The big news from the Q3 2013 earnings announcements so far is that the mainstream financial media has discovered non-bank financials. The non-bank sector has been growing fast, this as the traditional financials comprised of depositories and broker dealers have been flat to down in terms of revenue and earnings. The non-banks include a number of different platforms and strategies, making the selection and analysis process difficult for novice observers. But if you’re looking for top line growth in the post Dodd-Frank world, non-banks are the place to prowl when it comes to financials.
The publicly traded names in the non-bank sector can be divided into several categories, including various flavors of large multi-asset managers like Blackstone (BX), The Carlyle Group (CG) and Fortress (FIG). There are specialized finance companies like CIT Group (CIT) and ORIX Corporation (IX). And then there are real estate companies and investment trusts or REITs focused on a wide range of residential assets from whole loans to residential mortgage backed securities (RMBS) to 1-4 family rental properties to mortgage servicing rights (MSR).
Some of mortgage REITs have affiliates that provide financing and/or management services, as in the case of PennyMac Mortgage Investment Trust (PMT) and PennyMac Financial Services (PFSI). FIG and its progeny, like Nationstar (NSM), Newcastle (NCT), New Residential Investment Corp. (NRZ) and a myriad of other FIG-controlled legal entities comprise one of the more complex corporate groupings operating in the mortgage space today.
Perhaps the most visible sector in terms of growth is non-bank mortgage servicer/lenders, led by names such as Ocwen Financial (OCN), Walter (WAC) and NSM. According to Inside Mortgage Finance, OCN ranks number four in terms of total servicing and NSM ranks sixth. Wells Fargo is the largest loan servicer in the US and the biggest among the top banks, roughly 2.5x the market share of JPMorgan Chase (JPM). There are many other smaller lender/servicers in the non-bank sector that specialize in areas such as asset management and distressed servicing, including my employer.
The major difference between commercial banks and non-banks is funding costs and regulation. Banks today fund their operations at something like 1/10th the cost of non-banks, which generally finance their assets via cash, short-term credit lines and repurchase agreements. The latter source of liquidity comes from, well, commercial banks. This capital and funding asymmetry and consequent liquidity risk is a major concern of regulators looking at the non-bank sector today. Long-term debt is another sources of funding, but one that is very expensive. Even large players like FIG, for example, still pay over 6.5% for unsecured parent level funding vs. a 3% dividend yield on FIG’s common. Compare this with 3/8th of a point blended cost of funds for WFC and other large money center banks.
In terms of capital, on the other hand, commercial banks are at a decided disadvantage to non-banks. Commercial banks are required to allocate at least 100% capital weightings (or $8 per $100 of assets) to risky exposures like non-agency mortgages or business loans, while government and agency obligations require a fraction of the capital cover. Under the Basel III accord, banks are actively discouraged from lending on most real estate transactions or any type of “at risk” lending for new, entrepreneurial business ventures. It is amazing how little comment one sees in the media about the stifling effects that Dodd-Frank and Basel III have on private credit creation, and thus jobs and consumer spending. The poor economic situation is not about “austerity,” as the Krugmanite socialists believe, but a dearth of credit creation in the private sector.
One reporter who does not need a tutorial on non-banks is Kate Berry at American Banker. She recently did an important story, “Nonbank Mortgage Servicers' Rapid Growth Alarms Investors,” that gets into some of the investor perception problems dogging non-banks. Berry writes that:
“[C]oncern is mounting among investors and analysts that Nationstar (NSM), Ocwen Financial (OCN) and Walter Investment (WAC) are getting so big so quickly that they are becoming too difficult to manage. Shares of Ocwen and Nationstar have plunged in recent days following earnings announcements in which the companies disclosed a range of operational problems, including delays in integrating acquisitions of servicing portfolios. Meanwhile, Walter recently disclosed that it is under investigation by the Consumer Financial Protection Bureau and facing scrutiny from the Department of Housing and Urban Development over management of its reverse mortgage program and other issues.”
An interesting thing about the AB story is that it tracks quite a bit of the alarmist narrative coming from some financial regulators in Washington. In particular the Consumer Financial Protection Bureau or CFPB, which fancies itself the paramount financial regulator in Washington in the post-Dodd-Frank era, has been making life miserable for many consumer lenders. CFPB, for example, makes a lot of fuss over whether or not it will allow the larger mortgage servicers to continue growing via transfers of loan servicing from the TBTF banks.
Delays of transfers of distressed loans from the large banks to specialty servicers hurt consumers and investors. But the folks at the CFPB seem unconcerned about collateral damage as they move to regulate every aspect of consumer finance in the US, from making mortgages to loan servicing to auto loans to debt collection. The hegemonic bluster from the CFPB comes as unwelcome news to the folks at the Federal Reserve Board, OCC, Financial Housing Finance Agency, and FHA, all of whom still have primary responsibility for the largest mortgage servicers. There is even news of an impending civil war between the CFPB and the other federal regulatory agencies, but no shooting has been observed as yet.
