Description

Recommendation

I’m not a housing bull in the near-term and have been short a few names with exposure to the industry but like many, I’ve been surprised by the strength in homebuilder and housing related stocks even as home sales volumes decline on account of higher mortgage rates.  It’s possible that I’ve misread the dynamics and wanted to add some long risk in the sector where there’s some downside protection if the fundamentals continue to weaken and start pressuring valuations.  I believe LDI credit fits that profile.  

All indications are that 2023 will remain a challenging environment for the mortgage industry with many forecasting another 20%+ decline in originations.  Beyond this year, I think it’s still too early to assume that housing and mortgage industry will normalize in 2024.  Even with these challenges, I believe LDI has sufficient liquidity and relatively liquid assets to make it to the other side.  Furthermore, like all its peers in the mortgage industry, LDI has taken significant steps to right size the organization and overhead by targeting expense cuts that total around $400mm.  This expense reduction plan is meant to size the Company for what it believes will be a $1.5tr mortgage market in 2023.  If management succeeds in getting the business to run rate breakeven by year-end 2022, I believe the liquidity will be sufficient to last well past the turnaround in the housing and mortgage sectors.  The Company will report year-end numbers in a few days and so we’ll have a better sense for how the restructuring is progressing.  

Buy unsecured notes.  The 6.5s of ’25 trade at ~74 and offer a CY of 8.8% and a YTM of 19.5%.  The 6.125s of ’28 trade at ~58 and offer a CY of 10.6% and a YTM of 19.5%.  While I own both and think they’re fully covered, my preference would be for the lower dollar 6.125s.  The bonds are well covered with unrestricted cash holdings of $1.1bn (will be lower on the next print) and $2.0bn of MSR holdings.  Some of this value will undoubtedly erode to fund operating losses over the next several quarters but I believe there should still be sufficient value remaining to cover the unsecured bonds.  

The equity with a market cap of $638mm trades at a discount to reported book value but is not interesting to me given my near-term views on U.S. housing.  At the right price (say, sub $300mm), however, I think it would make a wonderful lottery ticket to bet on the rebound in housing.  That is, if the Company avoids having to restructure, which I think is a strong possibility given what we know today.  

Current Situation & Industry Outlook

As most are well aware, the mortgage market has and continues to experience extraordinary and rapid change after two unprecedented years where originations totaled ~$8.0tr in 2020 and 2021.  This was fueled by ultralow interest rates, pandemic related dynamics, home price appreciation, and supply and demand imbalances, among other factors.  Similar to most mortgage originators, LDI scaled up operations to support record 2020 and 2021 volumes and is now rushing to reduce overhead and minimize cash burn in order to remain solvent. 

Industry wide, total mortgage originations are projected to be down by ~50% in 2022.  Refinancing volumes, which composed the majority of LDI's origination business in both 2020 and 2021, are projected to be down ~75% in 2022.  Forecasts for 2023 are not much better.  According to Fannie, Freddie, and Mortgage Bankers Association, the average decline in volumes is projected to be 24%, with Fannie calling for a 30% decline, and MBA projecting a decline of only 16%. The biggest differentiator between these forecasts is the purchase market, where Fannie is calling for a 23% decline in volumes compared to a 9% decline by the MBA.

Below are a few charts that show mortgage volume projections for the industry:

In response to the losses already experienced and to position for future weakness, the Company has embarked on a restructuring plan that it calls Vision 2025.  The plan is aggressive and takes immediate action to get the business to cash flow breakeven and to set the business up to grow market share.  

The four pillars of Vision 2025 are as follows: 

1. Transform the originations business to drive purchase money transactions with an expanded emphasis on purpose driven lending

2. Aggressively rightsize the cost structure in line with current and anticipated market conditions and set targets to achieve high performance 

3. Invest in the servicing business and other profitable growth generating initiatives such as digital HELOCs 

4. Optimize the organizational structure to emphasize client service, quality, automation and operating leverage

While much of this is fluff, the tangible results that will flow through the P&L over the next several quarters will come from headcount reductions (11,300 to 6,500 by year-end 2002), business process optimization, lower marketing and third-party spending, and real estate consolidation. The Company expects to generate on an annualized basis $375 – 400mm in expense savings and return to run rate profitability by year-end 2002. 

