Apr. 21: Notes on jumbo comp and comp structures, loan language, and servicing – hold or sell and why?

Forget eNotes, eSignatures, eMortgages. King Mswati III of Swaziland proclaimed his nation will be henceforth known as eSwatini. (“Henceforth” is one of those words not used often enough.)

“Excuse me Stewardess, I speak jive.”

“Rob, what do you hear about doing mortgages in every language spoken in the United States? As the owner of a small mortgage company in Southern California, if our docs misspell a word in Mandarin, am I going to be sued?” That’s quite an extreme example. As an update, the industry is proceeding slowly in that direction. Last week the FHFA, which seems to be spearheading this effort, held a meeting where representatives of banks and lenders were able to voice their thoughts. By some accounts we’re heading toward documents in various languages, but the borrower agreeing to actual legal documents in English. Prior to that, in October, the FHFA, expressed plans for a language preference question to get the ball rolling.


This week I wrote about servicing, and KBW sent out an “All Things Financial” podcast exploring the changing value proposition of holding mortgages and mortgage servicing rights for financial firms, including both banks and non-banks. “As mortgage interest rates have risen, refinancing has slowed, and the duration of mortgage loans has extended. With residential mortgages being the largest financial asset in the country (with nearly $10 trillion in outstanding loans), this simple change in the behavior of mortgage borrowers has implications across the financial sector. This week’s podcast features moderator Brian Gardner, KBW’s Head of Government Policy Research, Eric Hagen who covers the residential mortgage space with Bose George, and Chris McGratty who leads KBW’s small- and mid-cap bank research effort.”

I’m kind of stuck in AM Radio Land, but you can listen to the full podcast here: All Things Financial – KBW Podcast 163, Mortgage Prepayments Slow, Servicing Extends.

Gardner: How positive was the mood at the servicing conference last week and why is the industry feeling so good?

Hagen: We would characterize the tone from attendees at the conference as quite positive. That sentiment reflected a couple key themes discussed throughout the event: one being the expectation for higher interest rates, and another being the expanded financing options that have developed recently for financial buyers of mortgage servicing rights, or MSR.


Gardner: How is the mortgage servicing business organized today and which firms are best positioned to benefit from these trends?

Hagen: There have been some notable developments in the landscape of mortgage servicing, particularly the growth of non-bank mortgage originators and servicers, plus a wider array of third-party buyers of MSR. While banks remain the biggest servicers, among the top 20 owners of servicing rights, 11 of them are now non-banks, and it was noted at the servicing conference that about 20% of the sub-servicing market is now controlled by non-depositories. We believe this trend is driven by several factors including: 1) less favorable capital treatment for MSRs for banks under Basel III; 2) The move away from FHA origination and servicing by the larger banks; and 3) the growing interest in MSR from financial investors. We expect the growth of non-bank participants in the MSR market will continue to increase, especially if they can continue to finance the asset efficiently. All that said, we acknowledge banks are better holders of high quality prime MSR given their better liquidity and ability to finance MSRs with deposits.


Gardner: Can you lay out both the risks and the benefits to banks with mortgage operations in a rising rate environment?

McGratty: First quarter is seasonally a weaker quarter for the banks from a mortgage banking perspective and according to the most recent MBA Mortgage Finance Forecast origination volumes in 1Q18 are expected to decline 17% linked quarter – which is partly related to typical Q1 seasonality, but also likely impacted by the recent increase in interest rates. And based on the lower expected volumes, it’s possible that gain on sale margins come under a bit of pressure due to greater competition. So in aggregate, our analysts expect some pressure on this revenue line item in the quarter. That said, given the approximate 30 basis point increase in the 10-year Treasury during the quarter it’s possible that many banks write-up their mortgage servicing right (MSR) asset, which would benefit earnings this quarter; however, I’d argue most analysts and investors don’t necessarily pay for this source of earnings.


Gardner: How are the banks that are holding residential mortgages addressing the extending durations of their portfolios?

