The Refinance Boom is Over Implications for Mortgage Banking Through 2014 Highlights August 29, 2013 Kevin Barker 202.534.1398 [email protected]Steven Seperson 202.534.1387 [email protected]Companies Mentioned Ticker Price Target Rating BBT $42.00 Buy EVER $14.00 Sell FBC $14.50 Neutral FITB $19.00 Neutral NSM $58.00 Buy PFSI $18.00 Neutral PHH $26.00 Buy PMT $25.00 Buy PNC $82.00 Buy RF $10.50 Neutral STI $38.00 Neutral USB $36.00 Neutral WAC $43.00 Neutral WFC $42.00 Neutral The increase in mortgage rates has pushed refinance application volume down to levels we have not seen since early 2011. Given the expectation for rates to remain at current levels or potentially move higher, the refinance boom we experienced over the past 12 years has likely ended. Over the long-term, we expect this to result in a smaller, albeit more stable, market for mortgage originators if the market can effectively adjust capacity. However, in back half of 2013, we expect mortgage production revenues to be 20-30% lower than we saw in the first half of the year due to declines in both volume and margin. These declines have been confirmed by the 37% drop in the MBA market application index from last quarter and the ~20% drop in our gain on sale index. Market participants have already started to adjust to these declines by reducing staff, but it will likely take a few quarters before capacity adjusts to the decline in overall volume. We believe the headwinds in the mortgage market will continue to pressure companies heavily reliant on origination revenue through the end of the year. Second half of 2013 will test market. We expect the second half of the year to be one of the most competitive mortgage markets we have seen in the last five years. The recent rate move in rates and application volume is similar to what the market experienced from the second half of 2010 to the first half of 2011. During this period, mortgage banking revenue declined by an average of 26% for the largest market participants. We would expect the back of 2013 to look very similar to the first half of 2011, with a couple of exceptions due to changes in distribution and HARP volumes. Origination volume bottoms in 2014 over $1.2 trillion. The MBA estimates $1.1 trillion of originations in 2014. We believe this estimate could ultimately prove to be conservative because it assumes only 4.0% of all mortgages outstanding refinance in the next year. Since 1991, no less than 4.5% of all mortgages have refinanced in any given year. Considering HARP remains in place and many borrowers are now "in-the-money" with home prices continuing to rise, we believe at least 5% of mortgages could refinance in 2014, implying $490B of refinances. Combined with an estimated $750B purchase market, this could lead to an origination market between $1.2-1.3 trillion. Purchase-heavy originators have advantage. Lenders that tend to originate more purchase volume than refinance volume or have access to a larger pool of HARP-eligible borrowers will likely see a smaller decline in volume. Also, these lenders will tend to have stronger gain on sale margins considering borrowers are less price sensitive when buying a home or refinancing an underwater mortgage. Mortgage banks with largest purchase share during 2Q13 (in order): RF, WFC, BBT, USB, PHH, STI, EVER, FBC, PNC, NSM, FITB, WAC. We would point out NSM and WAC stand out as having a large amount of HARP-eligible borrowers in their servicing portfolios, which should be less impacted by mortgage rates near 4.5%. The banks most sensitive to the decline in refinance volume and margin, as it pertains to earnings, are FBC, EVER, FITB and USB. We would also expect PHH and PMT to see pressure on the top-line, but both are trading near or below TBV, we have significant declines already modeled and tend to originate more purchase volume compared to the industry. Adjusting estimates. We are adjusting our estimates to take into account the most recent indications of volume and margin. See page 2 for further details. See Important Disclosures on page 15 of this report.
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The Refinance Boom is Over - RealClearMarkets · Wells Fargo Mortgage Banking Personnel -Source: Wells Fargo Investor Presentation at Bank of America Conference 400 500 600 700 800
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The Refinance Boom is OverImplications for Mortgage Banking Through 2014
The increase in mortgage rates has pushed refinance application volume down to levels we have not seen since early 2011. Giventhe expectation for rates to remain at current levels or potentially move higher, the refinance boom we experienced over the past 12years has likely ended. Over the long-term, we expect this to result in a smaller, albeit more stable, market for mortgage originatorsif the market can effectively adjust capacity. However, in back half of 2013, we expect mortgage production revenues to be 20-30%lower than we saw in the first half of the year due to declines in both volume and margin. These declines have been confirmed by the37% drop in the MBA market application index from last quarter and the ~20% drop in our gain on sale index. Market participantshave already started to adjust to these declines by reducing staff, but it will likely take a few quarters before capacity adjusts to thedecline in overall volume. We believe the headwinds in the mortgage market will continue to pressure companies heavily reliant onorigination revenue through the end of the year.
