The dour housing market over the past 18 months has thrust struggling independent mortgage lenders (IMBs) into what seems like a pot of water that is coming slowly to a boil.

As the heat rises, so too does the number of lenders seeking to exit the market. The trajectory of merger and acquisition (M&A) deals bears that reality out.

The pace of M&A deals in the IMB market in 2022 and projected for 2023 combined is expected to be more than double the mark set during the unicorn lending years of 2020 and 2021, according to one recent industry analysis. And that excludes the count of lenders who have or soon will exit the market silently, off the radar of public records. 

Garth Graham, senior partner at the STRATMOR Group overseeing mortgage-lender merger and acquisition (M&A) activities, said in 2020 and 2021 there was a total of 43 M&A deals involving IMBs with annual origination volume of $500,000 or more. Last year that figure hit 50 deals, and for 2023 STRATMOR projects there will be at least 60 such M&A deals — for a total of 110.

“We have a pipeline right now of companies that have signed letters of intent but not yet closed,” Graham said. “That is significant, the highest it’s been years.

“…If the market stays as it is, there’s a lot more shakeout coming.”

Graham said it’s easy to track stock deals involving IMBs because there are so many public filings. It’s much harder to track asset sales, he added, because there are limited required public filings. 

He said STRATMOR and many of its peers also advise clients not to announce asset deals because such publicity is not a benefit to either party to the transaction.

“Normally you’re trying to keep it out [of the public eye],” he explained. “It [publicity] helps the advisors, and it helps the [loan-officer] recruiters, but it doesn’t exactly help the buyer and seller trying to get settled in a transition of the assets of the company.”

Graham added that STRATMOR has good visibility into both stock and asset deals occurring in the market due to its research capabilities, but he does concede there is one exit strategy — a lender shutdown — that is pretty much a dark box as far as tracking the numbers.

Consequently, the shrinkage of the existing IMB industry may be even more severe than the M&A figures alone reveal.

“… We have absolutely been involved in shutdown engagements [this year],” Graham said. “In 2020, we had none of those,” adding that they are absolutely increasing in the industry, “but that’s very hard to track.”

“Shutdowns are not exactly my favorite part of our consulting practice,” Graham said. “But we help lenders with it, and usually they need help, because it’s a lot more complicated and there’s a lot more risks.”

Occasionally, he explained, there’s an extraneous external event that makes a lender “a dead man walking,” but most of the time a shutdown is being pursued because the lender’s leadership waited too long to seek a buyer.

“They could have marketed their company, and they could have done a reasonable M&A, and they could have had a more graceful exit and probably be paid a premium, but they waited too long,” Graham said. “…We have calls with lenders every single week in that category.”

Mounting pressures in mortgage

The pace of shutdowns and M&A deals continues to rev up, in part, because of several mounting industry pressures that are cranking up the heat on IMBs.

Chief among them, according to Brett Ludden, managing director and co-head of the financial services team at Sterling Point Advisors, are the rapid pace of loan-repurchase demands coming from the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac coupled with mounting pressure on struggling lenders to remain in compliance with GSE and warehouse covenants. Those covenants, or contracts, include requirements related to lender financials, such as minimum net worth or income requirements, that, if breached, can lead to cancellation of the agreements.

If an IMB is cut off by the GSEs for violating its net worth requirements, for example, it can still sell its loans at a haircut to loan aggregators, but such a covenant violation, Ludden and other experts say, also will trigger increased scrutiny from its warehouse lenders.

“A number of lenders right now are concerned with covenants,” Ludden said. “Fannie Mae has ratcheted up pressure, for example, with their move to monthly P&L [profit and loss] reviews with companies that are not performing, and they expect those companies to deliver on their forecasts on production and profitability month over month. 

“…If I’m a warehouse-line provider, I’m going to say, ‘Hey, if they get cut off by Fannie, I’m going to assume that Fannie knows something that I don’t know, and we’re going to cut them off too. So, that’s going to be a challenge as well.”

