This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
Last week, financial markets wiped out about a quarter of the market value of large US banks and nonbank companies. One of our core holdings, U.S. Bancorp (USB), closed Friday just shy of 1.6x book vs over 2x only a couple of weeks back. When USB goes below 1.5x book, we’ll be nibbling again.
In a funny way, as we said on Twitter last week, the coronavirus or COVID19, took some excess air out of the obvious bubble in US equities. This market wanted to go down, but did not know how. Thanks to Uncle Xi Jinping and COVID19, Federal Reserve Board Chairman Jay Powell’s problem is fixed for now. Yet the low level of interest rates remain both an immediate opportunity and also the most important long-term problem facing the US banks and the broader financial sector.
First the good news. Last year, thanks to lower interest rates, was the best year in mortgage lending and secondary market sales in half a decade with over $2 trillion in production. Refinance volumes actually exceeded purchase loans in Q4 2019. And 2020 is looking to be another record year in terms of both volumes and profitability, this even as loan loss rates continue to be muted due to low interest rates. JPMorganChase (JPM), for example, reported strong results in mortgage banking for the past several several quarters.
But with the rising volumes comes risk in terms of home price appreciation. The chart below shows loss given default (LGD) skewing sharply negative for bank owned multifamily loans, a pattern that is shared with LGDs for residential loans, construction and development loans, and home equity loans (HELOCS). These outlier indications of negative credit costs harken back to 2005. Then as now, negative LGDs for residential real estate suggest that monetary policy is too accommodative and that home price inflation is actually quite high.
“JPMorgan Chase & Co. is shifting workers to handle an expected surge in demand for home loans as the American housing market looks forward to its strongest spring in at least a decade and the coronavirus sends mortgage rates lower,” reports National Mortgage News. Indeed, the entire industry is gearing up for a big year in terms of both purchase and refinance transactions, with a bumper crop of new mortgage servicing assets awaiting financial investors.
Indeed, as we reported earlier in The Institutional Risk Analyst, both JPM and Citigroup (C) are said to be keen on re-entering the correspondent channel in a serious way, part of a larger trend that is seeing commercial banks regaining market share in residential mortgage aggregation and servicing.
As we prepare The IRA Bank Book Q1 2020 for publication later this week, there are a couple of key takeaways regarding the mortgage sector from the Q4 2019 data from the FDIC. In particular, Q4 2019 actually saw bank sales of mortgage notes with servicing retained rise above $6 trillion for the first time in almost a decade, again signaling a renewed interest in correspondent lending and servicing on the part of several large banks including JPM, C and others. Of note, the unlevered yield on the $38 billion in bank owned mortgage servicing assets in Q4 2019 was over 9%, as shown in the chart below.
Another positive data point for bank mortgage banking: The nonbank share in mortgage servicing actually declined in Q4 2019, this as bank sales of residential mortgage backed securities (RMBS) surged. In particular, Q4 2019 actually saw sales of mortgage notes with servicing retained rise $20 billion, the first time in almost a decade bank RMBS securitization volumes have risen.
While the banks are re-entering the market as aggregators and sellers of correspondent loans into the agency and government RMBS market, the nonbanks remain the predominant originators of loans. And with the surge in lending volume driven by falling interest rates will also come a surge in loan prepayments on existing mortgage securities.
Last month, our friends at SitusAMC had capitalization rates for new production conventional 3.5% coupons indicated at 5x annual cash flow, a valuation that now is rendered stale by February’s frantic equity selloff and interest rate rally. Maybe 3-4x? As with the MBA production volume estimates for 2020 and beyond, we expect to see significant revisions to prepayment rates for premium coupons in coming days.
Now the bad news, of sorts. Even as volumes for residential mortgage loans surge in 2020 and beyond, the rest of the bank loan book is being squeezed. Yes, the wild rise in bank interest expense has stopped and reversed down below $40 billion per quarter. The trouble is, interest earnings are falling faster, and thus net income for US banks fell again in Q4 2019.
Returns on earning assets, one of the most basic measures of aggregate bank profitability, are again falling under the dead weight of quantitative easing (QE) and panic buying of risk-free assets. We’ll discuss this troubling trend in detail in the new edition of The IRA Bank Book.
The forward scenario for residential mortgage risk kinda looks like this. Falling rates cause a surge in residential mortgage production in 2020, but the disruption due to COVID19 is so pronounced that the US economy slips into recession. The FOMC responds with even lower interest rates, causing yet another manic surge in mortgage refinance and purchase loan production in 2021-22. RMBS coupons will fall into the low 2s, but then comes the punch line after 2022: a larger than expected upsurge in credit costs.
After almost a decade of FOMC-suppressed credit default activity, the LGDs in the $11 trillion portfolio of residential mortgages will skew in the other direction. We suspect the rate of change in visible default rates will be considerably faster than in past cycles. Defaults will occur at both ends of the mortgage credit stack, including the high-end, prime jumbo production that is now trading well through the TBA curve.
And with the industry and many large institutional investors in the residential asset class leveraged to the rafters, the cost of distressed servicing will come as a very unpleasant surprise to some investors. Large Buy Side players who think that they own cash flows attributable to specific mortgage servicing assets via participations may also be surprised, in the event of servicer default or forced sales. Read the fine print.
And the mortgage industry will see another wrenching process of distressed loan resolution and also consolidation among nonbank mortgage companies and REITs. The nonbank servicers will clean up the mess as the commercial banks happily provide the financing. And life will go on.
But the next couple of years in residential mortgage lending and servicing could be a very profitable and also quite volatile ride indeed.
ABOUT CHRISTOPHER WHALEN
Christopher Whalen is the 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.
