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August 16, 2021 | Last week, Rocket Companies (NYSE:RKT) reported Q2 2021 earnings. Like the rest of the industry, RKT showed significant slowing of volumes and profitability in the second quarter, with results negatively impacted by rising interest rates and a consumer exhaustion after a torrid year of record loan production. Total loan origination volume for RKT fell 20% to $83 billion in the quarter while EBITDA was cut in half to $1.2 billion vs $2.4 billion in Q1 2021. Gain-on-sale (GOS) margins for RKT fell to 2.78% vs 3.74% in Q1 2021 and a record 5.2% in Q2 2020, reflecting the squeeze on credit spreads that is negatively impacting the entire interest rate complex. RKT’s GOS margins are shown below.
The big question: Will the industry snap back due to now falling interest rates? Of course, defining what we mean by “snap back” requires some discussion. First and foremost, we have the issue of volumes, which lower rates for MBS and new mortgage notes will presumably take care of in due time. Word from the channel is that it took at least a quarter point drop to get the proverbial patient to move in terms of consumer volumes – but move it did in July.
Then comes the question of secondary market spreads, which may continue to tighten as the year progresses. RKT CEO Jay Farner boldly predicted higher lending volumes in 2021, suggesting that the nation’s most efficient producer intends to take market share with both hands:
“We are entering the third quarter with tremendous momentum across our entire platform and we are poised to have a record year across our platform from Rocket Mortgage to Amrock, Rocket Homes and Rocket Auto. I’d like to think about this. Over the past several years Rocket Mortgage has grown volume and taken market share consistently. In 2018 we originated $83 billion in mortgage volume. In 2019 that grew to $145 billion and we ended 2020 with $320 billion in mortgage volume.”
Like Mr. Cooper (NASDAQ:COOP), RKT managed to build its portfolio of mortgage servicing rights (MSRs) even though constant prepayment rates (CPRs) remain in the 20s or higher in the case of RKT. The Detroit-based firm services 2.2 million loans and carries its MSR at a multiple of 3.46x annual cash flows or around 85bp of mostly conventional servicing asset. COOP, by comparison, carries its servicing at 1.1x book or 110bp, which is about right given how fast RKT pools tend to prepay.
Moving to United Wholesale Mortgage (NYSE:UWMC), the firm managed to grow volumes sequentially Q1-Q2, but almost lost money in the process. Second quarter 2021 net income of $138.7 million included a $219.1 million decline in fair value of MSRs as compared to $539.5 million for 2Q 20 including $70.0 million of expenses related to amortization, impairment, and pay-offs of MSRs.
Readers of The Institutional Risk Analyst will recall that UWMC CEO Matt Ishiba, who is a man unafraid to promote his company, had offered to match the price of any loan in the broker channel through the end of June 2021. The result was a $450 million drop in adjusted net income and a two-thirds cut in EBITDA, this as expenses rose almost 10% sequentially. Look for cost cutting in Q2 2021. The table below comes from the UWMC press release.
It is important for readers to remember that UWMC, which is a company incomparable to any other mortgage company, uses non-standard metrics to describe its business. Thus “total gain margin” is not comparable to GOS reported by RKT or other mortgage firms. What we can say is that this measure is down 75% year-over-year (YOY). Needless to say, Mr. Isihiba is no longer challenging other issuers with a promise to match secondary market prices for wholesale loans.
UWMC stepped up the value of its MSRs from cost to fair value in 2021, creating several billion in paper capital in the process. The weighted average coupon on the MSR is below 3% and the unpaid principal balance has grown 150% in the past year with an average age of loans of 7 months. UWMC’s MSR portfolio is 80% conventional loans, high teens government loans and a tiny jumbo mortgage business. The table below shows balance sheet highlights for UWMC.
The firm held $12 billion in loans available for sale at the end of Q2 2021, a 125% increase from the previous quarter. Comparisons with the growth rates for the Countrywide Financial of old are entirely appropriate, but we hear that this crew does not have the capital markets skills of their storied predecessor. That could be good or bad depending on your perspective.
While UWMC reports total equity of $2.6 billion, in fact its tangible equity is half that amount if you subtract the step-up of the MSR valuation, bringing non-funding debt to more than 100% of tangible equity. If you consider that the $1.3 billion in tangible capital is just about enough to fund the credit haircut on the staggering $12 billion in warehouse lines, there is very little left in the cash drawer. But the fact of high leverage does not daunt Mr. Ishiba:
“UWM is built to succeed not only when there is a refi boom and margins are at record highs, but also when margins are compressed and purchase business drives the volume. Consumers are increasingly coming to realize that working with a broker is the cheapest, fastest and easiest way to get a mortgage, and as long as the wholesale channel flourishes, so will UWM as the undisputed leader and champion of the channel.”
Looking at RKT and UWMC, we have two very different perspectives on the mortgage business. Both companies are being buffeted by market volatility and sharp swings in secondary market spreads, but RKT has the broader business model and greater operational efficiency. In terms of MSRs, both firms feel the negative impact of the shift in the Treasury yield curve, which continues to be the biggest factor impacting MSR valuations.
When Ishiba states that UWMC will prosper “as long as the wholesale channel flourishes,” he states the case succinctly. UWMC is the classic bottom-feeder, what we lovingly call the monkfish. His fate will follow conditions in the wholesale channel, which is the first channel to disappear in a rising interest rate environment. Will interest rates rise anytime soon? Probably not, but the market does not care. As a result, look for UWMC to push the envelope in terms of loan purchase volume as Ishiba tries to balance declining profitability with higher volumes. We all know how that story ends.
When Countrywide ran into a brick wall in 2006, Bank of America (NYSE:BAC) as warehouse lender was there to acquire what remained two years later. As and when UWMC runs into trouble due to either interest rate risk or credit expenses, there will be no large bank warehouse lender to catch the fall. Indeed, just to remind everyone how fast things can change in the mortgage finance channel, below is the income statement from Countrywide’s last 10-Q for March 31, 2008, prior to the close with BAC, showing negative revenue.
The growing number of investors who have been burned in mortgage stocks have learned a hard lesson, namely housing is highly correlated to interest rates and particuarly credit spreads. Add quantitative easing to the mix and you get some truly bizare outcomes. If you don’t know what a coupon spread is or how spreads relate to the valuation for MSRs, then you don’t belong in this investment, period. That is why most of the stocks in this sector have been flat to down all year.
Source: Google Finance