Red flags are starting to proliferate among nonbank mortgage originators, creating credit risk for the banks that fund their operations.
In recent months, a top 20 originator filed for bankruptcy, two banks have reported credit losses from mortgage warehouse lines and a top originator's debt issuance has traded at distressed levels. Mortgage defaults remain near historic lows, but pressure is still high on nonbank mortgage companies. Profits have been squeezed for years due to a highly competitive market that has limited gain-on-sale margins, and the recent decline in rates has weakened collateral.
For banks with multiple lines of business, weaker mortgage results represent a net income headwind. For nonbanks with a singular focus, it can threaten their viability.
"If funding were ever to dry up, the model is broken and these companies wouldn't have enough financial flexibility to keep originating," said Stephen Lynch, a credit analyst for S&P Global Ratings.
Stress in the nonbank mortgage sector could mean credit losses for banks that act as warehouse lenders. Nonbanks utilize warehouse lines to fund loans that are then sold to investors, and the nonbank uses the proceeds from that sale to repay the banking warehouse lender. If a nonbank fails, the warehouse lender can seize loans that have been originated but not yet sold. The recent decline in rates has reduced the value of originated loans.
That decline in value played a role in a $7.5 million loss for Customers Bancorp Inc. from a mortgage warehouse credit. The bank seized the interest-only portion of securities backed by reverse mortgages originated by the borrower, but the value of the collateral did not fully cover the bank's exposure.
On Customers' second-quarter earnings call, Chairman and CEO Jay Sidhu suggested fraud played a role as the warehouse borrower "turned out to be perhaps using some unethical means." Bain Rumohr, senior director in U.S. banks for Fitch Ratings, said nonbank fraud tends to be a primary driver of banks' credit losses in the mortgage warehouse space and that credit losses are otherwise rare. At the same time, he said the low-profitability environment might encourage nonbank operators to stretch the rules. Customers was the No. 10 largest warehouse lender in the first quarter with $3.1 billion of warehouse commitments, according to data provided by Inside Mortgage Finance, an industry publication that conducts a survey.
The nation's largest bank, JPMorgan Chase & Co., had the most exposure in warehouse lines to nonbank mortgage lenders in the first quarter with $14.0 billion of commitments. The No. 2 bank on Inside Mortgage Finance's list was Texas Capital Bancshares Inc., which had $6.3 billion of commitments in mortgage warehouse lines in the first quarter.
While Texas Capital continued to report issues with credit quality in the second quarter, the deterioration came from energy loans. Management described the mortgage business generally as having low credit risk.
However, another top mortgage warehouse lender reported credit issues in the second quarter. First Horizon National Corp. was the No. 8 mortgage warehouse lender in the first quarter, according to Inside Mortgage Finance. The company reported an uptick in its charge-off ratio in the second quarter due to a single mortgage warehouse lending relationship.
"We took a partial charge-off on a mortgage warehouse client that was impacted due to a liquidity event," said Susan Springfield, chief credit officer for the bank. Springfield said the warehouse client had a nontraditional flow line that created the liquidity issue whereas most of the bank's warehouse borrowers had traditional flow lines, making it a "one-off situation."
While lower rates lower the value of key assets held by nonbank lenders, the situation should boost refinance volume moving forward. That will offer struggling nonbanks a reprieve by boosting revenue, said Guy Cecala, publisher of Inside Mortgage Finance. That heavier flow of volume came too late for two top nonbank lenders.
Stearns Holdings LLC filed for bankruptcy July 9. Its bankruptcy filing pegged the lender as the No. 20 originator in the country and attributed its failure to tough market conditions, liquidity issues and an inability to restructure debt. The company's president and CFO wrote in a declaration that increased competition and the rising rate environment in 2016 reduced the lender's volume at the same time that the company's senior secured notes approached maturity dates.
"What Stearns encountered was the rising-rate environment, the slowdown in new purchase activity as well as refi activity and then their banks decreasing their advance rates on their warehouse lines, so that put things in a tailspin," said Johann Juan, director in nonbank financial institutions for Fitch Ratings.
It was the second nonbank mortgage originator of size to file for bankruptcy this year. Ditech Holding Corp., the industry's 44th-largest mortgage originator in 2017, filed in February. Company executives similarly cited market conditions as a factor in the company's need to file for restructuring.
And one of the largest nonbank mortgage lenders has seen pricing fall on its speculative-grade debt. Freedom Mortgage Corp., the No. 13 mortgage lender in 2017, issued $250 million of debt in March with a coupon of 10.75%. Investor interest has been muted with the debt trading at 93.5 cents on the dollar as of July 26, and the debt has been part of S&P Global Ratings' distress ratio, which includes speculative-grade issuances with option-adjusted composite spreads of more than 1,000 basis points over U.S. Treasuries.
Credit analysts at Moody's, S&P Global and Fitch said the market has concerns about Freedom's profitability outlook, a high level of leverage and regulatory compliance. In June, the Consumer Financial Protection Bureau fined the company $1.8 million for inaccurate data in its mortgage reporting. In June 2018, Ginnie Mae restricted the company from securitizing loans insured by the Department of Veterans Affairs. Ginnie Mae has been cracking down on unnecessary refinancing activity, commonly referred to as churning. Analysts said that could make it difficult for the nonbank to take advantage of the refinancing opportunity created by lower rates. The company did not respond to a request for comment.
While lower rates should boost volume, the relief to nonbank mortgage originators will likely prove temporary, said Warren Kornfeld, a senior vice president for Moody's financial institutions group. He said he expected more consolidation when rates were rising in 2016 and 2017, but many of the small, privately owned companies in the space have been able to withstand bouts of little to no profitability. The recent decline in rates should provide further support for those nonbanks — for the time being.
"In the very near future, it's deferring the inevitable," Kornfeld said. "The inevitable being you need more consolidation in the industry to have healthier profitability."
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