The Next Asset Likely to Blow Up Big Banks’ Balance Sheets

NEW YORK (The Street) -- As beleaguered mortgage-debt collector Ocwen Financial Corp. (OCN) moved to sell off its portfolio under pressure from regulators, more than a few veteran mortgage-industry executives were surprised that one of the buyers turned out to be JPMorgan Chase & Co.  (JPM).

Big banks exited the mortgage-debt-collecting business in a hurry from 2009 to 2014, and it was easy to see why. They paid billions in fines and did untold damage to their reputations in exchange for a paltry fee -- roughly $500 per year before expenses on a typical $200,000 mortgage. Another big factor was the new capital rules known as Basel 3, which penalize banks with heavy exposure to the mortgage-debt-collection business, known as mortgage servicing.

Banks would still make home loans, of course, but it appeared they were happy to leave the servicing to non-bank specialists such as Ocwen, Nationstar Mortgage Holdings (NSM) and Walter Investment Management (WAC).

The exodus, though, was apparently short-lived. In addition to JPMorgan Chase, PNC Financial Services Group  (PNC), Regions Financial Corp.  (RF) and SunTrust Banks  (STI) have all been bidding for mortgage-servicing assets, frequently called mortgage-servicing rights. Aided by borrowing costs that are lower than those of the non-bank servicers, some banks are earning eye-popping returns of more than 20% on MSRs. And the returns are amplified by leverage and complex hedging strategies. But even proponents say the risks are substantial.

JPMorgan Chase declined to comment. The bank still has yet to confirm that it is buying MSRs on $45 billion in mortgages from Ocwen, though the deal has been widely reported and was confirmed to The Deal by a person with knowledge of the transaction. Wells Fargo  (WFC), PNC, SunTrust and Regions also declined to comment on their strategy regarding MSRs or MSR hedging.

"I do think it's an attractive asset but I think it's kind of shortsighted to think that it's going to be a 20% yielding asset for the long term," says Bob Koets, a trader at Boca Raton, Fla.-based AVM Solutions who consults with banks on their MSR-hedging strategies.

Most people have never heard of MSRs, but these assets and related hedges are among the most volatile instruments on bank balance sheets. That's because their value shifts constantly with changes in interest rates. The largest banks all hedge this risk, though the hedges can at times be more volatile than the MSRs themselves.

"If you don't have MSR hedging expertise -- and frankly most people don't -- and we get into volatile times, then there's a lot of risk," Koets said. "It's not easy." Asked whether bank losses on MSRs or MSR hedges could represent a systemic threat, Koets replied, "absolutely."

In fact, several institutions, including a set of fairly large and well-known banks, have foundered on MSRs. And some experts believe the business is about to get much more difficult to operate. That's why some big banks are staying out.

Still, just as many are finding the lure of returns irresistible. While many of the banks could withstand a complete collapse of their MSR operations -- thus rendering the systemic risk somewhat remote -- the resulting hit on their stock prices would not be pretty. So it pays to keep an eye on which banks are going in even further.    

On the face of it, mortgage servicing appears simple. A new loan to a borrower with strong credit typically costs about $60 per year to service, according to Mark Garland, president of Denver-based MountainView Analytics and a specialist in MSR valuation. So the servicer typically earns $440 of the $500 annual fee.

If the borrower runs into trouble, however, the work can get expensive. The foreclosure process can cost $1,000 annually, and in states like New York it can take as long as three years, Garland said.

Additional revenues can come from late payment fees, sums borrowers pay to wire money and avoid the late payment, and interest servicers earn between the time they collect the payment from the borrower and pass it on to the investor in the loan. Added costs include lost interest income when borrowers don't pay on time and servicers have to advance payments to investors. Servicers aren't on the hook for the loan itself, however.

The going market rate to acquire the MSR on a performing mortgage is 1%, or $10 million on a portfolio of performing mortgages where the outstanding debt totals $1 billion.

That is priced to generate a pretax return of roughly 8% to 11%, compared with a commercial real estate or business loan that yields in the 2.5% to 4% range. "It's another way to increase your income -- whether it's fee income or interest income -- compared to making commercial loans at very low yields," said Kevin Barker, analyst at Compass Point Research & Trading.

HomeStreet (HMST) a Seattle-based bank, gets closer to 12% to 15% returns on mortgage servicing, according to CEO Mark Mason. That's because it performs better than the norm when it comes to controlling expenses and avoiding defaults, he said.

But that's just the starting point. HomeStreet has roughly doubled those returns through hedging. "A lot of people don't understand the technicalities or the metrics of hedging servicing assets. Most people believe hedging costs you money," Mason said.

Banks hedge MSRs because their value falls as interest rates decline, due to an increased likelihood homeowners will refinance their mortgage and the servicing contract will be canceled sooner than anticipated.

