Loan Limit Primer; Lessons on Basel III, Ocwen Debt Ratings, and Mortgage Company Ratings and Profits

"We must, indeed, all hang together or, most assuredly, we shall all hang separately." No, the CEO's of Freddie and Fannie did not say that, it was Benjamin Franklin. But some will suggest that it can also apply to F&F, who won't hang but who, over time, are merging their policies and practices. Last week, in case you missed it, Fannie Mae and Freddie Mac aligned certain servicing polices, and spread the word via announcements reflecting their recent effort to comply with an FHFA directive that the Enterprises work together to harmonize certain of their servicing policies and develop a consistent framework for assessing servicer performance. Fannie's bulletin can be found at https://www.efanniemae.com/sf/guides/ssg/annltrs/pdf/2012/svc1221.pdf and Freddie's at http://www.freddiemac.com/sell/guide/bulletins/pdf/bll1220.pdf. They include changes regarding performance metrics for assessing servicers' fulfillment of their duties, compensatory fee structures, servicer violations and remedies, and servicing terminations and transfer of servicing. Some contractual changes take affect now, although the bulk of the servicing changes occur on January 1.

"Rob, what do you hear about the conforming loan limit changes for this year?" The quick answer is, "Ask your Fannie or Freddie rep." The longer answer is more entertaining. In "the old days," Fannie and Freddie would bring out the new limits on the weekend after Thanksgiving, and the maximum loan amount was set based on the October-to-October changes in median home price. (By the way, the Office of Federal Housing Enterprise Oversight - OFHEO - set the criteria on what constitutes a conforming loan, including debt-to-income ratio limits and documentation requirements.) But things became fuzzy when a temporary increase in the Conforming Loan Limits for high-cost areas of living was incorporated into the 2008 economic stimulus package, moving it up from $417,000. Congress authorized an increase of the single family residences limits to the lesser of $729,750 or 125% of the median home value within the metropolitan statistical area (MSA). Last year this $729,750 level was ratcheted back to $625,500 - and although there was plenty of griping along the coasts, the housing market did not collapse. And LO's and Realtors on those coasts need to remember that there is not a lot of political push from the country's midsection for high conforming loan limits.

So at this point, the $417,000 limit applies across most of the country. But in areas with high home values (I believe 250 counties), the government increased those limits. So look for a change in November, although it will impact very few areas of the country.

One thing that really could have a big impact is Basel III. Many groups believe that Basel III's proposed changes to required capital by banks would be a big setback for the mortgage industry, and in turn real estate values. Those groups are now joined by the Conference of State Bank Supervisors (CSBS): http://www.csbs.org/news/press-releases/pr2012/Pages/pr-100312.aspx. "Although they support higher levels and improved quality of capital, the state regulators argue that the transaction-level approach proposed by federal regulators is too complex and leaves the financial system susceptible to more volatility." In my travels around to various groups, it seems that while senior management is often aware of the ramifications of Basel III, loan officers, escrow officers, and Realtors are not.

How will Basel III impact mortgage earnings, and what are the ramifications on the Ocwen/Homeward deal? A seasoned industry vet wrote to me yesterday, "Even though non-banks are not subject to the Basel III rules, and even though the risk-weighting is going from 100% (of 8%) to 250% (of 8%), banks will still only have to hold a minimum of 20 cents of equity to every dollar of MSRs under the new rules, which will allow the banks to generate very attractive return on equity from that kind of leverage.  For non-investment grade non-banks that are holders or MSRs, even though in theory they can hold less than 20 cents of equity for each dollar of MSR, any lender that will finance MSRs is more likely to require at least 50 cents of equity for each dollar of MSRs, and when Countrywide was rated single A it had to hold 33 cents of equity for each dollar of MSRs. Without a debt rating, your financing is likely limited to a short term bank line of credit that will create refinance risk as a result of investing long and borrowing short. Assuming unlevered returns on MSRs remain in the high single digits over a cycle, even if you can finance in the medium term note market like a PHH (rated Ba2 by Moody's, BB- by S&P), their last MTN issuance on August 9, 2012 carried a very unattractive coupon of 7.375%, which was better than the Dec 2011 issue with a coupon of 9.25%, but still terribly unattractive financing.  Ocwen's ratings are worse by my source (SNL) which shows a B1 rating from Moody's and a B rating from S&P.  Coincidently, Ocwen has not issued any debt since 2004 but has issued common equity, which has a much higher implied cost of capital than debt. I am not sure why Ocwen is trading at 354% of tangible book value for a business that creates a sub-teen ROE but I admit I have not studied the company's model in detail.  (OCN's six month annualized ROE was 9.06%, and its full year 2011 ROE was 7.86%. On the surface, it seems like a potentially interesting short idea (and it does not pay a dividend)."

And T.J. Leverte from California writes, "On the surface it makes no sense that a financial (even non-bank) should trade at such a high multiple of book. The short answer is that returns are higher than they appear, and the business is not a finance business but a service company. Their business model has been transforming over the last 12 months. The new risk weighting on MSRs are much stricter but most banks are well within Basel III rules.  I think banks will find the mortgage business continue to be profitable as they are seeing today.  As we all know, with BofA leaving it creates an enormous opportunity for a number of players. As for OCN, its subprime MSRs have been a good performing asset because they have been insensitive to voluntary prepays, and advances have been dropping thus increasing ROI.  OCN will tell you that they target and have generated a 20+% pretax profit on invested assets.  This is not readily apparent in past financials because they amortize MSRs at a faster rate than they realize, and ROI is initially lower during the boarding process due to inefficiencies and high level of advances.  As the MSR ages, returns improve.  Since much of the MSRs were boarded in 2011, you can see the benefit from these bulk MSR purchases.  So their ROE is substantially higher than what past financials appear."

