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Specter of the S&L crisis haunts today’s mortgage market

A major restructuring of the nonbank sector is in the cards if current market dynamics persist, experts predict

In the reflection, a mortgage executive sees faint images of the savings and loan crisis of the 1980s and 1990s.

The financial chaos that sparked the savings and loan crisis of the 1980s, leading to a government bailout, now haunts the independent mortgage banking market this Halloween season — and beyond.

Independent mortgage banks (IMBs) account for nearly 74% of agency mortgage originations, which is the bulk of the market, according to a recent report by the Urban Institute’s Housing Finance Policy Center (HFPC). In 1980, some 4,000 savings and loan institutions (S&Ls or thrifts) accounted for about half of the nation’s $960 billion in outstanding home mortgages at that time.

The federal agency set up in the late 1980s to oversee and dispose of the assets of failed thrifts, the Resolution Trust Corp. (RTC), closed 747 S&Ls with assets of more than $407 billion. 

One market expert sees a similar fate ahead for IMBs, absent an RTC, predicting that over the next two years more than one-fifth of the nonbank lenders now operating nationwide will merge or otherwise disappear. 

The pressure cooker prompting that dire prediction is being heated by persistent inflation and rising interest rates. Mortgage origination volume this year is projected to decline drastically, by $2 trillion to $2.1 trillion compared with 2021, according to estimates by Fannie MaeFreddie Mac and the Mortgage Bankers Association (MBA). Most of that decline will be on the refinance side, with the MBA estimating that the refi share of originations will drop from 62% last year to 33% this year and 27% in 2023.

Rate locks on rate-term refinancings in August were down 93% from a year ago and cash-out refis were down 78%, according to Black Knight.

“Many [IMBs] expanded operations during an unsustainable refi boom and now face painful adjustments,” said Richard Koss, chief of research at New York-based mortgage-data analytics firm Recursion.

John Toohig, head of whole-loan trading at Raymond James in Memphis, explained that the mortgage market has essentially been cut in half from last year’s volume. “So, there’s fewer loans to go around, fewer loans being sold at premiums, so mortgage companies are likely in for consolidation,” he said.

Storm Brewing

Tom Capasse is managing partner and co-founder of New York-based Waterfall Asset Management, a global alternative investment manager with some $11 billion in assets under management. The firm specializes in asset-backed credit, whole loans and private equity.

There likely will be 40 to 50 deals done this year. The primary deals are large IMB’s buying smaller IMBs. 

Garth Graham, senior partner at stratmor group

Capasse sees the headwinds facing the independent mortgage banking industry over the next couple years as being near hurricane-force in their impact. He points out that in 2021, 85% of the U.S. mortgage market was ripe for refinancing, but today closer to 10%. 

“There’s roughly 4,400 independent mortgage banks in the United States, and we estimate that probably half two-thirds today are breaking even at best,” he added. “[Origination] volumes have fallen 50% to 60%, but margins have fallen 75%.

“You’re going to have a lot of fallout,” Capasse added. “We think that this period of restructuring that’s occurring in industry is probably an 18-month to two-year process, and at least one-fifth of the industry will probably merge or go away.”

There are many economic variables that can yet affect the future course of events in the industry, for better or worse, including Capasse’s dire projections for the IMB market. Still, signs of the stress facing the market have surfaced already this year — with the Chapter 11 bankruptcy filing by First Guaranty Mortgage Corp; the failure of Sprout Mortgage; a dozen channel exits; and the many mergers and acquisitions completed or in motion.

Garth Graham, senior partner and manager of mergers and acquisitions activities for the STRATMOR Group, a Colorado-based mortgage advisory firm, said for all of 2021, there was a total of 29 merger and acquisition deals that involved at least one IMB. So far in 2022, he added, “there are over 25 already, and the pace is picking up.”

“There likely will be 40 to 50 deals done this year,” Graham said. “The primary deals are large IMB’s buying smaller IMBs.”

Graham explained that if a smaller IMB’s loan volume is cut in half, it’s hard for that lender to cut its corporate expenses in half to remain profitable. “Meanwhile,” he added, “a large buyer might be able to load that same [mortgage] production [via an acquisition] and not take on any [additional] corporate expenses.”

“Lenders that turn all their attention to refinances when that business skyrockets enjoy huge profits,” Graham said. “But the tide always eventually turns, and when it does, many of those lenders struggle to stay afloat.

“We’re seeing a lot of that this year, and it will certainly continue in 2023.  … Over 50% of IMB’s lost money in Q2, and that number will go up in Q3.”

Graham said there are now many buyers who are active in the IMB space, and “the lender who does not want to risk their company or put capital into their company during this downturn should (and is) considering an exit.”

“We get calls every day on that basis,” he added.  

Past is Present

Rising interest rates, inflation and risky loans made to chase higher returns all contributed to the rolling S&L industry crisis in the 1980s. Texas was ground zero for the S&L industry implosion, with more than 40% of thrift failures in 1988 — the peak year for the crisis — occurring in the Lone Star State.

This looks a lot like that [the S&L crisis], though there won’t be any RTC, but it smells a lot like what happened back in those days, when savings and loans got restructured or went out of business.

Tom Capasse, managing partner at Waterfall Asset Management

“Emblematic of the excesses that took place, in 1987 the FSLIC [the now-defunct Federal Savings and Loan Insurance Corp.] decided it was cheaper to actually burn some unfinished condos that a bankrupt Texas S&L had financed rather than try to sell them,” states the Federal Reserve synopsis of the S&L crisis. 