And banks offset this risk by buying assets that rise in value as interest rates fall. HomeStreet buys interest-rate swaps and mortgage-backed securities that earn roughly 2.75% on average. To hedge roughly $112 million in servicing assets in 2014, HomeStreet bought hedging instruments worth about $500 million, according to Mason.

To calculate its return on the hedge, HomeStreet multiplies 2.75% by 4.5 to get 12.375%, since the hedge represents 4.5 times as many assets as the MSRs. "That yield in effect becomes additional income or enhances the yield if you will on the servicing assets themselves," Mason said.

So by adding 12.375% to the 12% to 15% yield, HomeStreet generates returns of nearly 30%. That's not a bad trick in an environment where 10-year Treasuries yield 2%. "A commercial bank that earns 10% return on equity is good performing commercial bank," Mason observed.

Not all banks hedge MSRs. Austin Tilghman, president and CEO of MSR-hedging consultant United Capital Markets, said he believes the largest 15 mortgage banks all do, though many slightly smaller ones do not because they don't understand how to do it. He contends many more banks should be hedging, arguing those most exposed to losses may be precisely those that don't hedge.

FBR Capital Markets analyst Paul Miller used to be skeptical of MSR hedging, but he said he has been won over by conversations with hedging specialists. "People have told me if you're a bank and you're flush with liquidity, the hedging is not a dangerous thing," he said. "Wells Fargo has been doing it for years."

"For Wells Fargo it's an income generator," Miller added. "It comes across as hedging gains but it's very consistent."

The profits have indeed been consistent at Wells, but the hedging and the value of the underlying assets can rise or fall by billions of dollars in any given year. Even if Wells remains successful in avoiding blowups, it seems almost inevitable some institutions will stumble, as has occurred in the past.

Jim Cramer's charitable trust Action Alerts PLUS owns Wells Fargo. Get full analysis on the stock with a free trial subscription.

Examples of such stumbles include Homeside Lending, a Jacksonville, Fla.-based institution which misvalued MSR assets, causing it to hedge those assets improperly, according to a 2002 report commissioned by its former owner, National Australia Bank. Homeside's errors led to more than $2 billion in writedowns over a four-month period.

MSR hedging also contributed to the blowup of National City. Once the seventh-largest bank in the U.S., the Ohio-based lender was forced to sell itself to PNC in a federally assisted deal in 2008. There was also Cendant, a conglomerate that saw its mortgage unit announce a surprise $175 million quarterly loss in September 2002 due to a refinancing wave.

Since the 2008 financial crisis, however, it has been "a golden era for hedging servicing," according to AVM's Koets.

That could change if interest rates were to rise sharply, or begin to swing up and down, making it expensive for banks to reposition their portfolios. Indeed, in recent days a sharp selloff in German government debt and a more moderate one in U.S. Treasuries have prompted several bond-market experts from Janus Capital Group's Bill Gross to Michael Novogratz of Fortress Investment Group to warn -- yet again -- about the end of the multi-decade bond bull market.

"You have to make adjustments to your hedge on a regular basis either because your portfolio grew, shrank or changed in risk characteristics," explained UCM's Tilghman. For example, a bank that needs a $90 million interest rate hedge in one month might suddenly find it needs a $100 million one in the next. "That adjustment is painful," Tilghman said.

Still, given the success banks such as HomeStreet and Wells Fargo have enjoyed, it seems worth asking whether other big banks aren't missing out on sizeable returns by carrying fewer MSRs on their books. Bank of America (BAC), the most aggressive seller of MSRs, owned just $3.5 billion in such assets as of the end of 2014, down from nearly $20 billion at the end of 2009. By contrast, Wells Fargo's MSR balance has declined to $13 billion from $16 billion over the same period.

Bank of America isn't interested, however, in owning MSRs strictly for the return, according to spokesman Jerry Dubrowski.

Instead, the bank wants to "refocus our mortgage business on our core customers: people that we do business with in some other part of the bank," Dubrowski said. Unlike Wells Fargo, Bank of America no longer buys mortgages it doesn't originate itself. Bank of America is no longer interested in "people that come in through a different door, have no relationship with us, have no desire to have a relationship with us and are only using us for the balance sheet," Dubrowski added.

Indeed, banks that view MSRs merely as assets to be bought and sold for their return characteristics risk losing sight of the fact that behind each loan serviced is an actual or potential customer. HomeStreet CEO Mason conceded his bank learned this lesson the hard way last year when it sold MSRs on mortgages worth $3 billion to SunTrust. HomeStreet sold the assets to prepare its balance sheet for the effective date of Basel 3.