Second half of 2013 will test market. We expect the second half of the year to be one of the most competitive mortgage marketswe have seen in the last five years. The recent rate move in rates and application volume is similar to what the market experiencedfrom the second half of 2010 to the first half of 2011. During this period, mortgage banking revenue declined by an average of 26%for the largest market participants. We would expect the back of 2013 to look very similar to the first half of 2011, with a couple ofexceptions due to changes in distribution and HARP volumes.
Origination volume bottoms in 2014 over $1.2 trillion. The MBA estimates $1.1 trillion of originations in 2014. We believe thisestimate could ultimately prove to be conservative because it assumes only 4.0% of all mortgages outstanding refinance in the nextyear. Since 1991, no less than 4.5% of all mortgages have refinanced in any given year. Considering HARP remains in place andmany borrowers are now "in-the-money" with home prices continuing to rise, we believe at least 5% of mortgages could refinance in2014, implying $490B of refinances. Combined with an estimated $750B purchase market, this could lead to an origination marketbetween $1.2-1.3 trillion.
Purchase-heavy originators have advantage. Lenders that tend to originate more purchase volume than refinance volume or haveaccess to a larger pool of HARP-eligible borrowers will likely see a smaller decline in volume. Also, these lenders will tend tohave stronger gain on sale margins considering borrowers are less price sensitive when buying a home or refinancing an underwatermortgage. Mortgage banks with largest purchase share during 2Q13 (in order): RF, WFC, BBT, USB, PHH, STI, EVER, FBC, PNC,NSM, FITB, WAC. We would point out NSM and WAC stand out as having a large amount of HARP-eligible borrowers in theirservicing portfolios, which should be less impacted by mortgage rates near 4.5%. The banks most sensitive to the decline in refinancevolume and margin, as it pertains to earnings, are FBC, EVER, FITB and USB. We would also expect PHH and PMT to see pressureon the top-line, but both are trading near or below TBV, we have significant declines already modeled and tend to originate morepurchase volume compared to the industry.
Adjusting estimates. We are adjusting our estimates to take into account the most recent indications of volume and margin. Seepage 2 for further details.
See Important Disclosures on page 15 of this report.
Refinance volumes still have not bottomed and we are entering the slowest
months for purchase volume. Purchase volumes are expected to peak in 3Q13
before dropping off in the seasonally-slow fourth and first quarters of the year.
Overall origination volumes are estimated to be ~$400B in 3Q13, ~$280B in
4Q13, and ~$280B compared to an average of $310B during the first half of 2011.
Mortgage Origination Forecasts ($B)
Source: MBA, Fannie Mae, Freddie Mac, Compass Point
If we were to take a closer look at mortgage banking revenue compared to the
second half of 2013, we estimate the average decline between 1H11 and 2H10
was 26%; in-line with our estimate for a 27% decline from 1H13 to 2H13. The
primary driver of the decline in our mortgage banking estimates is a decline in
origination volume. The average decline in our gain on sale margin is only 19%
compared to the 22% decline in the first half of 2011, but the decline expected this
time around is skewed due to changes in distribution mix (less
wholesale/correspondent lending).