“The thrift crisis came to its end when the RTC was eventually closed on December 31, 1995,” the synopsis states. ”The ultimate cost to taxpayers was estimated to be as high as $124 billion.”

Like the 1980s, the country now finds itself in a period of high inflation — 8.3% annualized as of August per the Consumer Price Index — as well as fast-rising interest rates. 

The Federal Reserve has raised its benchmark rate by 3 percentage points since March of this year — helping to catapult the interest rate on a 30-year fixed-rate mortgage from just under 3% in October of last year to about 6.7% as of early October 2022, according to Freddie Mac’s market survey. The Fed is expected to announced more rate bumps in the months ahead.

Unlike the havoc and taxpayer burden created by the S&L crisis some 40 years ago, however, what’s expected to unfold in the nonbank sector restructuring ahead, Capasse said, will be a much more orderly, market-driven process — absent a taxpayer bailout or asset-liquidation agency like the RTC of the S&L era, he added.  

That’s primarily because the bulk of the nonbank assets that will be up for grabs in the industry re-alignment — mortgage loans and servicing contracts — are quality assets that are performing well. 

“This looks a lot like that [the S&L crisis], though there won’t be any RTC, but it smells a lot like what happened back in those days, when savings and loans got restructured or went out of business,” Capasse said. “So, it’s the same thing with these 4,400 independent mortgage banks. 

“At least 1,000 of them are going to go through some level of restructuring over the next two years.”

Unlike in the past, the likelihood of the industry benefiting from another refinance wave in the next few years appears remote.

Bose George, Managing Director at KBW

For the buyers — other better-positioned industry players, including competing IMBs, private-equity firms, real estate investment trusts, banks and more — that means solid assets will be available at bargain-basement prices.

“[The restructuring] will involve sales of these very clean, good senior-credit quality assets, like mortgage servicing rights and non-QM home loans and these scratch-and-dent loans — the illiquid assets on the balance sheets of these highly leveraged IMBs that are going to provide investment opportunities,” Capasse said.

In short, the IMB industry will contract and reconfigure via failures, asset sales, mergers and acquisitions, according to Capasse’s forecast. The mortgage-finance space will be opened up to many new players, and some existing players will expand their reach in the market.

“There will be more consolidation within the nonbank space,” he said. “The big, especially the tech-driven, lower customer-acquisition cost lenders, like the Rockets, etc., they will do very well in this environment — in the post-restructuring environment. 

“And you’re going to see more innovative banks that will re-enter the [mortgage] market, and so you’ll probably see increased bank market share as well,” Capasse added. “It’s consolidation within the nonbank space and the re-entry of the bank lenders as well.”

A recent report by New York-based investment bank and broker-dealer Keefe, Bruyette & Woods (KBW) echoes the industry-consolidation projections advanced by Capasse.

“With competition elevated and a majority of the mortgage universe well over 300 basis points [3 percentage points] out of money to refinance, we think the operating outlook for mortgage originators remains very challenging,” the report states. “Unlike in the past, the likelihood of the industry benefiting from another refinance wave in the next few years appears remote.

“So, while industry consolidation has been limited in the past, we think the current backdrop could act as a catalyst for M&A [merger & acquisition] activity.”

The KBW report even details some potential acquirers in a future market restructuring: Rocket MortgageUnited Wholesale Mortgage and Mr. Cooper. Among the potential acquisition or merger targets, according to the report, are HomepointloanDepot and Guild Holdings (the latter of which says it actually plans to be a buyer).

The overall read is … I don’t think the sellers are near the level all these buyers were hoping for.

Ken Richey, Managing Partner of Richey May & Co.

“Acquisitions of smaller non-public companies are also likely, and there are many such potential merger partners given the relatively fragmented nature of the industry,” the KBW report concludes.

One industry expert, however, is not yet convinced there is a major restructuring ordained for the market — at least not quite yet. Ken Richey is the founder, managing partner and head of merger and acquisition services for the mortgage banking industry at Colorado-based accounting, tax and business-advisory services firm Richey May & Co.

As of now, with respect to the IMB market, Richey says the number of buyers in the market exceeds the number sellers, based on his firm’s data.

“We’ve come to conclusion that the IMBs, even many of the smaller ones, that have lost money just haven’t lost enough of their equity or their accumulated earnings that they made during 2020 and 2021,” he said. “When we ran the percentages, a lot of them that lost money, lost less than 5% of their equity, and the ones that lost more money, maybe they lost 10% or 12% of their equity.

“There are certainly some that probably lost significant portions of their equity, and they’re out being sellers, but the overall read is … I don’t think the sellers are near the level all these buyers were hoping for.”

Richey added that the market needs to appreciate the tenacity and entrepreneurial spirit of IMB owners. He said many have been through the down cycles of the mortgage market previously and know how to cut costs and “get small” to survive downturns.

“They’re great leaders, but they’re not very good followers,” Richey said. “And when you when you decide to give your company up to somebody else, you’ve made a decision to start to follow instead of lead. 

“And that’s why they resist, even with their checkbooks.”

Even Richey, however, recognizes that many of the IMBs that are struggling now can’t hang on indefinitely. If the mortgage market doesn’t start to improve soon, including rate stabilization, the pressure to sell will only intensify, he concedes.

“We don’t necessarily believe that it’s in the best interest of the consumer to have massive consolidation, and we’re not predicting that,” he said. “But we do think if we have two or more bad quarters [ahead], the financial pressures or financial incentives could change, and we could see significantly more [selling] activity going into the first quarter of next year and beyond.”

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