McGratty: From the banks’ perspective, most of them utilize a combination of portfolio retention and selling into the secondary market for their mortgage businesses but focusing on the proportion that they elect to keep I’d say this conversation should be inclusive of the strategies they may be implementing in their investment portfolios. As we know, portfolio durations extend as rates move higher so really the discussion should focus on aggregate extension risk – that is within both loan and bond portfolios – and the key here is to strike the appropriate balance.


Gardner: How about the mortgage REITs, what are they doing to address the extending durations or their portfolios?

Hagen: Duration extension like we witnessed in 1Q18 is likely to be a fairly neutral event for most mortgage REITs. On the one hand, when interest rates rise, and MBS durations extend, it typically forces most mortgage REITs to add additional hedges to reduce the interest rate exposure in their portfolio. Most mortgage REITs target very minimal interest rate risk, so adding more hedges can have the impact of narrowing net interest margins. However, we expect the improved yield due to slower prepayment speeds should offset the impact of any earnings drag due to additional hedging.


Gardner: Do you see growth opportunities for variable rate lenders?

McGratty: There’s clearly an emphasis by the banks to put more variable rate loans on their balance sheets in a rising rate environment – regardless of loan type.  For example, in recent years banks have really tried to increase their commercial and industrial (C&I) lending efforts where yields respond favorably based on rising interest rates.


Gardner: What are the best investments in the mortgage space for the balance of the year? 

Hagen: In terms of stocks that benefit from holding MSR in a rising rate environment, we would highlight New Residential (NRZ), which is a mortgage REIT that is primarily an MSR investor. The shares are currently trading at the low end of the historic price/book range at 1.06x and yields 12.3%. We would also highlight Two Harbors (TWO) which owns MSR primarily as a hedge against its holdings of Agency MBS. We like this strategy because it greatly reduces the potential spread risk from hedging with other products and protects book value as a result. TWO trades at about a 5% discount to book value with a 12% dividend yield, which we view as stable in the current environment. On the operating company side, we would also mention Nationstar (NSM). While we are Market Perform on the name, we like the company’s large servicing portfolio, and the fact that it’s an operating company potentially allows it to perform better than the mortgage REITs we mentioned earlier in a rising rate environment. Other mortgage stocks we currently like include Redwood Trust (RWT) a jumbo mortgage originator and investor that trades at a discount to book value, and the mortgage insurers (MTG, and ESNT), as that sector has been under pressure because of perceived risk from a new mortgage insurance program rolled out by Arch Capital (ACGL) in partnership with Freddie Mac. We also like the fact that mortgage insurer earnings have limited direct correlation to interest rates and are driven more by the strength of the housing market.


Gardner: What are you telling investors to do regarding mortgage lending in the SMID bank space?

McGratty: To think about mortgage lending and exposure thoughtfully.  We all know mortgage is an important asset class for the banks, and for the smaller banks, the home mortgage is often critical toward client acquisition.  For the most part, SMID-cap banks have reasonable – but not outsized exposure – to mortgage but it’s important to understand an individual bank’s underlying mortgage strategy.

Compensation – always a topic

In response to a comment I had in my email recently on the issue of paying different commissions for jumbo loans, one well regarded mortgage banking attorney wrote in clarification. “Paying LOs different BPs for jumbos (or other loans) based on loan size results from application of the ‘cap/floor’ and should not be based on individual loan size itself.  While the maximum/minimum concept is expressly permitted by LO Comp, paying more (or less) BPs for an individual loan based on loan size-such as a commission structure that paid 125 BPs for conforming loan amounts, but paid 75 BPS for Jumbos-could be viewed as a ‘proxy’ for profitability under the CFPB’s proxy rule, because (at least at the margins) a loan officer could influence a consumer to take more or less money on the loan.”

Thank you to Brian B. for sending along this story about the Supreme Court’s ruling on overtime – a pro-employer shift?

