By Carmen Arroyo, Steven Church and Maxwell Adler | Bloomberg
The U.S. mortgage industry is seeing its first lenders shut after a sudden spike in lending rates, and the coming wave of failures could be the worst since the bursting of the housing bubble some 15 years ago.
There is no systemic meltdown coming this time around because there hasn’t been the same level of excess lending and because many of the biggest banks pulled out of mortgage lending after the financial crisis.
But market watchers nonetheless expect a string of bankruptcies broad enough to trigger a spike in layoffs in an industry that employs hundreds of thousands of workers, and potentially an increase in some loan rates. More of the business is now controlled by independent lenders, and with mortgage volumes falling this year, many are struggling to stay afloat.
“Non-banks are poorly capitalized,” said Nancy Wallace, president of the real estate group at Berkeley Haas, the business school at UC Berkeley. “When the mortgage market crashes, they’re in trouble.”
In 2004, only about a third of the top 20 refinance lenders were independent businesses. Last year, two-thirds of the top 20 were non-bank lenders, according to LendingPatterns.com, which analyzes the industry for mortgage lenders. Since 2016, banks have seen their market share fall from around half to around a third, according to news and data provider Inside Mortgage Finance.
Many of the so-called shadow lenders will emerge relatively unscathed from this downturn. But some lenders have already ceased operations or significantly reduced operations, including Sprout Mortgage and First Guaranty Mortgage Corp. Both specialize in riskier loans that are not eligible for government support.
First Guaranty, a company which, according to court documents, is majority-owned by fixed-income giant Pacific Investment Management Co., filed for bankruptcy, saying it failed after making loans earlier this year including the value has dropped. He held onto those loans until he had enough to pool them into bonds and sold them to investors, and he temporarily funded them with a line of credit.
Once interest rates started to climb, lending volumes declined across the sector, according to court documents. That meant the company could no longer find enough new loans to consolidate or secure enough financing to keep operating, First Guaranty chief executive Aaron Samples said. Companies such as Flagstar Bank and Customers Bank owe about $418 million, according to court documents.
First Guaranty employed 600 people before filing for bankruptcy in June and issued $10.6 billion in loans last year, court records show. Days before seeking court protection, the company laid off 471 workers because it could not secure enough financing to weather a cash crunch.
Independent lenders gained a foothold in the market because banks pulled back heavily after the 2008 financial crisis, which began with excessive mortgage lending. Regulators have often encouraged retirement, and it’s still happening: Wells Fargo & Co., Wall Street’s largest US mortgage firm, plans to shrink its home-lending empire, Bloomberg reported this week.
Unlike banks, independent lenders often don’t have emergency programs they can call on for funding when times are tough, nor do they have stable deposit funding. They depend on lines of credit which tend to be short term and depend on mortgage prices. So, when stuck with bad assets, they face margin calls and risk bankruptcy.
Many independent lenders have managed their risk well, and for lenders who work a lot with government-backed companies like Fannie Mae and Freddie Mac, the situation is less dire. They can often get emergency funding from government-sponsored companies if they run into trouble. But lenders who make riskier loans and work with GSEs less often have fewer options when faced with margin calls.
“Part of the reason these companies are in trouble is that loans cannot be funded by GSEs,” David Goodson, head of securitized credit at Voya Investment Management, said in a telephone interview. “Financing options are more limited, which is particularly painful when financial conditions tighten.”
Many other lenders have seen their loan values fall, said Scott Buchta, head of bond strategy at Brean Capital, an independent investment bank.
The Federal Reserve has tightened rates by 2.25 percentage points this year in an effort to control inflation, and US 30-year mortgage rates have jumped above 5% for government-backed loans. That’s close to their highest levels since the financial crisis, around 3.1% at the end of last year.
This has reduced the value of home loans made just a few months ago. A mortgage taken out in January and not eligible for government support could have been trading in early August at around 85 cents on the dollar. Lenders usually try to give out loans worth around 102 cents to cover their initial costs.
For a lender whose loans have fallen to 85 cents, the losses can be debilitating, even if they have not yet been realized. On top of that, business is plunging widely. The overall volume of mortgage applications has fallen by more than 50% this year, according to the Mortgage Bankers Association. These trading terms incentivize banks that provide lines of credit called warehouses to make margin calls and cut credit.
“Warehouse lenders in this industry seem to be extremely savvy in this downturn, unlike in 2008,” said bankruptcy attorney Mark Power, who is representing creditors in the First Guaranty bankruptcy. “They make margin calls quickly.”
Banks have emergency funding they can tap into in times of crisis, which can often keep them afloat in difficult times. But not always: Federal Reserve emergency funding is generally only available to solvent institutions with a chance to recover. During the last recession, so many banks had so many troubled loans and troubled assets of all kinds that hundreds went bankrupt. Non-banks also went bankrupt.