What To Do When Profits Bolt Down

“Banks that are state or federally chartered cannot file for bankruptcy, they get taken over by the FDIC or state regulators. But a lot of mortgages are serviced by private companies that are privately or publicly held,” Power explained. “Last year in the spring of 2022, interest rates spiked. At the same time, the Fed and Treasury pulled back on the amount of money they were putting into the system, which means they weren’t buying as many mortgage-backed securities. The market became extremely tight.”

Power said that as soon as the market tightened, loans with locked rates caused mortgage companies to start losing out on money from loans, causing significant cash drains on liquidity. “And banks who lend to them started holding back and charging higher interest rates,” Indelicato added.

Over the Years

The two partners have been working with each other as bankruptcy attorneys for decades. They joke that the other is the third most important relationship in each other’s lives, aside from their respective wives and mothers. The two share similar opinions about the market; last year’s market — which has continued into 2023 — is something that both Power and Indelicato describe as chaotic.

“Last year we saw several loan companies that didn’t have a deep enough balance sheet got hit and lost money, they had significant cash outflows,” Power said. “When interest rates double, people are less interested in getting loans. The volume of new homeowners looking for loans dropped about 50%, so imagine that your revenue dropped by half. And layoffs and severances also contribute to money being lost.”

Clifford Rossi, an executive-in-residence and Professor-of-the-Practice at the University of Maryland’s Robert H. Smith School of Business and financial risk expert, says that the demise of a mortgage business can be avoidable. “Simply put, no matter what type of entity the mortgage company is, they need to be practicing good interest rate and liquidity risk management practices,” he said.

Indelicato says that it all comes down to liquidity. “A lot of non-bank originators are struggling because they don’t have liquidity,” he explained.

Power added, “What’s contributing is that banks don’t have a big enough balance sheet, and [they] will see more defaults, especially those with adjustable-rate mortgages. People are going to try and sell their homes There’s going to be a decline in the real estate values of the homes because there will be more inventory. We saw the same thing in 2008. The amount of cash needed to service mortgages just became too much, and banks couldn’t keep up.”

So what makes today different from 2008? Indelicato says it’s important to remember the market that we’re coming out of. “The pandemic caused us to see an incredible uptick in home purchases. The origination and refinance markets were off the charts,” he said. “A lot of companies built infrastructure to maintain this demand, which disappeared overnight.”

Indelicato says that they represented First Guaranty Mortgage, which filed for Chapter 11 bankruptcy in June 2022. “They built a platform to service more loans, which disappeared overnight. Their liquidity was strangled. The impact of the increased interest rate affected that and their profitability.”

To put it into perspective, Power says that 2021 was the largest year of loan originations in the industry. A year later, the market cut in half.

Avoiding the Slump

Rossi, who formerly held senior risk management and credit positions at Freddie Mac and Fannie Mae, says that mortgage institutions now are not as stable as they once were.

“Due to structurally what’s been happening over the last 15 years, traditional banks have largely exited the origination and servicing sides of the industry, which led non-bank financial institutions to take that space over,” he explained. “Generally speaking, though, they suffer from certain characteristics that make them volatile: They’re thinly capitalized, they don’t have to adhere to certain risk requirements, have volatile liquidity and sources of liquidity, [and their] depositories are dependent on low-cost deposits.”

Rossi also says that today’s economy coupled with the changing mortgage business — which was formerly driven by refinances and has changed into a purchase market — makes it hard for mortgage businesses and lenders to eke out profits. Additionally, he says that state regulatory policies have become lax. “IMBs aren’t diversified and aren’t subject to federal safety and soundness oversight, and state regulators may give oversight,” he said.

Rossi, like the Federal Reserve, predicts a mild recession shortly down the road, and anticipates that mortgage companies will reflect that.

“What goes around comes around. The best thing that these institutions can do is make sure that they’re bolted down from an interest rate and liquidity standpoint, especially when it comes to managing their liquidity risk seriously,” he said. “Diversifying their lines of credit and purchase agreements doesn’t hurt either, as well as having contingency backup sources. Those are easy things that companies can do.”

What’s Salvageable?

When a mortgage company files bankruptcy, both Power and Indelicato describe the process as grueling and unnerving, especially when it comes to saving the company’s assets. To put it bluntly, Indelicato says that his firm was only able to salvage one mortgage company’s assets — but only for a limited time. “Generally what happens when a mortgage originator files is that they’re really supported by warehouse lines. Those all dry up. But it doesn’t mean there’s not salvageable assets,” he said. “You just have to know how to liquidate them.”

Power simply says the process is “complicated,” especially since the companies are servicers of government agencies like Fannie Mae and Freddie Mac. “When the companies go bankrupt, that’s a default on the GSEs,” he explained. “And they just lose the ability to continue funding loans. They can try to finish loans in the pipeline, but that doesn’t always go through.”

Power says that mortgage companies have many different types of assets on their balance sheets such as title work, and that Power and Indelicato’s job is attempting to monetize those assets as a last-ditch effort. “This isn’t a systemic issue, either,” Indelicato said. “This is a business model issue. It’s the growth of 2020 combined with skyrocketing interest rates that caused this. It may not cause a recession like 2008 and 2009, but it may make it harder to get mortgages. It’s going to be more costly, and will affect the home market.”

“I agree with Mark [Indelicato],” Power added. “Higher interest rates obviously affect a lot, and I think we’ll even see the construction industry — which caters to home building — will see less demand. We’ll see rippling effects of this, but it won’t be as deep a drop as we saw in the last recession.”