This is a syndicated repost published with the permission of The Institutional Risk Analyst. To view original, click here. Opinions herein are not those of the Wall Street Examiner or Lee Adler. Reposting does not imply endorsement. The information presented is for educational or entertainment purposes and is not individual investment advice.
October 28, 2021 | On January 1, 2022, the state and federal moratoria on residential home foreclosures will end. The relative quiet that has prevailed in the market for 1-4 family loans will also likely conclude, ushering in a new period of regulatory danger for mortgage servicers. Illustrating the mounting risk, the Office of the Comptroller of the Currency issued a consent order with Cenlar FSB, the largest loan sub-servicer in the US. Below are some thoughts on why this event is important to both mortgage lenders and servicers, and the investors in this sector.
- This CO for Cenlar contains a laundry list of issues many banks and mortgage servicers have seen in the past. That said, this action is the most stringent order applicable to a bank we can recall from OCC in a decade. While there is no fine (and no finding of consumer harm, of note), the limit on transfers, board actions is draconian even for a large bank. It will take years, significant resources for Cenlar to remediate.
- In simple terms, the OCC seems to have decided to apply large bank rules to a small bank that happens to be the largest sub-servicer in the market. Cenlar is known as a large but squeaky-clean platform. But the bar has now been raised and Cenlar’s reputation has been damaged by the OCC’s action. Again, there was no finding of consumer harm or even an error, so the OCC’s actions seem entirely preventative.
- Keep in mind that OCC’s actions are, in part, driven by a desire to avoid reputation risk that arises from weak systems and controls. But that is precisely the effect of this CO by the OCC. Big question is whether the states, CFPB take this example and start to apply these standards for “unsafe and unsound” practices more broadly to IMBs.
- For the short and medium-term, the biggest chunk of sub-servicing capacity in the mortgage industry has been taken offline. Given the record flow of MSRs going to buy side investors and smaller banks, there is likely going to be a prolonged shortage of sub-servicing capacity in the industry. Could be years before Cenlar is able to take new assets. Indeed, Cenlar may need to raise capital and/or consider other steps in response.
In January 2022, foreclosures will begin and the states and CFPB will be waiting to pounce on ANY sign of error with respect to remediation of consumer defaults. Handling non-QM loans will be especially problematic for servicers because they do not come under the CARES Act moratoria from a legal perspective, but regulators will pretend that they are and dare lenders and servicers to fight. A conflict between investors and regulators may result in litigation. What fun. The period of relative quiet from CFPB and other agencies may be ending.
Mr. Cooper (COOP) reported Q3 earnings this week and saw earnings drop sequentially as volumes likewise fell. Unlike Q2, there was no $485 million gain from the sale of Title365 to Blend Labs (BLND) to boost reported earnings. BLND reports earnings on November 10th, just five days before the end of the reporting period. We’d be surprised if BLND is even close to profitable. The Street estimates that BLND will lose money this year and next. The expenses of Title365 may actually hurt BLND’s results going forward.
COOP marked up the valuation of its MSR book to 121bp, reflecting the increasingly frothy conditions in the secondary market for MSRs. This resulted in a $153 fair value adjustment to earnings compared with a $135 million markdown last quarter.
COOP also benefitted from $131 million in revenue from early-buyouts of government loans (EBOs). Many of these loans were modified and sold into new pools. Of note, the redefault rate for modified FHA loans is in mid-double digits through Q2 2021. The EBO opportunity for banks and IMBs is trending lower as these distressed credits that do not get back on track inevitably fall into foreclosures.
While under GAAP issuers are not allowed to include the optionality of the refinance transaction in the valuation of an MSR, but investors clearly are mindful of that opportunity. For the same reason that MSR valuations are rising, COOP actually saw its gain-on-sale margin expand in Q3, a welcome but likely temporary bump caused by rising Treasury benchmark rates.
Of note, the major buyers of conventional MSRs are large banks and IMBs, as well as community banks hungry to replace earning assets. Unlike government loans which trade only at the pool level, conventional loans may be bought and sold individually, a feature that is particularly attractive to community banks.
Indeed, banks and IMBs are outgunning funds and REITs in the secondary market for MSRs. As total returns are pushed down below the minimum 7% unlevered yield that is the minimum for Buy Side investors, banks are winning more and more pools. This may be cause for concern, however, since the rate of migration from FHA loans and Ginnie Mae pools over to conventionals is accelerating.
How many buyers of conventional MSRs today understand that they are paying premium prices for pools comprised increasingly of FHA borrowers with no additional mortgage insurance? The movement from government to conventional assets, often via a cash out refinance, is good for consumer liquidity, but may carry future problems for banks as and when asset prices fall and default rates begin to normalize. Investors in conventional MSRs may be called upon to support servicer loss mitigation activities.
These newly coined conventional borrowers are a direct result of the market manipulation of the Federal Open Market Committee. Because loan-to-value ratios have fallen so dramatically as home prices have risen, many FHA borrowers can take cash out and avoid private mortgage insurance in their new conventional loans. Down the road, however, the FOMC’s social engineering will carry significant risks for banks, investors and the GSEs themselves, which will once again make loan repurchase claims on lenders and their investor clients to compensate for the cost of loss mitigation.
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