The mortgage banking business is one of the most cyclical industries. In 2020 and 2021, it feasted on easy refinancing activity courtesy of the Federal Reserve's rate cuts in reaction to the COVID-19 pandemic. But the mortgage origination boom ended when the Fed started raising interest rates to slow inflation.
Mortgage bankers have been absolutely hammered this year, with some going bankrupt and some radically restructuring their businesses. One publicly traded mortgage banker has bucked the trend, however: Mr. Cooper Group (COOP 3.62%).
Mortgage servicing assets respond positively to interest rate increases
Mr. Cooper is a leading servicer and originator of mortgage loans. The company originates loans through its direct-to-consumer channel, and it purchases completed loans from smaller mortgage originators. The company is also a major mortgage loan servicer, and this has been the big driver of earnings this year.
A mortgage servicer performs the administrative tasks of managing a mortgage. The servicer ensures that the borrowers make the monthly payments, that mortgage-backed security investors get the principal and interest payments they are owed, that property taxes and insurance payments are made, and it works with borrowers if they get into trouble and miss a payment. If the loan eventually goes into foreclosure, the mortgage servicer will handle that, too. The servicer is compensated 0.25% of the mortgage balance outstanding per year.
These mortgage servicing rights are worth something. These are highly unusual assets in that they increase in value as interest rates rise. Mortgage servicing assets are also affected by other economic considerations, but interest rates make the biggest difference.
Mortgage bankers generally like servicing assets because they act as a natural hedge for the mortgage origination business. When interest rates fall, the mortgage origination business picks up as borrowers refinance. Conversely, when rates rise, the mortgage origination business shrinks. Mortgage servicing assets behave differently. When rates fall, they decline in value; when rates rise, they increase in value.
Mortgage servicing has driven results, but it might be played out
During the second quarter of 2022, servicing accounted for 77% of the company's revenue. In the prior-year second quarter, it contributed nothing to revenue. This year's servicing income more than offset the decline in origination revenue. Mr. Cooper actually reported an increase in revenue year over year when most other originators reported big declines.
The question now is whether servicing income can continue to offset the company's declining origination revenue. The Fed continues to raise short-term interest rates, but mortgage rates might have peaked, and if they have reached their peak for this cycle, then mortgage servicing rights have probably reached peak valuation.
If we are headed into a recession, delinquency rates will increase, and that increases mortgage servicing costs and therefore decreases servicing profits. It also makes the mortgage servicing rights worth less at the margins.
Mr. Cooper is trading at 6.3 times analyst expectations for 2023 earnings per share. This is not necessarily cheap, because mortgage bankers rarely trade at big multiples. If rates begin to fall, Mr. Cooper will see a reversal of servicing income. Origination volumes will certainly pick up somewhat, but it could take a substantial decrease in rates to bring back refinancing activity.
And unless rates rise substantially from here, Mr. Cooper might have milked about all it can from its servicing assets.