Some mortgage lenders – the worst of them – are beginning to go broke. According to a report from financial news service Bloomberg on Friday…

“The U.S. mortgage industry is seeing its first lenders go out of business after a sudden spike in lending rates, and the wave of failures that’s coming could be the worst since the housing bubble burst about 15 years ago.”

Uh-oh.

It’s true. In June, one of the first dominoes fell.

Mortgage lender First Guaranty – which originated $10.6 billion in mortgage loans in 2021 – filed for bankruptcy, after saying it laid off 80% of its employees and stopped making new loans.

The company is owned by the fixed-income giant Pacific Investment Management, best known as Pimco. It said in its bankruptcy filing that it has $473 million in debts. Most of that is owed to banks that provided funding for its residential mortgages, including Flagstar Bank and Customers Bank.

First Guaranty dealt in “non-qualified mortgages,” or non-QMs. Non-QMs go to borrowers with erratic income, and they’re different from the “qualified” mortgages that came into federal law after the financial crisis and that have stricter eligibility requirements.

In July, another non-QM company, Sprout Mortgage, suddenly laid off hundreds of employees and closed its doors. The company is now being sued – by employees for three weeks of pay and other firms for defaulting on millions of dollars of home loan purchases.

Too much borrowing. Too much risk-taking. Not enough cash. These lenders are the opposite of the steady cash-generators our research team likes to recommend owning.

First Guaranty, which had about 600 employees before the layoffs, lost “only” $23 million in the first four months of 2022. But coupled with the company’s unrealized losses, that was apparently enough to kill it. And it happened only as the tip of the “higher interest rate” iceberg first started to emerge from the economic ocean.

We’ve spoken at length about the Federal Reserve’s influence on the housing market and mortgage loans. The Fed’s interest rates track closely with the central bank’s benchmark lending rates in the banking system and on through the U.S. economy.

When the central bank indicated it would start hiking its benchmark interest rates late in 2021, you might remember that mortgage rates started to rise quickly. By June, just three months after the Fed started raising rates, a 30-year fixed mortgage hit close to 6%.

Mortgage demand cratered to a 20-year low that same month.

This is by design from the Fed, which is seeking to lower inflation however it can. That means by slowing demand in the economy, and it can do that most directly by influencing the costs of loans. (In real estate, this also means making homes unaffordable for many people and indirectly causing rents – and inflation – to rise in the process, too.)

Mortgage rates have cooled slightly lately. But First Guaranty’s CEO blamed the Chapter 11 filing on two factors: a combination of plummeting demand for new loans and a “dramatic collapse” in refinancing and the fact that First Guaranty couldn’t get enough financing to keep operating.

The company said its existing mortgages are serviced by third parties, meaning the bankruptcy filing won’t disrupt them. But it laid off close to 500 employees and has left its lenders on the hook for hundreds of millions of dollars.

The Fed’s benchmark lending rate has gone from near 0% to close to 2.5% in eight months (and rates could keep going higher, more on that discussion below). The central bank is having an impact.

As Keith Lind, the CEO of non-QM lender Acra Lending, told the industry publication HousingWire.

“These aren’t bad loans, just bad prices.

Lenders with thin or negative margins haven’t been able to withstand higher rates.”

The reactions came quickly. A few weeks after First Guaranty filed for bankruptcy, word leaked that one of the lenders it burned would now be asking 16 loan originators for larger funding advances.

As John Toohig, the head of whole loan trading at investment bank Raymond James, told HousingWire.

“We need to see rates kind of stabilize, flatten for a minute, just to kind of be able to work out the problems.”

He added that the “hope is that at some point next year, the Fed will have eased up on its monetary-tightening policy to fight inflation and rates might head lower.”

The good news, at least so far, is that we’re not talking about big-name banks like JPMorgan Chase, Morgan Stanley, or Bank of America, like we did in the financial crisis 15 years ago.

Since the financial crisis, the biggest banks have dramatically downsized or even eliminated their mortgage businesses, and independent lenders have stepped in to fill the void.

Hence the non-QM designations and the rise of independent lenders like the ones we’ve mentioned today. These now-bankrupt mortgage lenders are relatively small, though when you add them up, they make up a significant chunk of the mortgage business.

For example, two-thirds of the top 20 mortgage refinancing companies were non-banks last year, according to LendingPatterns.com. That’s roughly twice as many as 2004.

And these companies don’t have the luxury of a government backstop to bail them out when things go wrong. As Bloomberg shared in its report.

“Unlike banks, independent lenders often don’t have emergency programs they can tap for financing when times get tough, nor do they have stable deposit funding. They depend on credit lines that tend to be short-term and depend on mortgage prices. So when they’re stuck with bad assets, they face margin calls and potentially go under.”

The situation is less dire for lenders that work with government-backed companies like Fannie Mae and Freddie Mac. But that doesn’t mean big banks are immune to the consequences of a higher-interest-rate world, either.

 

US Economy

 

  • Housing inventories are running at last year’s levels.
  • However, the situation is much worse when measured in months of supply (the difference is due to slower home sales).

 

 

  • Active listings from Realtor.com are well above last year’s level.

 

 

  • Builders have been reducing prices.
  • The end of the housing cycle or just a pause?

