This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst.
Last week saw news reports that Quicken Loans is considering an IPO, an exciting prospect for the mortgage sector where private ownership and Buy Side sponsorship tend to be the rules.
Leslie Picker at CNBC broke the story Thursday and says Goldman Sachs (GS), Morgan Stanley (MS), Credit Suisse (CS) and JPMorgan (JPM) are managing the deal, according to the cable business news network.
As we told Robert Armstrong at The Financial Times, there are several other players in the top ten nonbank seller/servicers that could access the public equity market – particularly now that the Federal Open Market Committee has guaranteed a bull market in residential mortgages for the next several years.
Raising equity capital is always a good thing, especially when the profit margins for lenders are the best in a decade and likely to continue.
But the key aspect of public ownership that can truly bring big benefits to nonbanks is the ability to build an investor base for both debt and equity.
By raising term debt funding, nonbanks can diversify their capital structure and add stability to their liquidity profile, even if the yield spreads over risk-free assets are wide in comparison to depositories.
You see, nonbanks like Quicken are more efficient than depositories, a lot more. This is one reason why members of the Financial Stability Oversight Council hate them so. Treasury Secretary Stephen Mnuchin is said to have a special dislike for nonbank lenders and reportedly hopes to see a small servicer fail this year.
Remember, nonbanks make loans and service loans, especially gnarly distressed loans. Big banks buy loans and write loans off. Big difference.
As the largest and most efficient nonbank lender in the market, Quicken is said to seek a technology valuation for its business in the tens of billions of dollars. This type of valuation is justified and reflects the huge capital investment that has made the company the biggest nonbank lender by volume and also one of the best regarded companies in terms of consumer satisfaction and overall reputation.
In any consumer facing business, reputation is the key measure of “capital.”
One of the better operators in the residential mortgage sector says that Quicken going public at a healthy double-digit earnings multiple will open the door to other issuers.
Of course, the best valued stocks in the mortgage sector are the data and software vendors, led by Black Knight Inc (BKI) and Core Logic (CLGX). BKI closed Friday at 5x book and on a 77 price/earnings ratio.
The first mortgage lender in our comp universe is First American Financial (FAF), the $6.1 billion revenue lender based in Santa Anna, CA. At 1.2x book and an 8.5 P/E, FAF is up 25% in the past 30 days and is a consistent performer in a highly volatile industry.
Industry benchmark PennyMac Mortgage Trust (PMT), an externally managed REIT (aka “the balance sheet”), closed just above book value on Friday but with no current P/E, a common problem in the sector due to Q1 losses.
PMT is up 77% in the past 30 days, BTW, but remains down for the last 52 weeks. PennyMac Financial Services (PFSI), which manages PMT, closed Friday at 1.2x book on a 4 P/E. PFSI is up 80% in the past 12 months and +31% in the past month.
As we’ve noted previously, the owners of mortgage servicing assets such as PMT and New Residential (NRZ), a REIT managed by Fortress Investment Group (FIG), took substantial losses in Q1 2020. As with PMT and PFSI, FIG declaims control of NRZ, but the economic and management links suggest otherwise.
Both PMT and NRZ, in fact, puked actual and mark-to-market losses equal to 20% of managed assets in Q1. And FIG, lest we forget, is owned by none other than Softbank and Masayoshi Son, the Korean-Japanese billionaire, technology entrepreneur and investment huckster. And, as we predicted a while back, FIG and friends did come to the rescue of NRZ.
As the FOMC’s massive acquisition of assets has finally calmed market volatility, mark-to-market losses should be far less in Q2 2020.
What these metrics should hopefully suggest to our readers, however, is that equity valuations for nonbank mortgage stocks have snapped back far more quickly than earnings for the owners of loans and other exposures.
The good news is that the mortgage sector is making money hand over fist because of the wide primary-secondary market spreads. The bad news is that owners of mortgages and servicing like NRZ are in a world of pain, an unfortunate circumstance that is likely to continue due to torrid loan prepayment rates.
Unless you are really good at lending and, in particular, recapturing refinance opportunities from your owned portfolio, you are likely to see those mortgage servicing assets literally evaporate in coming months as duration of higher coupon MBS collapses.
Indeed, prepayment rates are so high that we hear that the FHA and GNMA are thinking about prohibiting early buyouts of defaulted government loans. Bad idea. More on this in a future comment.
Comments by Federal Reserve Board Chairman Jay Powell that the FOMC is not even thinking about thinking about raising interest rates basically tells you what you need to know about mortgage volumes for the next three years. But that's not the whole story.
The fact that the big warehouse lenders have throttled back on production of low-FICO loans ensures that late vintage government servicing assets will have the potential to significantly outperform current modeled returns for last year's GNMA 3.5% and 4% coupons.
The good news and the reason that Quicken and other private issuers may try to go public in the next couple of years is that the decline in interest rates is creating a huge opportunity for the industry. And the related increase in mortgage loan prepayments is essentially funding a good bit of the liquidity needed to deal with forbearance under the CARES Act.
Even in the worst-case scenario presented to Urban Institute by Moody’s on June 3rd, the industry does not even break a sweat on liquidity due to prepayment float.
The moral of the story is that while the commercial real estate sector is a slow-motion train wreck, the residential mortgage sector is humming along quite nicely.
Indeed, one lender told The IRA last week that he’d pay 15% for incremental capital today because the prospective gain on sale opportunity is so rich and volumes are straining existing bank lines. See chart below.
Since most of the larger lenders led by JP Morgan have imposed a 700 FICO floor on warehouse lines, lower income borrowers who normally would access the government market via the FHA are essentially SOL. Perhaps that’s what Federal Housing Finance Agency Director Mark Calabria meant when he told Housing Wire that it would be harder to get a loan in the future.
In addition, we hear that conventional lenders are taking dry loans directly to the cash windows operated by Fannie Mae (FNMA) and Freddie Mac (FMCC), this rather than take the risk of another policy curve from the FHFA while a pool is in gestation.
In a world where FHFA Director Calabria can hold press conferences at any moment, time is risk.
Suffice to say that if you look across the world of gestational finance among the major dealers, there is little or no conventional collateral apparent on repo facilities. Call this behavioral change on the part of investors and dealers the result of “policy risk” c/o Director Calabria.
While lenders are a little constrained in terms of funding, this only means that the current bull market in both government and conventional loans is likely to continue for several years. Better loans are being selected for pooling because of tightness in bank funding for government insured loans, yet volumes continue to grow.
Indeed, the strong gravitational pull of low rates – now sub-three percent for consumers – will also reflate the non-QM sector far more quickly than Director Calabria and others who pronounced the death of non-agency loans in April.
Just imagine what will happen to conventional loan volumes as and when the banks start to loosen up on warehouse lending rules regarding FICO, loiter time and other credit criteria.
But in the meantime, the larger, more efficient lenders such as Quicken, Amerihome (a unit of Apollo subsidiary Athene (NYSE:ATH), Mr. Cooper (COOP), Freedom Mortgage and Caliber Home Loans are making a lot of new loans and creating some very interesting mortgage servicing assets in the process.
It is no small irony to say that the low interest rate environment put in place by the Fed to deal with COVID19 is also creating a boom in residential mortgage originations on a scale comparable to the early 2000s that could see the sector significantly recapitalized in coming months.
We believe that Quicken will pave the way for a series of IPOs and acquisitions. Indeed, as and when the Quicken S-1 is dropped, we fully expect to see some private acquisition offers emerge.
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.
