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COVID has created some very obvious winner and losers.  Mr. Stock Market has generally done a good job figuring out who is who.  However, I think there is an interesting situation where Mr. Stock Market might be epically wrong.   The idea is First American Financial (“FAF”) - the largest pure play title insurer in the US.  For those not familiar with title insurance, it is generally required on any mortgage transaction to protect both the lender and homeowner from financial losses sustained from defects in a title to a property.  While it’s called “insurance”, it is not a very balance sheet intensive business compared to say a P&C insurer as loss ratios are in mid-single digits in title vs. 40-60% in more traditional P&C lines.  The business is more of a process / diligence business than your typical insurance company.  And profits are driven by notional volumes of mortgage originations across both residential and commercial buildings, including both purchase / sales and refinance transactions. 

As I am sure you aware, in response to COVID, the Fed has announced unprecedented stimulus in form of a near zero Fed funds rate, strong forward guidance, quantitative easing of both treasuries / agency MBS, measures to support money markets, corporate credit, fallen angels, etc.   This has resulted in Mr. Bond Market doing the following:  Fed futures pricing in NEGATIVE rates by June 2021, Eurodollar futures not pricing any kind of tightening until September 2022 at the earliest, a 55bps US 10yr Treasury, and 30yr Fannies trading at 1.24% (graph below).  Just 1 year ago, the US 10yr was 2.0% and 30yr fannie yields were 2.80%. 

As a general rule of thumb if you want to go from 30yr fannie secondary yields to what someone with good credit can get a new 30yr mortgage, add between 100-120bps. Assuming the current 1.24% fannie yield holds, adding +120bps results in a 30yr retail mortgage rate of 2.44%.  Mortgages have never been this cheap in the history of the US.  Nationally we are not there yet, but certain online originators are getting damn close:

https://owning.com/ 

2.25% 15yr Fixed at no closing costs

2.75% 30yr Fixed at no closing costs

Since these are priced at no closing cost, fair value with typical closing costs are probably more like 2.0% and 2.5% respectively. 

Then you had an article like this hit a couple days ago:

https://finance.yahoo.com/news/head-turner-mortgage-rates-15-060000865.html

“Thirty-year fixed-rate mortgages this weekend are averaging 2.87%, according to Mortgage News Daily, tying its survey's all-time low.

But UWM's new 15-year fixed-rate mortgages come with rates as low as 1.875%. That's unprecedented — and way down from the national average for those loans, currently 2.51% according to mortgage company Freddie Mac.”

This is partly explained by a simple lag effect – fannie secondary market yields are falling faster than originators are lowering rates.  To make matters worse, lenders are having a hard time handling the explosion in refinance transactions.  Some online originators have actually suspended applications:

http://www.lenderfi.com/

“Given the high volume of loans coming in we are not able to offer the service LenderFi was founded on, so temporarily we are not taking on any new applications.”

Another reason is the spread between purchase and refinance mortgages at the retail level are being held intentionally wide to act as a governor on volume.   Similarly, Jumbo spreads are being held wide because banks are taking a more cautious attitude toward geographies that might experience property price deflation to due urban flight (eg. NYC, San Fran) and often times these jumbos are held on balance sheet.   However, spreads are now beginning to slowly tighten up.  This is what my mortgage banker texted me yesterday (he works at a large money center US bank):

“The [refi] spread is definitely tightening, especially over the last week or so – but I am not sub 2 on  refi rate for a 15yr yet.  My refi 30yr rate is now hovering between 3-3.25% and my purchase 30 is near 2.75-3% as of yesterday in an ideal scenario.  The firm continues to improve on pricing, and management reconfirmed to us bankers this week that we remain committed to being a top 3 pricing lender in the space.  So we remain confident and hopeful that our rates will continue to improve as more Q2 data rolls out and credit should continue to loosen as well.  Our first set of positive underwriting guideline updates is set to take effect in the week ahead after having temporary restrictions in place for the last 3 months.  We’re getting there!”