From Oklahoma came, “When I see these comments about LO Comp, I think many are missing part of the equation. I agree with comments regarding profitability, productivity and market fluctuations. As an industry we are failing to correct the arrangements by some designed to skirt the intentions of Dodd Frank. Common expressions are, ‘work-around,’ ‘loophole,’ or, ‘cleared with legal.’ The practice is widespread. Some of these examples include:

“Loan Officers are still participating in revenue sharing. This is done by minimum required average revenue, typically measured by BPS, a side agreement to split overage or an agreement to cover marketing expenses for exceeding minimum margin standards. This is the calculated risk that they will not be audited by the CFPB, reported by a current or former (disgruntled) employee, or other regulators are not able to identify violations.

“Frequently changing Comp structure based on products and margins. I heard one changes plans monthly, using the pipeline and projected closing to determine commission plans.

“Pick a Play Plan – the LO determines the margins and sets commission level. Some are close to 200 bps. Conventional and Jumbo loans are handled by a Junior Loan Officer and the referring party receives a fee. I see 50 bps as the typical fee paid. Varying plans in one market and office could create fair lending issues.

“Changing the source of business from a self-gen deal to a repeat customer, internal referral or consumer direct/internet deal. This triggers a change in margin and commission (self pays higher BPS) allowing the originator (I mean company and LO) to capture the deal, game the system and misrepresent the circumstances.

“Lastly, a similar method is to change the loan to a ‘house’ deal – this is not like specialty lending products that could include 203K or reverse product. ‘House’ is simply to get the deal, lower margin, and either the LO receives a reduced commission or no commission at all.

“I have seen this behavior is across the board – banks, mortgage bankers, etc. I hope that we will either see some end the practice or some enforcement actions to cause others to re-examine their methodology and make changes. Currently we have excess capacity and removing some of these practices will level the playing field.”

(Thanks to Brad K. for this one.)

A professor stood before his Philosophy 101 class and had some items in front of him. When the class began, wordlessly he picked up a very large and empty mayonnaise jar and proceeded to fill it with rocks, about 2″ in diameter.

He then asked the students if the jar was full? They agreed that it was. So the professor then picked up a box of pebbles and poured them into the jar. He shook the jar lightly. The pebbles, of course, rolled into the open areas between the rocks.

He then asked the students again if the jar was full. They agreed it was. The professor picked up a box of sand and poured it into the jar.

Of course, the sand filled up everything else. He then asked once more if the jar was full. The students responded with a unanimous, “Yes!”

The professor then produced two cans of beer from under the table and proceeded to pour the entire contents into the jar effectively filling the empty space between the sand.

The students laughed.

“Now,” said the professor, as the laughter subsided, “I want you to recognize that this jar represents your life. The rocks are the important things — your family, your partner, your health, your children – things that if everything else was lost and only they remained, your life would still be full.

“The pebbles are the other things that matter like your job, your house, your car. The sand is everything else — the small stuff.

“If you put the sand into the jar first,” he continued “there is no room for the pebbles or the rocks. The same goes for your life. If you spend all your time and energy on the small stuff, you will never have room for the things that are important to you. Pay attention to the things that are critical to your happiness. Play with your children. Take time to get medical checkups. Take your partner out dancing. There will always be time to go to work, clean the house, give a dinner party and fix the disposal. “Take care of the rocks first — the things that really matter. Set your priorities. The rest is just sand.”

One of the students raised her hand and inquired what the beer represented.

The professor smiled. “I’m glad you asked. It just goes to show you that no matter how full your life may seem, there’s always room for a couple of beers.”

Visit www.robchrisman.com for more information on our industry partners, access archived commentaries, or to subscribe to the Daily Mortgage News and Commentary. If you’re interested, visit my periodic blog at the STRATMOR Group web site. The current blog is, “How Good is Your Company’s Cyber-Security?” If you have both the time and inclination, make a comment on what I have written, or on other comments so that folks can learn what’s going on out there from the other readers.


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Rob Chrisman