The decision to transition the MSR portfolio to an in-house platform will certainly improve margins and improve profitability in the years to come.  As far as the launch of the digital HELOC offering, it’s unclear to me how much this will help increase originations and profitability.  Management believes that HELOCs will be a meaningful contributor to revenues in 2023 as it provides customers with an attractive option to access their home equity at a time when home prices are close to all-time highs and first mortgages are benefitting from low rates locked in before the rise in mortgage rates.  The Company’s solution is easy and fast, in some cases the process takes as little as seven days.  Finally, it’s also not clear to me how its partnership with National HomeCorp, a homebuilder focused on affordable homes, or the strategy of purpose-driven lending and providing credit to underserved communities will drive purchase originations in the current environment.  

Interestingly, there’s also this proxy fight going on right now between the Company and Anthony Hsieh, it’s founder and largest shareholder with 57% voting power.  He’s clearly bullish on the prospects for LDI as he has spent close to $20mm buying stock on the open market over the last couple of years.  I have no idea how the proxy fight plays out but any activist type involvement by a large shareholder who wants to avoid losing everything in a bankruptcy type situation is a positive development in my view.  

Company Overview

Formed in 2010, LDI is a non-bank residential mortgage platform that was launched to disrupt the legacy mortgage industry and improve the mortgage experience for consumers.   It went public in February 2011 at $14.00/sh.  Like others, it built a technology platform designed around the consumer aimed at redefining the traditional mortgage process. The Company has grown rapidly from a start-up in 2010 to one of the largest non-bank retail originators in the U.S. with a market share of 2.2%. Things were going so well that they even decided to pay $10mm per year to get their name on the Miami Marlins baseball stadium (often the kiss of death).

The Company historically has had two channels for originations:  retail and partner. The retail channel focuses on directly reaching consumers through a combination of digital marketing and more than 2,000 digitally-empowered licensed mortgage professionals. In the partner channel, LDI traditionally worked with mortgage brokers, realtors, joint ventures with home builders, and other referral partners to generate revenues using the same technology and infrastructure utilized by the retail channel.  However, as part of the rightsizing efforts, the Company decided in 2022 to exit the wholesale business to shift to a retail-only platform.  The Company claims that working through third party mortgage brokers made it more difficult to control the customer experience but the reality is that this channel got incredibly competitive and margins collapsed across the industry.  

The products offered by the Company include conventional agency-conforming loans, conventional prime jumbo loans, FHA & VA loans, and home equity loans.  In addition, it also offers ancillary services such as title insurance and escrow, real estate referrals, and homeowner insurance brokerage.  

Prior to 2012, LDI would sell the MSRs associated with its mortgage loan products. In 2012, the Company began to retain a portion of this servicing in order to complement the origination business and diversify the revenue base. Servicing consists of collecting loan payments, remitting principal and interest payments to investors, managing escrow funds for the payment of mortgage-related expenses, such as taxes and insurance, performing loss mitigation activities on behalf of investors and otherwise administering the mortgage loan servicing portfolio in compliance with state and federal regulations.  The Company has grown to become one of the 15 largest mortgage servicers in the U.S.  

The Company’s strategy when it comes to retaining MSRs, both at the point of sale and through bulk sales, is driven by managing the balance sheet and liquidity targets.  In this current environment where losses are piling up fast and the Company needs a runway before it starts seeing the benefits from the restructuring program, MSRs have been and will continue to be sold to manage liquidity shortfalls.  

Summary Financials 

The Company has been on a tear growing originations from $35bn in FY17 to $137bn by FY21.  Profitability has also risen but is volatile year over year depending on gain on sale margins, which can swing wildly.  Clearly, FY20 was as good as it gets for profitability where originations skyrocketed and gain on sale margins widened sharply.  On the other hand, FY22 was the complete opposite where originations tanked and so did gain on sale margins causing LDI to lose an obscene amount of money.  

One of the benefits of the explosive growth in originations has been the strong increase in the servicing portfolio.  This provides a nice annuity-like servicing income stream and creates a large asset on the balance sheet that could be monetized to balance liquidity needs.

For FY23, origination volumes are projected to be down and it’s not clear to me how much gain on sale margins will improve.  The mass layoffs in the mortgage space will alleviate some of the pressure on industry margins but higher rates will continue to put offsetting pressure on margins for the foreseeable future. 

