So you want to be a rock'n'roll star
Then listen now to what I say
Just get an electric guitar
And take some time and learn how to play
And when your hair's combed right and your pants fit tight
It's gonna be all right
"So You Want to Be a Rock 'n' Roll Star"
The Byrds/Jim McGuinn & Chris Hillman (1967)
Last week confirmed many of the things about the financials and housing that we have been talking about since last summer. Those of you who were on the conference call for JPMorgan Chase’s 2Q 2013 earnings results will recall that Chief Financial Officer Marianne Lake disclosed that the bank was expecting a substantial drop in mortgage volumes in the second half of the year. In fact that is just what has happened. And as Lake predicted, revenues are falling faster than costs, meaning that JPM is losing money on mortgage originations. The other TBTF banks are in much the same situation.
The entire industry is in the midst of a massive consolidation in mortgage finance, with banks cutting back staff and operational infrastructure in an effort to right size business to the volumes expected in 2014. With mortgage applications at a two decade low and origination volumes running about half of last year’s levels, nobody is really sure just what expected volumes will be in 2014.
For example, the total of 1-4 family loans securitized by all US banks fell almost 5% over the past year to a mere $610 billion. Real estate loans secured by 1-4 family properties held in bank portfolios as of Q4 2013 fell to $2.4 trillion in the last quarter, the lowest level since Q4 2004. FDIC reports that the amount of 1-4 family loans sold exceeded originations by almost $30 billion or 5% of the total sold into securitizations.
Meanwhile JPM and other banks are hiring armies of new compliance officers to watch the employees who remain after the next round of cost cutting occurs. Reuters reported with respect to JPM:
The company said it expected total headcount to fall by 5,000 to 260,000 in 2014. Around 6,000 full-time and contractor jobs in JPMorgan's home loans unit and 2,000 jobs in its branch and credit-card network will be cut. At the same time, the bank expects to add 3,000 new jobs in its control function, including areas like compliance.
Sadly those new compliance officers cannot make loans, but they can certainly prevent their colleagues from making loans or doing any other sort of business. A lot of the pain you see at banks like JPM, Wells Fargo, Citigroup and Bank of America comes from the 2010 Dodd-Frank legislation. Next time CNBC has former Rep. Barney Frank on for a chat, they ought to ask him how it feels to be responsible for cratering the markets for US housing and financials single handed.
The banks as a group are running away from the mortgage sector, another reason why mortgage applications and volumes are falling. Most banks, if they make mortgage loans at all, will only write business that can be sold to one of the GSEs – Fannie Mae, Freddie Mac or Ginnie Mae. And even these loans are losing their allure because of the new regulations being spewed by the Consumer Finance Protection Bureau. The most recent 10-K for JPM has the following disclosure:
The CFPB issued final regulations regarding mortgages, which became effective January 10, 2014, and which will prohibit mortgage servicers from beginning foreclosure proceedings until a mortgage loan is 120 days delinquent. During this period, the borrower may apply for a loan modification or other option and the servicer cannot begin foreclosure until the application has been addressed.
What this means is that a home owner can default on their mortgage and basically live in the house for free for at least half a year before the bank can even contact the debtor. In states like Massachusetts, the home of Democratic Senator Elizabeth Warren, there is an additional cooling off period set by state law that starts after the federal cooling off period is done.
Bottom line is that a Massachusetts resident can default on their mortgage and live in the house for free for a year before the lender/servicer is allowed to contact them. So now you know why banks don’t want to touch a borrower with less than a mid-700 FICO score. But it gets better. Because of the pro-consumer legal regime in states like MA, home sales volumes are a fraction of pre-crisis levels. Prices for non-performing loans in states like MA, CT, NY and NJ are typically among the lowest in the nation.
Let’s continue that same paragraph from JPM’s 10-K:
The CFPB issued another final regulation which became effective January 10, 2014, imposing an “ability to repay” requirement for residential mortgage loans. A creditor (or its assignee) will be liable to the borrower for damages if the creditor fails to make a “good faith and reasonable determination of a borrower’s reasonable ability to repay as of consummation.” Borrowers can sue the creditor or assignee for up to three years after closing, and can raise an ability to repay claim against the servicer as a set off at any point during the loan’s life if in foreclosure. A “Qualified Mortgage” as defined in the regulation is generally protected from such suits.
