The guest commentary below was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
The Mortgage Bankers Association Secondary Expo is always one of the more important events of the year for the housing finance industry and 2018 was no exception. MBA Chief Economist Mike Fratantoni delivered the expected bad news that the industry slipped into net loss on new loan origination for the first time since 2014. Soaring regulatory costs and shrinking spreads are the culprits.
But the industry remains upbeat. Rob Chrisman summed it up:
“I know many owners and CEOs of residential lenders… and would never bet against their success. They represent a very savvy, entrepreneurial, and street-smart group of individuals but are faced with many risks, with LO comp, technology, housing inventory, and shrinking margins in the forefront.”
We could not help but be impressed by the innovation on display at the MBA event. A number of mortgage lenders are getting into new areas of credit such as “business lending” (aka funding fix n flip strategies) and other short-term credits. Reverse mortgage lenders are getting into forward jumbo lending, while jumbo shops now want to do reverses. REITs are buying lenders and old mortgage bankers are spawning new REITs. And there is even talk of non-bank construction and development (C&D) lending.
The fact that the likes of Goldman Sachs (GS), Zillow and Redfin are in the market for financing fix-and-flip projects and single-family rentals gives some investors confidence. And yes, the market has grown significantly. But we worry the Bernanke-Yellen monetary joy juice known as "QE," which has pushed up home prices by multiples of the supposed PCE inflation rate, is behind this surge in demand for home improvement loans. Cool off the home price appreciation and this new credit market chills out as well.
To give you an idea of the level of frenzy in bank C&D lending, in Q1 '18 US banks reported a negative cost of credit for this $350 billion asset class. Somehow we can’t see the opportunistic diversification into business lending ending well. And the fact that GS has decided to add fix n flip to crypto currencies in its portfolio of BIG IDEAS is most definitely a concern.
Lending on collateral like a residential home is a far better of a business than unsecured lending to small, often unincorporated businesses focused on home flipping. Some shops will lend 90% on the purchase of the spec home and then fund 100% of the improvements on the asset as well. As and when home prices stabilize in high value MSAs, the rationale behind this business will evaporate.
There are certainly signs that the credit market for residential exposures had matured. With the collateral under the residential mortgage sector showing continued signs of being “too good to be true,” loss rates actually rose in Q1 ’18 to 27% after falling into the twenties a year ago. This rate of loss given default (LGD) is still among the lowest levels seen in almost half a century for bank owned residential loans, as shown in the chart below. The average LGD for bank RESI loans going back to the early 1980s is 66%, of note.
Gillian Tett of the FT last week became the latest financial writer to call US housing a bubble. Tett confirms that the Federal Open Market Committee has manipulated US real estate prices to the point where a messy correction is inevitable. The downward skew in loss rates over the past several years certainly supports that view, but nobody on the FOMC seems to want to talk about real estate prices and how racing valuations have outrun conventional measures of inflation much less potential home buyers.
National Association of Realtors (NAR) released a summary of existing-home sales data showing that housing market activity this April fell 2.5 percent from last month and dropped 1.4 percent from last year. The MBA has total loan origination flows basically flat at $1.6 trillion annually through 2020. In markets such as New York, Austin and San Francisco, volumes in high end properties are softening. Luxury prices in New York actually peaked several years ago. Tett writes:
“But estate agents say that sales volumes in the first quarter of 2018 were at their lowest level for six years. Meanwhile the median price per square foot was 18 per cent lower than a year earlier, according to some reports. That leaves Manhattan estate agents nervously gossiping about the local outlook. However, it should prompt investors and policymakers to ask a bigger question: could New York’s jitters herald declines in other non-US real estate markets too?”
Ditto Gillian. In fact, the increase in loss rates on 1-4 family loan defaults is not yet mirrored in actual rates of default and delinquency. Past due bank owned loans at 2.5% is at the lowest level since Q4 ’07, an unfortunate yet accurate historical coincidence. A decade ago as today, credit seemed to have no cost and banks were reporting negative rates of loss. That situation pertains in the $400 billion portfolio of bank owned multifamily loans, where recoveries continue to exceed cash losses due to the huge price increases in this popular asset class. The rates of delinquency and charge offs are near zero for bank owned multifamily loans, as shown in the chart below.
Most of the operators we polled think that the low profit margin environment in residential lending will persist for years, even as sales volumes flatten out. Of interest, the MBA has purchase mortgages growing steadily in its loan production estimates, while mortgage refinancing volumes steadily fall.
Obviously mortgage refinancing is less attractive in a rising rate environment, But will home purchase transactions continue to grow in the post-QE world? This is the key question that will validate – or not -- expectations for businesses operating in the world of mortgage finance.
No surprise then that yields for both conventional and government-insured mortgage servicing assets are trading briskly in single digits. During our discussion of mortgage servicing rights (MSRs), one of the panelists wondered if it would not be possible to see mortgage prepayments drop even below current low levels.
The upward movement in prices for MSRs over the past year has been striking, with cash flow multiples for conventional MSRs north of five times annual cash flow and new issue GNMA MSRs in the mid-threes compared to half that level twelve months ago. This year marks five years running that yields on MSRs have fallen, a process now accelerating due to rising interest rates.
Seth Sprague of Phoenix Capital told the audience that institutional cash focused on the MSR market has surged over the past year. “Liquidity has basically doubled along with the number of buyers compared to a year ago,” he noted and added that rising interest rates are making the escrow balances associated with MSRs increasingly valuable along with the expectation of low prepayment speeds.
Mark Garland from Mountain View said that “We’ve all talked a lot about non-banks growing market share. We are starting to see the banks coming back to the MSR market. Banks are being very competitive. And we’ve seen new shops come to the marketplace. We traded a deal recently where the 30 year [cash flow] multiple went above 5.5 times. That would have been unimaginable six months ago.”
As the mortgage industry struggles with the “benefits” of quantitative easing and ultra-low interest rates, current and former Fed officials travel around the country congratulating themselves on their cleverness and engaging in chest pounding demonstrations over the profits earned via QE -- profits that should have gone to private investors but instead were remitted back to the Treasury.
Sadly for Bernanke, now the FOMC's System bond portfolio is badly under water to the tune of tens of billions of dollars. In fact, QE resulted in the transfer of trillions of dollars in income from private investors to the state and created grotesque distortions in asset prices like stocks and real estate. The acceleration in MRS valuations over the past year is as much about rising interest rates as it is due to Fed market manipulations.
Instead of boosting job growth and home affordability, the good citizens at the Federal Reserve have through excessive regulation and QE engineered scarcity of homes and a declining market for mortgage finance – precisely the opposite of the goals they pretend to pursue.
One thing that is pretty clear though is that over the past five years the cost of buying a home has soared faster than the official inflation rate, a fact that is likely to result in thousands of job losses in the mortgage sector over the next year and more. Consolidation is the name of the game in the world of mortgage banking, driven by sharply increased operating costs, falling loan origination profits and rising interest expenses.
The concern of course is what happens when home prices inevitably weaken. Martin Feldstein, writing in the Wall Street Journal, warns similarly for stocks but would likely also add a bubble in housing to the list of FOMC accomplishments:
“Year after year, the stock market has roared ahead, driven by the Federal Reserve’s excessively easy monetary policy. The result is a fragile financial situation—and potentially a steep drop somewhere up ahead.”
EDITOR'S NOTE
This Hedgeye Guest Contributor piece was written by Christopher Whalen, author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.