Current Mortgage Banking Forecasts: 2H10 vs. 1H11 and 1H13 vs. 2H13E
1 2H10 figures are based on FY10 results in which revenue and originations are calculated by taking
50% of the FY10 results 2 Excludes servicing revenue 3 Excludes provision expense 4 2H10 and 1H11 gain on sale margins based off origination volumes rather than application volume
Current Gain on Sale Forecasts: 2H10 vs. 1H11 and 1H13 vs. 2H13E
1 2H10 figures are based on FY10 results in which revenue and originations are calculated by taking
50% of the FY10 results 2 Excludes servicing revenue 3 Excludes provision expense 4 2H10 and 1H11 gain on sale margins based off origination volumes rather than application volume
Source: Company Reports, Compass Point
If we look at historical trends, gain on sale margins still remain elevated compared
to the 2002-2007 time period. Over the past three years, the main driver of gain on
sale margins (primary-secondary spread) has been at 0.97% compared to average
spread of 0.14% between 2002 and 2007. Now, if we were to adjust the spread for
higher g-fees (roughly 34 bps higher), the spread now compared to 2002-2007 is
0.63%. Finally, the profitability of servicing has come down significantly and
caused MSR valuations to drop. This has lead to lower MSR capitalizations,
which are one of the biggest drivers of margins. Prior to the start of the financial
crisis, in some cases, it would only cost banks 3 bps to service a performing loan
and they could capitalize MSRs in the 130-150 bp range. Also, there was a huge
market for non-agency originations with much wider margins than those realized
in the agency market. Currently, the GSEs' account for over 85% market share
compared to roughly 40% during the housing boom.
Compass Point Gain on Sale Index (2002-Present, Quarterly Average)
Gain on sale margins vary tremendously from company to company depending on a host of factors, including: (1) the difference between the rates the company funds a
mortgage and sells into the market (company-level primary-secondary spread), (2) type of mortgages sold (Fixed, ARM, 30Y, 15Y, etc), (3) valuation of MSR capitalized, (4)
hedging results, (5) mix of retail, correspondent, and wholesale originations, (6) mark-to-market of loans in warehouse and several other factors. Also, many companies will
include/exclude certain expenses associated with the origination of a mortgage. Hence, it is important to look at trends on the company-by-company level in order to forecast
gain on sale margins rather than the market as a whole.
The basic calculation of gain on sale margin (excluding expenses) assumes a mortgage is originated at the going rate in the market, a guarantee fee is paid to the GSEs,
servicing fees are paid to the mortgage servicer, and the mortgage sold into the secondary market. The difference between these rates, fees and the effective duration of the
mortgage in the secondary market results in a price in which a pool of mortgages could be sold. The fees and other costs associated with originating that loan could be
excluded from this calculation.
The following table is for illustrative purposes only and presents a very basic view on the economics of originating a mortgage. Mortgage originators will also take into
account excess servicing strips, best execution on nearest TBA pricing, pipeline values, hedging gains/losses and other items when calculating their true gain on sale margin.
Gain on Sale Economics 101
Source: Bankrate, Bloomberg, FHFA, Compass Point
Inputs 3Q13 Avg 2Q13 Avg 2005-2007 Notes
Mortgage rates 4.44% 3.78% 5.77% primary rate
Guarantee-fee 0.52% 0.52% 0.18% paid to GSE
Servicing fee 0.25% 0.25% 0.25% paid to servicer
Net Yield 3.67% 3.01% 5.34%
MBS yield 3.47% 2.74% 5.75% yield in MBS market
Net Spread 0.20% 0.27% -0.41%
Duration (years) 7.3 7.6 3.9 mortgage duration
Secondary Market Price $1,012.87 $1,018.40 $985.58 price of bond in market
Face Value $1,000.00 $1,000.00 $1,000.00 original value of mortgage
Priced-in Margin 1.29% 1.84% -1.44% diff between secondary $ and mortgage balance
Capitalization of MSR 1.00% 1.00% 1.50% initial value of MSR created (non-cash)
Total Gain on Sale 2.29% 2.84% 0.06%
Other expenses/income to consider: bps
Broker compensation 0.75-1.25% cost to acquire loan from bank/broker
Cost to originate 0.50-1.50% commissions, fees, third-party vendors
Financing costs 0.05-0.50% interest expense of warehouse facil ity/deposits
Fee income 0.10-0.80% application fees, etc.
Float income 0.01-0.10% interest income from loan before loan is sold in mkt
Important DisclosuresAnalyst CertificationI, Kevin Barker, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities or issues. I further certify that I have not received direct or indirect compensationin exchange for expressing specific recommendations or views in this report.
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