This year has been downright awful for mortgage originators as the Fed ramps up its efforts to get outsized inflation back under control. While the Fed has only recently started hiking the Federal Funds rate in earnest, longer-term rates have been rising steadily all year. Rising rates mean bad news for originators as volumes dry up.
And yet one mortgage originator, Mr. Cooper (COOP 0.20%), has managed to outperform its peers this year. What is its secret?
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Rising rates are bad for mortgage originators
Rising rates are generally bad news for mortgage originators. Rising mortgage rates mean borrowers will have higher monthly payments, which makes buying a house less affordable. Between rapidly rising housing prices and higher mortgage rates, many first-time and lower-income borrowers have been squeezed out of the market. Rising rates also make the classic loan refinance business dry up. Nobody is going to pay off a 3% mortgage to get a 5% one, unless they are taking cash out. In 2020 and 2021, these classic "rate and term" refinances powered the mortgage industry through two of the best years in history. Today, the feast has turned to famine.
The mortgage origination sector has underperformed this year
Most mortgage originators have seen their stock prices sell off as a result. You can see in the chart below how Mr. Cooper has outperformed competitors such as Rocket Companies (RKT -0.52%), UWM Holdings (UWMC -0.16%), and PennyMac Financial Services (PFSI 0.21%) since the beginning of the year:
The reason for Mr. Cooper's outperformance has been its outsized bet on mortgage servicing. Mortgage servicing is an unusual asset in that it actually increases in value as rates rise. Most other financial assets like stocks and bonds struggle in a rising rate environment.
Mortgage servicing -- an unusual asset that likes rate increases
Mortgage servicing rights come attached to every new mortgage, and they allow the holder to perform the administrative tasks in evolved with the loan in exchange for a fee of 0.25% of the mortgage amount. So if you have a $400,000 mortgage, the servicer will be paid a fee for collecting your monthly payments, sending the principal and interest payments to the ultimate investor, ensuring that property taxes and insurance are paid, and working with you if you get behind on your payments.
Mr. Cooper's servicing book accounts for about 41% of assets, compared to Rocket, where servicing is about 25% of assets, or United Wholesale, where they comprise about 32% of assets.
Servicing-related income accounted for 71% of Mr. Cooper's revenue in the first quarter, while mortgage origination accounted for the majority of Rocket and UWM Corp's revenues. This helped offset the declining origination volumes and smaller gain on sale that the entire industry is experiencing. In other words, bankers are making fewer loans and earning less on them.
Servicing makes a natural hedge for mortgage bankers in general. When rates rise, origination volume will fall, but servicing income will rise as the mortgage servicing portfolio becomes more valuable. When rates fall, the servicing portfolio will decline in value, but rising refinance activity will result in higher volumes.
Mortgage originators have been beaten up so badly this year that it is tempting to bottom-fish, but the Fed is going to do what it takes to beat inflation, and the entire sector will be under a cloud until the Fed is done with hiking rates. Mr. Cooper may be the best stock in an out-of-favor sector, but the fundamentals against the sector are not great so I'm not sure this is a good investment despite the outperformance.