What is means is that not only can the borrower default on the mortgage loan and sit in the house for a year, undisturbed, but he can also sue you. In states like CA, the borrower can get a shopping mall plaintiff lawyer, who can sue the lender/servicer/note holder for relatively minor errors. The defendant must actually foot the bill for the litigation in the People’s Republic of California. Assuming the case goes to trial, a settlement will cost as much as $50,000 or about 10x the maximum profit on the loan.
Q: How many times you think a lender/servicer/investor in mortgages will write a $50,000 settlement check before they stop making loans to below-prime borrowers?
A: The commercial banks are already there. This is one reason, mind you, that the market for below-prime lending is still not coming back.
Think of the current regulatory regime for mortgage lending as a menage à trois among state and federal politicians, the Big Media and regulators, many of whom were in politics before they mounted the ramparts to “defend consumers.” Just imagine Barney Frank, Liz Warren and CFPB chief Richard Cordray enjoying one another’s company in the political hot tub and you get the idea. The trial lawyers are serving the drinks, BTW.
Cordray, lest we omit, before he went to Washington, was OH AG where he frequently bullied lenders into large cash settlements for supposed violations of consumer protection laws. Now at CFPB Cordray is operating on a bigger stage, where he can extort settlements from all manner of lenders, loan servicers and anybody else who makes a living in the consumer finance sector. The unitary model of the CFPB gives Cordray unilateral control over the agency with none of the political accountability of a commission structure. And he is directly allied with the Big Media, who breathlessly report his latest offensives against “abusive lenders.”
The most overt attack against the lending industry came several weeks ago when a New York State regulator halted the transfer of about $39 billion in unpaid balance (UPB) of mortgage loans rights to Ocwen Financial (OCN) from Wells Fargo (WFC). Since last summer, federal regulators have quietly put in place a review process for loan transfers that requires both the seller and buyer of loans and mortgage servicing rights to gain approval.
The action by New York State is yet the latest layer of regulatory oversight over loan transfers dating back to the various settlements for “foreclosure abuse.” The credit rating agencies, who demand big dollars to assess the operations of bank and non-bank servicers, are also part of the shakedown game. Never mind that the people who work for the rating agencies are completely clueless about how the loan servicing business works. They want a fee.
Here is a list of the various regulatory agencies and their areas of responsibilities when it comes to the sales of loans and/or mortgage servicing rights (MSRs):
CFPB: Primary role consumer protection under Dodd-Frank as well as enforcement of compliance with the state AG foreclosure settlements. Any consumer loan from autos to mortgages to credit cards and student loans falls under Cordray and the CFPB. CFPB has also asserted authority over institutional loan and MSR sales.
FHFA: The Federal Housing Finance Agency enforces the AG settlement broadly and also seeks to protect Fannie Mae, Freddie Mac and the Federal Home Loan banks from risk of loss. In the settlement last year with Bank of America, FHFA announced that it would put in place an applications process for sales of loans and MSRs.
FHA/HUD: The Federal Housing Administration enforces the AG settlement and reviews transfers of loans that are securitized by Ginnie Mae, including FHA, VA and USDA loans. Again, the agency has final say over any sales of loans or MSRs by the agencies under its purview.
Fed/OCC/FDIC: The three major federal bank regulators oversee bank compliance with the AG settlement more generally, especially as it impacts bank financial soundness and reputational risk. All three have made clear to the largest banks that they do not want to see any further settlements for violations of law or regulation, another reason why the CFPB and state regulators can extract any sort of concessions from the TBTF banks. Note that the OCC has essentially become subordinate to FDIC, a remarkable turnabout that is due to the astute political skills of FDIC Chairman Martin Gruenberg.
NY & Other States: The State of New York is a player in all of this because it did not agree to the original AG settlement and instead decided to take an independent course in enforcing consumer protection. Most banks and non-banks are licensed as mortgage lenders in NY, giving the state direct jurisdiction. Remember too that virtually all of the mortgage loans in question are owned by an RMBS trust that is governed by NY law, thus the State of New York also has direct jurisdiction via the Martin Act. The other states are involved in overseeing the AG settlement and enforcing their own laws against mortgage abuses.