Suffice to say that all of the regulators are making life very difficult for loan servicers, each in their own special way, and especially for the largest commercial banks. This is one reason why commercial banks are not willing to originate new loans other than prime mortgages with little likelihood of default. In many respects, the only thing the CFPB is protecting Americans from is getting a mortgage. Read more on the history of Dodd-Frank in my latest article for The National Interest below:
If you follow non-banks that are trying to build value based on acquiring loans and/or mortgage servicing rights (MSRs) and have not read “FHFA’s Oversight of Fannie Mae’s 2013 Settlement with Bank of America,” you should do so. The proclivity for regulation via enforcement at CFPB, FHFA and other agencies is greatly slowing the process of working through the several hundred billion worth of remaining distressed assets and REO in the US banking system. And there are a lot more distressed assets still to be fixed inside the GSEs and HUD.
FHFA report on BAC: http://tinyurl.com/ocoe6g4
Meanwhile in the RMBS REIT space, the growing market angst regarding when and where the Federal Open Market Committee will change monetary policy is playing havoc with leveraged RMBS REITS such as Annaly Capital Management (NLY). NLY is near its 52-week low despite a handsome $1.40 per share or ~ 12% dividend yield, the highest in the S&P 500. Since the markets persist in predicting a change in the extreme monetary policy of the FOMC, this despite the poor quality of “better” jobs data, the result is extreme volatility for NLY.
In the most recent form 10-Q, NLY reports that its interest rate risk is small, with just a 1% change in portfolio valuation given a 0.75% move in benchmark interest rates – “with Effect of Interest Rate Swaps and Other Hedging Transactions (Page 52).” But the fact of shrinking unrealized gains and mounting unrealized losses on the NLY portfolio seem to be dominating the minds of investors, hedges or no. The fact that these positions are funded with repurchase agreements maturing in one year or less seems to be another worry. Even though NLY has doubled its cash position in the past nine months, the equity markets continue to punish this RMBS REIT.
NLY 10-Q: http://tinyurl.com/pkkr4em
Speaking of punishment, the latest disclosure from PMT suggests that the lender/servicer missed its interest rate hedges by a wide margin. Paul Miller of FBR writes in his latest note on PMT: “The company reported disappointing mortgage metrics with correspondent locks of $6.7 billion and fundings of $7.8 billion leading to a revenue/expense mismatch that drove a significantly lower gain on sale of 37 bps compared to 85 bps last quarter.” That’s a miss of $1.1 billion on hedging, a 16% gap between locks and funding.
Then we had the announcement last week from NSM that it is selling its wholesale lending business to Stonegate Mortgage (SGM), a move that caught the analyst community bysurprise. The official line is that NSM saw lending margins fall due to interest rate volatility. NSM says that will focus on servicing, solutions & REO sales, and investment vehicles due to higher margins. With this announcement, NSM just took earnings down 30% and has guided investors to expect an operating loss in Q4 2013.
A cynic might say that one reason for the NSM decision to sell most of its lending business to SGM is to reduce its profile with regulators and focus on the higher margin activities of servicing and buying MSRs. In particular, pressure from CFPB and other regulators on both non-banks and banks is intense, and is forcing continued deleveraging in the credit markets. Note that market leader WFC is down to 25% overall market share in 1-4s from 33% last year, and just 19% correspondent vs. 50% a year ago.
Meanwhile, the carnage in the commercial banking sector continues apace, with most of the major players in mortgage reporting double-digit declines in new origination volumes in Q3 of 2013 and related restructuring expenses. This is all still a surprise to some, but the trend in terms of lower refinance volumes has been visible since the start of 2013.
Mortgage industry maven Rob Chrisman reports that U.S. Bancorp (USB) and Regions Financial Corp. (RF), as well as other residential lenders, expect waning mortgage-refinancing activity to continue to create headwinds in the fourth quarter. USB estimates mortgage-banking revenue will decline about 30% from the previous quarter, Chief Financial Officer Andrew Cecere said Friday at an analyst conference in Boston.
At WFC, the year over year comparisons in mortgage banking were grim, with a 43% YOY decline in revenue to just $1.6 billion in Q3 2013. The 156% increase in servicing income miraculously made the overall drop in mortgage revenue seem less grievously bad. Mortgage loans held for sale fell by 25% YOY and overall the WFC balance sheet shows the worst effects of the Fed’s quantitative easing. The yield on earning assets at WFC fell from 4.28% in Q3 2012 to just 3.79% in Q3 2013, illustrating how the Fed’s overdone monetary ease is starting to cause the cash flow inside the financial sector to shrivel along with the income of individual and corporate savers.
The one thing you can say about the growth in the non-bank sector over the past several years is that it is a direct result of government intervention in the marketplace. Both Fed zero rate monetary policy and Dodd-Frank represent a massive intrusion by the federal state into the world of consumer finance. The extreme monetary policies pursued by the FOMC have launched a number of new bubbles in the non-bank world that are obvious for all to see – RMBS, REO to rent, to name just two -- but barely discussed in the media.
Add to all this the fact that all of the regulation by the CFPB and other agencies is arguably offsetting the intended expansionary effect of QE on the economy and specifically consumer finance. Along with the income shrinkage on savers of QE, the regulatory environment created by Dodd-Frank is retarding credit expansion for the private sector, hurting consumption and employment. But the interest rate risk created by the Fed after years of zero rates is very real and may soon be “Topic A” for Janet Yellen and other members of the Federal Open Market Committee. It’s like we all know that the emperor is naked, but none of us, not even the smallest child, is willing to say so.