As of the last reported quarter, the Company claimed to be on pace to meet its expense reduction goal of $400mm annualized for the second half of FY22. Management believes this level of cost cutting would rightsize the organization for a $1.5tr mortgage market.  In Q3 of FY22, expenses decreased by $126mm from the prior quarter, driven by lower personnel and marketing expenses.  This narrowed the losses significantly but clearly more needs to be done to get to breakeven levels.  In the Q4 report expected shortly, we will get an update on the restructuring process and whether the Company still expects to get close to breakeven levels going into FY23.  My base case assumes continued losses for at least the next couple of quarters with the Company posting a significant loss for FY23.   

Capitalization

For a Company losing a lot of money and possibly remaining unprofitable for some while longer, the balance sheet is overlevered with $1.3bn in secured debt and $2.3bn in total debt.  Net debt is closer to $1.0bn thanks to the large cash balance.  

LDI has four MSR facilities that have a total of $969mm in debt outstanding as of September 30, 2022.  They all accrue interest at Libor/Sofr plus a margin – in the table above, I’ve assumed a 7.00% all-in rate for simplicity.  One MSR facility is secured by Freddie Mac MSRs with a FV of $290mm. There is $206mm outstanding on this facility with a maturity of June 2023. At September 30, 2022, capacity under the facility was $268mm. Another $300mm MSR facility is secured by Freddie Mac MSRs with a FV of $527mm. At September 30, 2022, there was $300mm outstanding on this facility.  Another $500mm MSR facility is secured by Fannie Mae MSRs with a FV $621mm. At September 30, 2022, there was $348mm outstanding on this facility.  Another $200mm MSR facility is secured by Ginnie Mae MSRs with a FV of $527mm. It matures in May 2023. As of September 30, 2022, there were $117mm in debt outstanding under this facility.  

In addition to MSR facilities, the Company has a facility to borrow against interests in securitizations and also has servicing advance facilities.  In total, there’s $124mm outstanding on these facilities as of September 30, 2022.  

There is also $200mm in term notes outstanding that accrue interest at Libor plus a margin and mature in October 2023.  

There are also two unsecured bond issues outstanding.  In October 2020, the Company issued $500mm 6.50% senior unsecured notes that mature on November 1, 2025. In March 2021, the Company issued $600mm 6.125% senior unsecured notes that mature on April 1, 2028.  In Q1 of FY22, the Company repurchased $97.5mm face value of the 6.125s at ~88c leaving $503mm currently outstanding.  

Thoughts on Valuation and Recoveries

Given my focus on the credit, I’m less interested in what the range of enterprise values of LDI could be and more on the asset coverage range for the unsecured bonds.  I think it’s a near impossible task to project EBITDA and net income for this business over the next couple of years.  It’s much easier to place a value on the Company’s assets and make reasonable assumptions as to what the balance sheet could look like over the next year or two and how that impacts bond recoveries. 

LDI has a very high-quality asset base that is primarily composed of cash, and newly originated, very high quality MSRs, loans and loans held for sale.   For the purposes of this analysis, I’ve mainly focused on only two assets – cash and MSRs.  As of September 30, 2022, LDI’s unrestricted cash holdings and MSRs total $1.14bn and $2.03bn, respectively.   

MSR carrying values can be volatile as they swing around with interest rates.  Monthly payment speeds or CPRs drive MSR values and servicing profitability. With rates moving higher through most of 2022, prepayments speed fell, and this generated positive MSR fair value marks. However, late in the year, CPRs fell to pre-pandemic levels and seemed to have stalled given the modest decline in mortgage rates. Accordingly, banks have been posting modest decreases in the carrying values, after rising through most of 2022.  However, mortgage rates have risen again in 2023 and so the same banks will have to post increased values in Q1.  

The market for MSRs has been and continues to be active with buyers having paid 4.0 – 5.5x for assets in recent years – the multiple measures the price of an MSR loan pool expressed as percentage of the unpaid principal balance divided by the servicing fee.  

Based on my high-level assumptions below, I believe there’s $1.2 – 1.8bn of value that would be available to the bondholders, providing coverage of 115 – 174%.  These values as based on the balance sheet as of Q3 2022 and may prove to be a bit aggressive but doesn’t impact the overall thesis.  The Company reports its Q4 and year-end numbers in a few days so we’ll get updated balance sheet numbers and I expect cash balance to be lower by at least $150mm.  I also expect further value to erode over the next several quarters as the Company will likely continue to lose money putting pressure on the cash balance and perhaps forcing management to sell more MSRs. This makes getting to breakeven quickly critical for both the Company and the bondholders.  

Catalyst

* continued aggressive action to rightsize the organization to get to breakeven levels quickly

* demonstrate success with digital HELOC offering