 

 

  • Job offshoring has been limiting price gains in the US over the past few decades.
  • But the offshoring trend is now reversing, which is likely to be inflationary.
  • Labor costs point to persistent price pressures ahead.
  • More Americans hold two or more full-time jobs.
  • The St. Louis Fed’s financial stress index shows “no stress,” giving the Federal Reserve plenty of room to keep hiking rates.
  • The inflation expectations curve has flattened as oil prices moved lower.
  • The market expects inflation to moderate in the short term but remain “higher for longer.”
  • Groceries’ inflation is nearing 14% this month, according to YipitData.

 

 

  • But food inflation should be on the way down in the months ahead.
  • Outliers drove the recent slowdown in the CPI. Inflation remains sticky.
  • Slower gains in China’s producer prices should help ease US consumer inflation.
  • Regional Fed manufacturing gauges point to factory activity weakness at the national level.
  • The World Economics SMI report suggests that business activity growth has stalled but is not crashing.
  • Will we see further declines in vehicle sales?

 

 

  • Retail sales as a share of total consumer spending remain elevated.
  • Households haven’t seen such a sharp decline in real incomes in decades.

 

 

  • US business activity is in recession mode, according to the S&P Global PMI.

 

 

  • Growth in factory activity is slowing rapidly as output contracts.
  • The services PMI came in well below forecasts, with activity deteriorating quickly. Some of this weakness is driven by the housing market.

 

 

  • The Richmond Fed’s regional manufacturing report also shows deteriorating conditions.
  • Fewer companies are boosting wages.
  • Supplier bottlenecks are gone in the region as demand slumps.
  • The combination of data from the NY Fed, the Philly Fed, and the Richmond Fed points to rapidly easing supply chain stress at the national level.
  • Measured in months of supply, new home inventories hit the highest level since the financial crisis.

 

 

  • The July report on durable goods orders was a bit stronger than expected.
  • Capital goods orders and shipments growth (a proxy for business investment) remained robust
  • Home Mortgage applications are running just above 2015 levels, down more than 20% from last year.
  • There are a lot of apartment buildings under construction in the US (2 charts).

 

 

  • In the Labor market, half of the firms surveyed by PwC are planning layoffs.
  • Housing was a drag on growth (and will be again in Q3).
  • Despite a small decline, the GDP report does not signal a recession (yet). Private demand has slowed sharply, but the “final sales to private domestic purchasers” indicator (the “core” GDP) was up slightly.
  • There is no recession signal yet in corporate profits.
  • The Atlanta Fed’s GDPNow model estimate continues to show stable consumer spending growth this quarter.
  • The FIBER leading index points to further deterioration in economic growth.

 

 

  • The Kansas City Fed regional manufacturing index fell sharply this month, with production moving into contraction territory.

 

 

  • Demand is falling.
  • This chart shows new orders across the regional Fed reports we got this month.

 

 

  • 1 in 6 American homes have fallen behind on their utility bills, according to the National Energy Assistance Directors Association (NEADA). It’s the worst crisis the group has ever recorded, with households owing a combined $16B in unpaid bills, about double the pre-pandemic total.
  • There are signs of increasing financial distress among US households.

 

 

  • CEO confidence has been deteriorating, …

 

 

  • as business conditions weaken.

 

 

  • Fed officials have been jawboning rate expectations higher.
  • Even if inflation declines quickly, it may take much longer for the Fed to cut rates than the market currently expects.
  • The probability of a 75 bps rate hike in September is near 70% as Fed officials strike a hawkish tone.

 

Zombie Companies

 

Zombie companies can’t even afford to pay the interest on their debt. These will go bankrupt too.

Nearly one out of every four companies is a zombie. That’s the most by a long shot. It’s higher than before the last financial crisis and higher than the previous peak of 17%, set back in 2001.

 

 

These companies are living on borrowed time. They’re dependent on creditors who are willing to lend them more money when their debt comes due. They might be banking on their businesses turning around as they burn through their cash or they might have plans to sell assets or issue shares of stock to pay down debt.

The next recession is going to bury many of them. Zombies are already choking on today’s higher interest rates and inflation. An economic downturn will be the final nail in the coffin.

Higher rates and more expensive borrowing make business harder. It’s as simple as that. And this scenario can kill off garbage companies the quickest which is what we’re just starting to see.

Just last week, “meme stock” favorite AMC Entertainment (AMC) emerged as another example of this scenario, with its shares falling 30% – after a 25% loss last week – mainly because its rival Regal Cinemas said it’s considering filing for bankruptcy.

It’s like fear by association and for good reason. AMC has more than $10 billion in long-term debt.

 

Market Data

 

  • US natural gas futures tested resistance last week at the previous peak.

 

 

  • A short-term rejection of the 200-day moving average typically precedes market declines.

 

 

  • Equities tend to struggle when consensus earnings revisions decline.

 

 

  • Stocks face a challenging seasonal pattern ahead.

 

 

  • Corporate cash balances have been falling.

 

    • Cash holdings:

 

  • Year-over-year changes:

 

 

  • This charts shows the S&P 500 average forward P/E ratio under different inflation regimes (we are currently at 17.4x).

 

Source: Truist Advisory Services

  • Here is a similar comparison showing the trailing P/E.

 

Source: John Lynch, Comerica Wealth Management 

 

  • The S&P 500’s CAPE ratio remains elevated relative to history, which implies a period of lower market returns.

 

 

  • Corporate margins hit a multi-decade high last quarter.

 

 

  • PMI indicators continue to signal deterioration in corporate profits.

 

 

Quote of the Week

 

“Some people are such treasure that you want to bury them” – Indian Hills Community Center

 

Picture of the Week

 

 

 

All content is the opinion of Brian J. Decker