Over the past few years, mortgage origination has shifted away from depository institutions and into the hands of independent mortgage banking entities. This transition has led to concerns over the ability of non-bank lenders to weather adverse market conditions.
Non-bank lenders employ large amounts of leverage. They rely heavily on warehouse lines of credit to finance their operations, while their balance sheet assets are mostly comprised of unclosed loan-locks in the pipeline, hedge instruments, funded whole–loan inventory available for sale, and mortgage servicing rights. Growing concern over the relative illiquidity of MSRs in particular, combined with the exposure of non-bank lenders to Government–backed servicing assets, prompted Ginnie Mae to announce plans to perform stress-testing on their non-bank issuers in 2019. The COVID-19 pandemic, however, appears poised to deliver a real-world scenario far worse than any stress test—one whose market disruption causes a disastrous liquidity crunch for a large sector of the mortgage origination market.
As the pandemic began to unfold and equity markets went into freefall, flight-to-quality trades pushed yields on Treasuries to record lows. Mortgage-backed securities significantly underperformed their treasury benchmarks, causing the Fed to re-ignite its MBS purchase program on March 19th and inject additional liquidity into the RMBS market.
This move by the Fed had an unintended consequence, however. As mortgage rates dropped, TBA passthroughs1 rallied significantly. Because TBAs are a widely used hedge instrument for mortgage originators, this rally triggered widespread margin calls on originators who sell TBAs short to the broker dealer community via lines of credit. Typically, this strategy is considered prudent for lenders and carries little risk, as originators are simply offsetting their interest rate exposure on their locked pipeline by selling a deliverable hedge instrument. However, the sudden spike in unemployment created by the pandemic has generated considerable uncertainty around whether pipeline loans will actually be able to close. Traditional pull–through models are rendered useless, as they do not contemplate huge numbers of mortgage applicants losing their jobs within a short period of locking their loans.
The sharp uptick in expected pipeline fallout coupled with heavy hedge losses and increased volatility in the TBA market has created the perfect storm for a liquidity crisis. Within ten days of the Fed’s announcement, the Mortgage Bankers Association was sounding the alarm to regulators about the extreme pressure that mortgage originators, particularly non-bank institutions, faced in the wake of excessive TBA margin calls, and the risk of widespread defaults that would likely result unless swift action were taken.
Even with loans that make it past the closing table and into an originator’s available-for-sale warehouse, it’s not exactly business as usual in this environment. Broker-dealer balance sheets are “heavier” than usual because their network of end-account customers who typically invest in mortgage–related securities are looking to reduce their exposure to the sector. This is causing bid-ask spreads in the TBA market to widen and specified pool pay-ups to collapse, both of which cut into profit margins for originators and further strain liquidity.
Lenders that sell their originated mortgages via the agency cash window programs are not immune, either. Cash executions are rumored to be softening relative to MBS executions. Agency capital requirements related to the actual/actual remittance requirements for servicers who use the cash window are leading to higher model–implied guarantee fees. This is creating a disconnect between TBA hedges and cash window prices for closed whole loans, which also adds pressure to expected profit margins. Originators who sell to correspondent buyers face similar challenges as correspondent buyers price in additional margin to help offset extreme market volatility and the anticipation of increased future borrower credit risk.
Adding to the immediate concern about non-bank mortgage originator liquidity is the current dysfunction in the mortgage servicing rights market. Mortgage servicers in scheduled/scheduled remittance programs are on the hook to advance principal and interest payments on the mortgage, as well as tax and insurance payments when a borrower misses a payment. These advances can quickly become capital intensive, a particular concern for non-bank servicers.
As the pandemic unfolded, MSR buyers quickly evaporated as government agencies have scrambled to provide relief to borrowers facing hardship. Similar relief, however, has not been offered to mortgage servicers. With co-issue counterparties and correspondent lenders softening bids or pausing MSR purchases altogether, originators that typically sell loans servicing–released are now forced to either 1) sell at heavily discounted prices to the relatively small handful of remaining buyers, or 2) retain the asset. Both options adversely impact profit margins and exacerbate existing liquidity concerns. For originators that choose to retain servicing, the prospect of servicer advance requirements and borrower forbearance pose additional long-term capital and liquidity issues.
Not coincidentally, MSR valuations are falling. Non-bank lenders holding these assets will be at risk of breaching net-worth, leverage, and liquidity covenants for warehouse lines, MSR financing facilities, and TBA lines of credit. Breaching these covenants would have a devastating effect on the lenders’ ability to do business.
Every crisis is unique, but things are beginning to feel eerily reminiscent of 2008. During that crisis, RiskSpan leveraged its deep familiarity with mortgage credit to help capital markets participants navigate unprecedented market conditions. Today, we are assisting our mortgage originator clients with modeling the impact of COVID-19 across several areas, including:
- Balance Sheet and Liquidity Stress Testing
- Servicing Advance Scenario Modeling and Analysis
- Alternative Pipeline Hedge Coverage Models
- MSR and Whole Loan Valuations
Contact us for a free consultation.
