The nation's three largest nonbank mortgage servicers picked a tough time to make an aggressive push into mortgage lending, but their efforts could pay off once new mortgage rules kick in.
Mortgage volumes are expected to drop 32% next year and if those predictions materialize, 2014 will be the worst year for mortgage lending since 2000.
That could threaten profits at Nationstar (NSM), Ocwen Financial (OCN) and Walter Investment (WAC), all of which have been trying to parlay their expertise in servicing distressed loans into the more lucrative realm of mortgage lending. The origination business is already a tough nut to crack banks and credit unions enjoy a decided funding advantage over nonbanks and observers that nonbank servicers need to find a niche if they are to compete effectively against banks.
The core problem they are having now is that they have purchased the rights to service nearly $1 billion in distressed loans with the intent of refinancing big swaths of those portfolios. But refinancings have slowed dramatically for the subset of loans still eligible for the government's Home Affordable Refinance Program, or Harp, which expires at the end of 2014. Many eligible borrowers have already refinanced or have simply not responded to offers to do so.
"They're all getting hit by lower refinance volumes, and Harp refinancings are a lot of their originations," says Warren Kornfeld, a senior vice president at Moody's Investors Service. "Originations are very important for these companies, they have to be originators or they will be a melting ice cube."
The nonbank servicers have significantly ramped up their lending volumes over the past year through acquisitions.
Nationstar already had a sizable lending operation when it bought Greenlight Financial, a higher-margin direct-to-consumer lender in Irvine, Calif., last year. The Lewisville, Texas, servicer, which is owned by the asset manager Fortress Investment Group (FIG), had been looking to compete head-to-head with the likes of Wells Fargo (WFC). But an increase in interest rates has forced Nationstar to join the ranks of large banks that have scaled back and announced layoffs.
Last week, Nationstar said it plans to sell its wholesale and retail lending channels and cut 1,100 employees this quarter to reduce expenses and consolidate offices.
Jay Bray, Nationstar's CEO, said on a conference call last week with analysts that the lending business will post an expected loss in the fourth quarter. Nationstar originated more than $8 billion in the third quarter, up 13% from the second quarter. Its pipeline of loan applications a key metric indicating the next quarter's loan closings fell 12% from the second quarter, to $10.9 billion.
Meanwhile, Walter bought Residential Capital's origination platform in January. Walter, which owns the mortgage servicer Green Tree, originated $6.1 billion in the third quarter, a 30% increase from the second quarter, but the Tampa company's pipeline fell 11%, to $8.2 billion.
Ocwen last year bought Homeward Residential from the private-equity firm WL Ross & Co., and it said it plans to acquire more lending operations to boost revenues.
"People often criticize our industry as being a melting ice cube," Ocwen Chief Financial Officer John V. Britti said Tuesday at an investor conference in New York. "We think we can be competitive as an originator."
Ocwen originated $1.4 billion in the third quarter, down 14% from the second quarter, while lending originated through partnerships fell 300%, to $142 million. The Atlanta company did not disclose its pipeline of loan applications.
Scott Buchta, the head of fixed-income strategy at Brean Capital, says the nonbanks could carve out a niche by lending to underserved and minority borrowers that may be shut out of the home loan market by the qualified mortgage rule that takes effect Jan. 10. The QM rule requires that borrowers have a debt-to-income ratio of 43% or less, and it is widely believed that many banks will be reluctant to make loans that do not meet QM standards.
"Because of higher interest rates and the drop in refinancings, it's a bad time to be in the lending business," Buchta says. "But the nonbank servicers also could be ahead of the curve if they push into the underserved non-QM market."
For the past three years, the nonbank servicers have gorged on Harp refinances, which are restricted to loans backed by Fannie Mae and Freddie Mac with loan-to-value ratios of up to 125% or higher. Harp activity has dropped sharply, down 60% since April, Buchta says. Refinancings will clearly not be the same growth engine going forward.
"The question I think people have is what happens once they run out of Harp-eligible loans," says Bose George, an analyst at Keefe, Bruyette & Woods. "They are building out their origination business, but they have to prepare themselves for the post-Harp world."
Mark O'Brien, Walter's chairman and CEO, said on a third-quarter conference call with analysts that he expects so-called "recapture rates," which measure the percentage of borrowers who can still refinance, will drop in half from a high of 65%. Historically recapture rates have averaged 15% to 20%.
O'Brien was clear that as refinances drop, retail lending will have to pick up the slack.
"We still have hundreds of thousands of Harp-eligible loans in our portfolio. But over time, as Harp becomes fatigued and stale, there are only two places to go: retail and correspondent," said O'Brien. "The battle will be fought and won or lost in the retail business."
Kornfeld at Moody's agrees that nonbank servicers need to find a niche if they are to win market share from banks that have funding advantages. As others have, he predicts that nonbank servicers will ultimately move down the credit spectrum and lower credit standards to reach nonprime borrowers.
"We believe the companies will have to choose between lower profitability, lower market share, or expand into other lines of business," Kornfeld says.