. Of note, Bank of Montreal and BNP Paribas have jumped into the market for lending on MSRs and several large regional banks including Fifth Third Bank decided to jump into mortgage warehouse lending just as mortgage origination volumes were peaking. But a surfeit of lenders does not ensure adequate liquidity.

As operating cash becomes more challenging for the mortgage industry, federal regulators led by Federal Housing Finance Agency Director Sandra Thompson have an opportunity to get ahead of a problem before it becomes acute. Thompson has already taken ownership of the government loan market by including different capital requirements in the FHFA’s proposed issuer eligibility rule. Time to go from ownership to leadership. 

Whereas the sounds of fear and panic heard among IMBs in May 2020 turned out to be false alarms, the liquidity stress facing the mortgage industry today is real. The true scope of the threat will soon be manifest in falling bids for legacy loans and MSRs. This time around is not just different from 2020, but it could be the worst year the industry has seen in a decade. 

At a minimum, the FHFA needs to raise with the Financial Stability Oversight Counsel the need for a liquidity backstop for government lenders. Moreover, the FHFA ought to explore immediately reopening Federal Home Loan Bank membership to IMBs with a regulated insurance or broker/dealer affiliate. The issue here is not capital, but access to liquidity in a time of disappearing loan collateral. 

The Biden administration needs to merely raise awareness of the liquidity issue and indicate that a response is in process to growing pressures on IMBs. The FSOC must state that they are aware of the pressures caused by a change in Fed interest rate policy and are prepared to act to address liquidity needs in the government loan market. The banks will take this as a positive sign and continue to lend. Problem solved — for now.