The Mortgage Bankers Association puts out a monthly “MBA Mortgage Market Forecast”. 

https://www.mba.org/news-research-and-resources/research-and-economics/forecasts-and-commentary/mortgage-finance-forecast-archives

To be honest, this forecast does not really help my bull case.  Housing starts down.  30yr mortgages rates with 3-handle for 2020-2022.  A 2020 uptick in mortgage originations only to fall sharply again in 2021 back to 2019 levels.  So my opinion of course, is that this forecast is woefully out of touch with what Mr. Bond Market is screaming.  However, what I think is notable is the last line – Mortgage Debt Outstanding.  In 2019 it was 10.7 Trillion.   A 2-handle mortgage rate for the next 2.5 years puts a large percentage of the 10+ Trillion of mortgage debt in the money for a refi.  That may sound unbelievable, but look what Black Night noted in their May mortgage monitor:

https://www.blackknightinc.com/black-knights-may-2020-mortgage-monitor/

“The month’s data also showed that the 13.6 million refinance candidates in the market today could save an average of $283 per month on their mortgage payment. If all eligible candidates were to refinance their mortgages, they would see an aggregate savings of $3.9 billion per month, representing a potentially significant and much-needed stimulus to the economy. Of these, some 4.6 million could save at least $300 per month on their mortgage payments, while 2.6 million would be able to save at least $400 per month. Much more detail can be found in Black Knight’s April 2020 Mortgage Monitor Report.”

https://cdn.blackknightinc.com/wp-content/uploads/2020/07/BKI_MM_May2020_Report.pdf

Digging in further, note Page 11:

“Despite rising delinquencies, some 13.6 million homeowners still meet broad-based eligibility requirements to refinance, which include being current on their mortgage, and could shave at least 0.75% off their first lien rates by refinancing

Mortgage rates fell to a record low of 3.13% on June 18 according to Freddie Mac’s Primary Mortgage Market Survey (PMMS); an additional one basis point decline would increase that population by 20% to 16.3 million, an all-time high for refinance incentive”

1 basis point increases refi population by 20% - That’s quite a slope!!  Assuming a $200k average mortgage balance, we are talking 50 million+ mortgages. 

So maybe that is pie in the sky but just go give some orders of magnitude here.  Assuming 75% of the 10 Trillion is in the money and that refi’s over the next 2.5 years - that is 3 Trillion of refi volume per year.  Then if you add 1.3 trillion of purchase volume, you are at 4.3 Trillion/ year.  Sounds crazy, I know.  So let’s assume only 50% of the 10 Trillion refi.  That still gives you 2.0 trillion of refi per year + 1.3 purchase, which gets you to 3.3 trillion in volume. 

Any way you slice it, this will be an epic refi cycle provided we have 2-handle mortgage rates.  So right now there is a big disconnect between how Mr. Stock Market is viewing FAF stock (market cap $5.7 billion, trading 50mm a day) and how Mr. Bond Market is pricing trillions of treasury /agency securities that trade billions a day.  My contention is that Mr. Stock Market is being less efficient here.  As of last Friday’s close, FAF was down 12.5% YTD – doesn’t sounds like a COVID winner.  

So turning to FAF stock – first off, its not widely covered.  6 analysts – 5 buys, 1 hold.  Pre-COVID (early March) it was trading at $65 and expected to earn around $5.50 – so a 11-12x PE.  Over the following two months, FAF’s earnings estimates were understandably crushed to $3.25 as the entire economy ground to halt and unemployment skyrocketed.  Obviously, you need a functioning economy to have mortgage opinations.  However, the beauty here is that you can track monthly title order count data.  FAF publishes monthly data with a 10-day lag.  Even during the depths of the COVID pandemic lockdowns (March, April, May), FAF opened more title orders each of those months than 4Q 2019:

http://investors.firstam.com/investors/financial-information/title-order-counts/default.aspx

http://s21.q4cdn.com/992793803/files/doc_downloads/2020/07/Title-Orders.xlsx

Then in June, open title orders really took off (131,400).  Excluding March 2020, the last time FAF exceed 131,400 was August 2016.  Keep in mind that fannie yields averaged 1.64% for the month of June.  We are at 1.24% today.  July data will come around August 10th, and I expect title orders to grow again.  That being said I wanted to spend a minute reviewing the events from the last 3 weeks:

Friday, July 10th – FAF publishes strong June title orders.  FAF stock closed $46.34 the day prior

Thursday, July 23rd  – FAF beats 2Q nicely.  $1.03 EPS adjusted vs. .76 estimate.  FAF stock closed 55.72 the day prior

Friday, July 24th – Street consensus for FAF’s 3Q20 is revised up from 0.79 to $1.11.  FAF stock closes at 54.34

Monday, July 27th – STC, small cap title insurer upgraded by KBW.  FAF stock closes at $52.85

Friday, July 31st – FAF closes at 51.01, down 12.5% YTD

The disconnect continues.  The 2Q beat was sold.  The positive 3Q revision was sold.  The competitor upgrade was sold.  30yr fannies went up in price every day last week (yields lower every single day).  FAF was down 4 out of 5 days last week.  I think the post earnings sell off is due to combination of technical factors (performance reversion + value factor issues)  vs. anything fundamentally wrong with FAF. 

There is a lot more to discuss as it relates to FAF, but I am going to focus quickly on some big issues:

1)     Refi vs. Purchase mix and impacts to profitability.  A refi transaction generates about 60% of the revenue of a purchase transaction so clearly not as profitable.  So a higher mix shift to refi, keeping volumes fairly constant will create a negative EPS revision.  However, purchase transactions are recovering nicely, and numerous data point support this

a.      Economic data (building permits, existing homes sales, housing starts, new home sales, pending home sales) are recovering nicely

b.      Homebuilders ETF XHB +10% YTD

c.      Urban flight is real.  Look at AVB and EQR - rental rate declines, vacancies up in big cities. COVID + Work from Home + Social unrest + skyrocketing crime = family exodus to suburbs

d.      Affordability to buy a house at 2.5% 30yr mortgage very different than a 4% 30yr mortgage from 1 year ago.  I think there is real risk of national rent decline.  Mortgage rates are proxy for housing costs, and they are deflating rapidly.  Big cities will be massively oversupplied with multi-family housing.

e.      COVID is having a real impact on people’s desire for second homes.  Peoples attitudes are really changing as it relates to things like Boats, RVs, beach homes, etc.

2)     Refi spike isn’t a 1q or 2q impact to be discounted away.  I am arguing for a refi cycle the likes of which has never happened in the US, lasting 2-3 years. 

3)     Commercial volume decline hits profitability hard.  Yes it does.  However, commercial is not dead.  Per FAF 2q call:

“In our commercial business, revenues in the second quarter declined 39% from the prior year, better than our April forecast of a 50% decline. In response to the economic uncertainty, we've seen a slowdown in activity across all commercial asset classes in the second quarter. And it's our expectation that the segment will remain under pressure for the rest of the year. However, we have seen an improvement in open orders in the recent weeks, with July commercial orders down just 10% versus last year.“

So commercial volume recovery will lag, but down 10% is very different than down 50%.  And many commercial mortgages are structured as balloons with mandatory refi events.  So structurally that provides a baseline of commercial volumes.  Finally, under a Biden administration, 1031 tax free exchanges could be at risk.  This could spur incremental volumes if investors think 2021 brings a whole new tax regime into play. 

FAF’s NTM street estimate is $4.12.  Given the absolute level of rates, the potential for refi and jumbo spreads to collapse, the propensity for banks to be greedy, and the desire for consumers to save money, the ingredients are in place for FAF to easily surpass pre-COVID levels of profitability.  In all honesty, the hard part for me is giving you an EPS upside case because I am tasked with forecasting something that has never happened before - the entire country refinancing their mortgage! 

That being said, $6 of EPS at 12x = $72 / share.  That is 40% upside to invest in what I think is a structural COVID winner… and the market has priced in next to nothing.  Sooner or later, the monthly data will matter.  

Catalyst

Monthly title order counts

Positve EPS revisions