By Brett Horn
Four companies we cover -- CoreLogic (CLGX), Lender Processing Services (LPS), First American Financial (FAF), and Fidelity National Financial (FNF) -- depend, at least in part, on the volume of residential mortgage transactions (both sales and refinancings) to generate revenue, as they provide services that take place at the point of origination. As a result, these companies struggled after the collapse of the housing bubble. While record-low rates and the resulting surge in mortgage refinancings have benefited these companies' top lines, investors should be aware of the potential impact of a decline in refinancing volume, especially as the market has shown a tendency to overreact to current volume.
First American and Fidelity provide title insurance services whenever a residential property is sold or refinanced. Mortgage processors CoreLogic and LPS provide tax, flood zone, and appraisal services at the time of sale or refinancing. These companies could be viewed as tollbooths in the mortgage industry, although their revenue can fluctuate significantly depending on current volume of transactions, and fixed costs can magnify the impact on the bottom line. Still, we view these companies as having economic moats, as they are leaders in scalable businesses.
All four companies have other business lines. The title insurers also service the commercial real estate market, First American has some small specialty insurance lines, and Fidelity has expanded into the restaurant and auto parts industries. While the vast bulk of title revenue comes from residential title work, margins on commercial title are significantly higher.
The mortgage processors are more diversified in their revenue sources. They have data and analytics businesses and also provide services related to distressed mortgages, a business that typically is negatively correlated to the origination business. But the volume of residential mortgage transactions is still a key driver for these firms' results.
Collapse of Housing Bubble Hit These Businesses Hard
The industry experienced a significant drop-off in volume following the collapse of the housing bubble, as sale and refinance activity came down from unsustainable levels. The falloff was harder for the title insurers than for the processors, as the processors, especially LPS, had an offset from their countercyclical default businesses. However, the title insurers cut costs in response and margins have recovered in the years since.
Source: Mortgage Bankers Association, Case-Schiller.
Refinance Volume Key in Post-Bubble Environment
Residential sale volume has yet to meaningfully recover; the biggest swing factor in the post-bubble environment has been the volume of refinancing activity. In response to record-low rates, refinance volume has picked up sharply over the past year. This has led to a much more favorable environment for the title insurers and mortgage processors. While sales activity is still low, a strong refinancing market is creating a more balanced picture. Current refinancing volume is not much lower than we saw during the last decade and are well above the 1990s level.
Source: Mortgage Bankers Association, Case-Schiller.
We believed the group was undervalued (CoreLogic and First American particularly so) in 2011, as the market was overreacting to year-over-year declines and ignoring the fact that sales volume would improve in the long term. While the sales improvement has yet to happen, the market has reacted strongly to the recent surge in refinancing volume, and the group is now about fairly valued, in our view.
Fall off in Refinance Activity Could Be Major Headwind
With mortgage rates at historic lows, the mortgage market is currently heavily refinancing-driven. Given that the market has tended to respond to changes in refinance volume, investors should consider the potential impact of a decline in refinancing activity. Even if volume doesn't decline, the companies will lap the strong uptick in the fourth quarter of this year, and year-over-year comparisons will be more difficult.
Source: Mortgage Bankers Association, Case-Schiller, Freddie Mac.
Looking at the historical relationship between mortgage rates and refinancing volume demonstrates a few important points. First, the ongoing decline in rates over the past 20 years has been a persistent tailwind for refinancing volume. With rates now this low on an absolute basis, we question whether this trend has much more room to run.
Second, it is impossible to estimate any "normal" level of refinancing activity as refinancing volume can vary widely. Refinancing volume depends on a number of factors such as interest rates, the previous path of interest rates, and the trend in home values. But current volume has only been materially outstripped during the height of the housing bubble, and there appears to be more long-term downside than upside.
Further, trough refinancing volume following an uptick in rates is dramatically lower than current levels. If we average the four-quarter trough periods following the rate upticks in 1994, 1996, and 1999 (given the unusual conditions of the past decade, we believe the 1990s are a better comparison), we come up with a refinancing volume level about 80% lower than we've seen over the past four quarters.
Finally, while we have no special insight into the future trend in rates or the timing of any increase, we can see that refinancing activity has fallen off materially almost immediately after any uptick in rates. This suggests a decline in refinancing activity could be both dramatic and abrupt.
HARP Could Extend Refinancing Window
One factor that has held back refinancing volume in the face of lower rates is that many borrowers are underwater on their mortgages and therefore unable to refinance. Late in 2011, the Home Affordable Refinance Program, designed to help underwater borrowers refinance their mortgages, was restructured to induce banks to participate more actively in the program. This change has been one of the drivers in higher refinancing volume over the past year, although lower rates still appear to be the main catalyst. CoreLogic estimates that 10.8 million mortgages are underwater, and only about 1.4 million mortgages had been refinanced under HARP through the end of the second quarter. Presumably, most underwater borrowers have not refinanced their mortgages since the housing bubble popped and are therefore likely to be paying rates much higher than the current level. As a result, if HARP continues to gain traction, high refinance volume could persist longer than in previous low-interest-rate environments, even if rates tick up a bit. Still, the period of high refinance volume will not persist indefinitely.
Timing of Improvement in Sales Volume Is Other Main Factor
While a falloff in refinancing volume seems inevitable long-term, the timing is uncertain. While an uptick in sales volume also seems inevitable, it is difficult to know when that will occur. But we see more long-term downside than upside, and the potential exists for a dramatic decline if refinancings fall off before sales recover. Either way, it seems likely that the industry will need to move through another period of weak volume before settling. Even if sales activity normalizes, total volume could fall about 35% from current levels if rates increase and refinancings plunge. The only scenario in which we could see a material increase from this point is if sales pick up before refinancing volume declines.
Potential Downside a Risk as Well as an Opportunity
While we believe the stocks are currently about fairly valued from a long-term perspective, shareholders should consider the potential impact of another decline in volume. The stocks generally sold off despite the announcement of very strong third-quarter results driven by high refinance volume, which suggests there may be limited upside from this point, even if refinancing volume stays strong in the near term.
Conversely, investors not holding a position may want to keep these names on the radar in case a falloff in volume presents another buying opportunity, much as we saw in 2011. All else equal, we view CoreLogic and First American as the best choices, as we believe they have stronger management teams and are more of a pure play on a sales volume recovery than their respective peers.
We reiterate that while origination volume is a key driver, these companies operate other business lines that don't depend on residential mortgage originations, and this is not the only factor driving their overall results. We think the title insurers could suffer a bit less from a plunge in refinancing volume, as their profit margins on refinancings are significantly lower than on residential sale activity and much lower than on commercial real estate. The mortgage processors could be particularly exposed if a drop in refinancings coincided with a rapid decline in their default businesses, a scenario that played out in 2011.