Part of the problem facing banks and non-banks is that we have the blind leading the blind when it comes to the understanding of regulators and the Big Media regarding the mortgage lending industry. For example, the NYT and Financial Times, among others, repeatedly report that specialty mortgage servicers like OCN have been purchased “tens of billions of dollars of mortgage servicing rights from large global banks.”
No, in fact the total fair value of all MSRs held by US banks is less than $50 billion, according to the FDIC. The non-bank servicers like OCN, Nationstar (NSM) and Walter (WAC) have purchased loans with a UPB in the hundreds of billions of dollars. And remember that the total first lien loan holdings of all US banks and RMBS trusts totals into the many trillions of dollars, right? So everybody just calm down.
Another frequent error made by the Big Media, which is picked up by regulators and our esteemed professionals in the ratings industry, is the idea that non-bank servicers don’t have to follow the same laws and regulations as commercial banks. Again this is wrong.
Not only do the non-bank servicers like OCN and WAC have to follow Dodd-Frank and the regulations from the CFPB, but they also inherit all of the legal undertakings from a bank when they acquire loans. All non-bank servicers that acquire loans from any party subject to the AG settlement inherit the very same duties and responsibilities, period.
One of my favorite errors that you see constantly in the Big Media and from regulators like the CFPB and the State of New York is the idea that it is good business to push a home owner into foreclosure. Anybody with even the slightest idea about the world of distressed servicing knows that the law now requires that loan modification is the first order of business when a borrower gets into trouble. But apparently the folks at the CFPB and the State of New York, where it can take a creditor up to three years to foreclose on a house, have not gotten the memo.
If you actually know the world of distressed servicing, there are three golden rules when it comes to a non-performing loan. First is keep the owner in the house. Second is protect the asset and make sure that maintenance, taxes and insurance are current. And third is to preserve the cash flow of the loan via loan modification, if possible. Keeping the family in the house and protecting the asset and cash flow, even with a substantial modification, is always better for the note holder, whether that is Uncle Sam or a private investor.
Because of the phalanx of regulators how involved in reviewing loan transfers, the top four TBTF banks are having profound problems moving legacy assets off of their books. The case involving WFC and OCN is a case in point, but that situation does not even begin to describe some of the operational problems facing other TBTF lenders who cannot perfect the documentation of legacy loans up to current standards.
If you cannot bring a loan made by, say, Countrywide or WaMu up to the full doc standards that are now the law of the land, then you cannot sell the loan – period. Neither the regulators nor the potential buyer of the asset will play if the loan file is not complete. Since the AG settlement as well as federal bank regulators are expecting that all distressed legacy loans be transferred to a special servicer, you can understand why this is a problem. A big problem.
Bank of America, for example, has taken legacy residential mortgage assets down from $953 billion in 2011 to just $516 billion at the end of 2013. BAC’s 10-K confirms that “the decline in the Legacy Residential Mortgage Serviced Portfolio in 2013 was primarily due to MSR sales, loan sales and other servicing transfers, modifications, paydowns and payoffs.”
Keep in mind too that the TBTF banks really want to sell any loans that are either distressed or likely to be distressed in order to avoid future problems. This is one reason why, despite the current noise from regulators, the non-bank servicers as a group led by the likes of WAC, NSM and OCN are going to have pretty attractive prospects going forward. This opportunity is driven by Dodd-Frank as well as acts of idiocy like the Basel III capital rules, which penalize banks for making private loans but set sovereign exposures as having no risk. More on this in a future note.
The key takeaway of all this is that the pain and suffering of commercial banks when it comes to residential mortgages is not nearly done. Over the next several quarters, lower expenses for loan-loss provisions and a reduction in litigation reserves will be more than consumed by expenses related to downsizing mortgage operations for the top four banks. Look for increased regulatory scrutiny to slow the pace of loan sales and MSR transfers, hurting efforts by the top banks to shed problematic legacy exposures. And most important, the regulatory attack on bank and non-bank lenders will continue to adversely impact the housing sector.
Indeed, due to the good works of the likes of Richard Cordray and Elizabeth Warren, the housing prices could actually decline in many markets as 2014 unfolds. In Northeastern judicial states such as CT, NY and MA, prices are already falling and inventories of unresolved home foreclosures remain very elevated.