The mortgage space is in the throes of a “massive and truly terrible period of restructuring that conjures up biblical images of the apocalypse,” wrote R. Christopher Whalen in his latest, weekly article for the Institutional Risk Analyst, and the fate of Ditech Holdings serves as a critical example.
Ditech, which filed for bankruptcy for the second time, is seeking bids for the sale of some or all of its business. But, as Whalen questioned, do its remaining assets have any value?
Specially, Whalen pondered, what will happen to Reverse Mortgage Solutions, Ditech’s HECM servicing business?
“RMS is consuming cash to such an extent that the company’s DIP lenders had to allocate a big portion of resources – $1 billion in working capital – to RMS as part of the bankruptcy filing,” Whalen wrote, noting that Ginnie Mae will be on the hook if the business is abandoned in bankruptcy.
The problem, according to Whalen, for those holding mortgages and mortgage servicing rights? The unstable climate created by the Federal Reserve’s policies that is wreaking havoc on the market.
Rumor has it that the Federal Open Markets Committee may end the runoff of the system open market account – or SOMA – portfolio later in 2019, and if that’s the case, expectations for rising rates will need to be adjusted, Whalen said.
The constant manipulation is giving the market whiplash.
“In effect, the Fed is discarding any hope of restoring private function and particularly unsecured lending in the U.S.,” Whalen wrote.
“By manipulating all manner of asset valuations, the FOMC has created two very specific risks for holders of mortgages and MSRs that are not well understood in the equity or debt markets,” he continued.
Whalen said that by accelerating prices for homes, mortgages and MSRs to “ridiculous levels,” the Fed has essentially crafted a short-put position for those holding mortgage credit and servicing exposures.
Its policy of “quantitative easing,” or injecting new money into the nation’s money supply, will inevitably damage the financial markets, he said.
“Like shooting heroin, once a central bank gets onto the QE habit, it is impossible to stop without deflating the financial markets,” he said.
Further, “fair value” accounting rules imposed by the Financial Accounting Standards Board and the Securities and Exchange Commission add an extra bit of nonsense into the equation, according to Whalen.
“As benchmark interest rates fall, the modeled prepayment speeds for mortgage exposures will accelerate, this on the assumption that mortgage refinancing activity will increase –maybe,” he wrote. “Holders of MSRs, specifically, will be forced to take ‘fair value’ non-cash losses on their mortgage exposures, even if they are running aggressive hedge positions.”
And, the credit risk embedded in all one- to four-family mortgages that were originated during the three phases of QE may begin to emerge in the next 18-24 months, Whalen predicted, and this will drive up servicing costs for MSR holders. As owners of the servicing asset, MSR holders are responsible for the cost of resolving a distressed mortgage.
If the Fed does indeed resume another QE policy, should we face another downturn (as housing predicts) Whalen said those operating and investing in mortgage finance need to take note.
“With MSR valuations under the twin pressure of again falling long-term interest rates and rising capital costs of default servicing, investors could see the double-digit gains in the best performing asset class in the fixed-income market suddenly reversed, with catastrophic consequences for the mortgage market and certain publicly traded mortgage REITs,” he wrote.
“Given the impending resumption of QE, investors who are long servicing need to take pause,” he continued. “MSRs carry both interest risk and, as many have forgotten, default risk garnished with reputational hazard.”