Mason said borrowers who took out a mortgage with his bank believed "their relationship over the life of their mortgage would be with HomeStreet and we had to breach that when we sold that servicing and it was very negative for us. Notwithstanding all the direct and calculable financial impacts we had a very negative social impact on the business."

As a result, HomeStreet has no further plans to sell MSRs, even though Mason believes they got the highest price paid in the marketplace for conventional servicing assets. "We had a good experience economically with the sale but everything else was very negative." Just as HomeStreet's decision to sell its MSRs hurt its relationships with customers, JPMorgan Chase thinks owning MSRs has advantages beyond their potential to generate strong returns.

Miller, the FBR analyst, says he asked JPMorgan Chase mortgage chief Kevin Watters what he thinks people most frequently fail to understand about his company's mortgage-banking business. "It's the servicing," Miller said Watters told him. "They miss the fact that servicing supports production, and if you don't have a decent-sized servicing platform you can never maintain any type of predictability in the mortgage bank."

For example, banks that service a loan stand a good chance of winning the refinancing business if rates fall.

That partly explains why Regions CFO David Turner stated on the bank's most recent earnings call that while it is looking for servicing assets, "We aren't going to buy just any portfolio. We want to buy a portfolio that's in our market. We want a portfolio where those can be our customers."

That may mean selling credit cards or asset-management services to a mortgage holder, but it may also mean refinancing a loan if interest rates fall. So lost servicing fees are offset by the fee for originating the new loan. Currently, however, with rates expected to rise, the outlook for MSRs is favorable. Rising rates mean fewer mortgages get refinanced and MSRs rise in value as the servicing contracts should last longer.

Nonetheless, the shadow of past implosions lingers over the asset class. Bad bets on interest rates played a big role in the savings and loan crisis of the 1980s and '90s.

Looking at available numbers, however, it seems like a tall order for MSR losses to take down a systemically important institution. Wells Fargo has a nearly $200 billion capital cushion comprised mainly of equity and long-term debt to protect it against insolvency. Even in the difficult-to-conceive scenario in which Wells' entire $13 billion MSR portfolio went to zero, the bank would still have plenty of protection. Wells doesn't disclose how much money it uses to hedge that $13 billion portfolio, but assuming it employs a strategy similar to HomeStreet, it could be four and a half times as large -- or nearly $60 billion.

Marty Mosby, bank analyst at Vining Sparks, is not unsettled by these numbers, however. The securities Wells uses to hedge its exposure are nearly as safe as short-term Treasury bonds, and they will move in the opposite direction of the $13 billion in assets being hedged. "It's a lot easier to hedge this than what people really imagine," Mosby said. "You have 30% swings in the overall value but at the end of the day the income impact is very modest." .

But if it's so easy, how to explain the blowups in the past? Losses such as those often occur when banks are essentially gambling rather than hedging, Mosby said.

"What banks will do at times when earnings are tough is they'll outsmart themselves and say 'look at this profit!' and they'll start to use those folks that are in the market hedging [as] folks in the market taking proprietary positions and they'll disguise it as mortgage servicing hedging," Mosby added.

Mosby said he is most familiar with the National City blowup, but UCM's Tilghman makes a near-identical comment to describe the $2 billion in losses at Homeside. "That wasn't a hedging problem," Tilghman said. "That was a speculative problem."

Figuring out how to tell the difference does not appear to be the easiest task. Mosby said he believes warning signs will appear in quarterly results "All of a sudden instead of seeing a natural kind of number that shows some consistency you start to see wild swings from one quarter to the other. Then all of a sudden you know they're taking proprietary positions," he said.

This scenario sounds like the kind of realization that might send a bank's shares tumbling 20% all at once. Whether or not it's a systemic threat, banks' renewed interest in MSRs should be viewed with some skepticism.

As hedging consultant Koets put it: "If there was something that could earn 20% risk-free it's not going to exist in a 1% interest rate environment. There's got to be a risk there."

Undoubtedly there is. But as long as interest rates stay close to historically low levels, it is a risk an increasing number of banks are likely to embrace.

If you liked this article you might like

Wall Street Ends Lower as Crude Slumps, French Election Looms

Wall Street Ends Lower as Crude Slumps, French Election Looms

Stocks Mostly Lower as French Election Raises Uncertainty, Crude Slides Below $50

Stocks Mostly Lower as French Election Raises Uncertainty, Crude Slides Below $50

Stocks Decline as French Election Raises Uncertainty

Stocks Decline as French Election Raises Uncertainty

American Express Sparks Rally on Wall Street, Treasury Secretary's Tax Comments Light a Fire

American Express Sparks Rally on Wall Street, Treasury Secretary's Tax Comments Light a Fire

Closing Bell: Ocwen Financial Loses Half Its Value; Nasdaq Sets New Record

Closing Bell: Ocwen Financial Loses Half Its Value; Nasdaq Sets New Record