In most cases, if a lender’s warehouse lines start to evaporate, it also loses the liquidity necessary to fund new loans.

“The ironic thing about it is that by cutting off these struggling companies, you create, to some extent, a self-fulfilling prophecy, which is by cutting them off, you’re going to make them worse off,” Ludden said.

He added that on the loan-repurchase front with respect to the GSEs, Sterling’s data shows that there has been “a material increase in the speed at which repurchase requests have occurred from the time of [loan] origination.” Repurchase requests are prompted after GSE quality-review teams uncover underwriting errors in mortgages purchased by the agencies.

“It could be the GSEs are trying to get their money back faster in their review process because they’re worried about these lenders going under,” Ludden said. “We still think the [repurchase-wave] peak occurred in the third or fourth quarter of last year, but we’re seeing that repurchases in the first, second and into the third quarter of 2023 are not that far off from the peak of late 2022.”

Ludden explained that every time a lender has to repurchase a loan from the GSEs, they face the prospect of either selling it at a loss in the “scratch and dent” market or holding onto it, if possible, with the hope that in the future “they can sell it at less of a loss.”

“If you have to repurchase even just four loans, you just paid out a million dollars of your cash,” he added. “That is a lot of money to smaller lenders, or medium-sized lenders.

“…To me, it’s the $500 million to $1 billion players [based on mortgage originations] that are really going to feel the brunt of the challenge here because they have $2.5 million net worth requirements, they’ve got material cash requirements, and they’ve been burning through their equity for the past 18 months — and it’s not going to let up.”

A “killer” 5-10 years ahead

Brian Hale, founder and CEO of Mortgage Advisory Partners, said the mortgage market has simply been down longer than most originators anticipated when rates first started spiking in the second quarter of last year in the wake of the Federal Reserve’s inflation-fighting campaign.

“My own view is the first couple of quarters of 2024 are still going to be less good than people thought they were going to be six months ago,” he said. “And so, the group of companies that could have sold, might have closed, decided to hold on thinking rates are going to come down eventually.

“First of all, no, they don’t. Secondly, I think they will [rates will improve], but not as fast as people want or need them to come back to improve the market … and so you still have an awful lot of lenders who aren’t making profit [in fact, up to three-quarters of the industry by some estimates].”

Hale added that at this time, “buyers have the upper hand.”

“I just think the entire calculus on when things get better, and how much they get better, has shifted to the right on the timeline,” he said. “So, what people are now talking about is mid-2024 or maybe 2025 will be a killer [renewed boom].”

Offering a note of optimism for lMBs now enduring the bleak landscape out there, Hale said when the market does rebound, it will be after the hard times have “rinsed out a lot of capacity, and so the rush will come back against a much skinnier industry, and things will feel great” for the survivors. 

“I still believe that the next five or 10 years are going to be killers in the real estate, mortgage and homebuilder markets as far as the eye can see, once this inflation disaster gets behind us,” Hale said. “I think if you can be a survivor, you can do very well then.”

Ludden, however, sees survival as the key word in all of this and far from a given for many lenders. He said the margin erosion independent mortgage banks are experiencing now makes the game ahead about survival of the fittest.

“I’ve talked to multiple lenders that saw double-digit decreases in margins month over month throughout the second quarter,” he explained. “And talk about pain because you’re already struggling….

“You’re trying to do business, and somebody’s willing to give up some more margin, so they win the business, but that hurts the industry as a whole. It’s kind of a fight to the bottom.”

Ludden said his firm saw what he considers “a groundswell” of renewed interest in the second quarter of this year from mortgage lenders seeking some kind of exit from the business. He added that the “next roughly 12 months” is going to be the real test of who survives and who disappears from the market.

“If you’re breaking even right now, you’re not making money in the fourth quarter [of 2023], and you’re likely not making money in the first quarter [next year],” Ludden said. “The next time you’ll likely make money is going to be March of 2024, so that’s a long way to go, and if you get to August or September [next year] and you’re not in super shape, I’d say you’re in real trouble.”

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