T.J. continues, "In addition, recently they have created a way to lower their tax rate to 10%, and the recent Homeward acquisitions will lump on a huge growth to earnings in 2013.  Estimates for 2013 are $4.25/share. Still, should a servicer (and now an originator after buying Homeward) who buys MSR's trade at such a high multiple of book even with a mid-teens adjusted ROE?   Maybe not.  However, OCN and Nationstar (for that matter) are designing their business "asset light".  MSR's will be funded by separate entities while OCN will continue to get paid to service the loans. OCN currently uses HLSS for their subprime MSRs and will create another one for prime MSRs.  Nationstar uses Newcastle and a private investment arm to purchase MSRs.  So this capital light, model essentially removes the capital intensity nature of the business, creating a high return scalable business. In this case, it deserves a large multiple. I would also make the argument that I believe that current production MSRs are generating a much higher return that high single digits.  Much of the research I have seen puts newly originated MSRs in the low teens. We have also seen large banks (who do have servicing capability) hire OCN, WAC and Nationstar to do subservicing on a flow basis.  Why would they do this?  Because they don't have the capability/ability/desire to service delinquent loans.  I do believe that the current regulatory environment is driving business to the special servicer non-banks, not necessarily due to capital restrictions (Basel III) but due to the various servicing rules that will hit because of Dodd Frank.  Most banks created their servicing arm for scale not for implementing high touch servicing rules.  Banks would prefer these special servicers deal with this.  And since there is a lack of special servicers relative to demand, their returns should be higher." (If you'd like to reach T.J., formerly with Talkot Capital and starting a new hedge fund, he can be found at tj@talkot.com.)

Lastly, on last week's Ocwen news of entering the loan origination business with its purchase of Homeward Residential, I received a note clarifying things from CMC. To clarify, "Homeward never purchased any MSRs from CMC or Cunningham. CMC somehow got swept up in several reports (incorrectly) in the Ocwen news. WL Ross funds remain shareholders in CMC (which owns 100% of Cunningham), and nothing of CMC was sold in the Ocwen transaction." Thank you!

On to a little M&A, investor, and personnel news to give us a flavor for recent trends. As always, it is best to read the full bulletin.

Although the commentary rarely lists personnel moves (there are too many), here's one that will make brokers happy. Congrats to R.J. Arnett, now the EVP of wholesale lending for ICON Residential Lenders. It was recently announced that Rushmore Loan Management Services has signed an agreement to acquire ICON from Grand Bank NA. The transaction is expected to close in the fourth quarter of 2012 or the first quarter of 2013.

Kinecta Federal CU is requiring that the updated Anti-Steering Declaration (available at https://www.kinecta.org/uploadedFiles/Broker/KFCUW6293_LenderPaid_LO_CP_AntiSteeringDeclaration.pdf) be used for all transactions with Lender Paid Compensation that were submitted on or after September 21st or that are currently in the pipeline.  All of the borrowers listed on the Note should sign the Declaration at least one business day prior to closing, as should the loan officer.  Previous versions of the Kinecta Anti-Steering Declarations are no longer being accepted.

KBW announced that NBT Bancorp and Alliance Financial Corporation, public companies based in and around NY and the Northeast, have entered into a definitive agreement under which Alliance will merge with and into NBT. The merger is valued at approximately $233.4 million and is expected to close in the second quarter of 2013 subject to customary closing conditions, including receipt of regulatory approvals and approvals by NBT and Alliance stockholders.

Over the weekend, and during the holiday, analysts and the press continued to cogitate on Friday's payroll numbers. (Jobs and housing, housing and jobs - and especially with the impending election, a move like that is surprising.) Most accounts agree that the September Employment Report showed a massive disconnect between the payroll employment survey and the household employment survey through the third quarter, allowing the unemployment rate to drop to 7.8% despite lackluster payroll job growth. This represents the lowest rate since Obama took office.  How does the unemployment rate fall by so much when the economy only produced a meager 114,000 jobs? Well, the "headline" 114,000 comes from the "Establishment" or business survey where businesses are called and the birth/death ratio guesstimating is also factored in to come up with a number.  There are also revisions over time which gets us to a more accurate figure down the road. But the unemployment rate comes from the "household" survey, where phone calls are actually made to households. This survey showed a jump of 873,000 more people employed in September. On balance, this report confirms an economy producing 125,000 to 140,000 jobs per month and that is not even enough to keep up with immigration and population growth. 

Unlike the fireworks on Friday, there aren't too many scheduled market moving numbers this week in the United States. Yesterday was a bond market holiday, there is zip today, and Wednesday pretty much only has the MBA apps numbers. (Wednesday has the Fed's Beige Book in the afternoon.) Thursday has Jobless Claims, some Trade Balance figures - which include the import and export prices. And then on Friday are the Producer Price Index and some forgettable University of Michigan Consumer Sentiment numbers. Rates have, however, improved from Friday: the 10-yr has gone from 1.75% to 1.71%, and agency MBS prices are better by .125-.250.

Many folks wonder what happened to all the "great" jumbo and Alt-A guidelines. Here's your answer: http://www.youtube.com/watch?v=jDzV3qycOqM.