Mortgage Servicers Get Hammered as Interest Rates Fall
Employment cost index
The U.S. Bureau of Labor Statistics prepares the US ECI (employment cost index) quarterly. The ECI is the counterpart of the CPI (consumer price index). One way of thinking about the ECI is that it represents the wage side of the wage-price spiral, whereas the CPI represents the price side.
Interested in AGNC? Don't miss the next report.
Receive e-mail alerts for new research on AGNC
Employment costs rose 0.6% in the quarter ending March 31, 2016. Over the past 12 months, compensation costs for civilian workers have risen 1.9%. Benefit costs have risen 1.7%. For private industry workers, wages and salaries rose 1.8% and benefits rose 1.2%.
Meanwhile, healthcare cost inflation rose from 2.5% last year to 3.3% this year. The latest annual wage inflation data are closer to 2.6%, so wage inflation might be accelerating. That being said, politicians are proposing policies such as mandatory paid family leave and mandatory paid sick days. These kinds of policies add costs to labor without delivering more value to the employer, which will inhibit wage inflation.
We’re also seeing big proposed price increases from big health insurers, especially for government policies. This could indicate future healthcare cost inflation, which increases employment costs.
Impact on mortgage REITs
If benefit costs are rising, then workers are becoming more expensive. However, that doesn’t mean they have more money to spend. This trend increases employment costs, but we aren’t seeing a big uptick in consumption. Regulation can increase the cost of labor without putting extra funds in workers’ pockets.
Note that unit labor costs rose 4.1% in the first quarter as productivity was -1.0%. This trend is bearish for future wage growth. Increases in the standards of living are mainly linked to productivity growth. There has been some debate in the academic community about whether we’re measuring productivity correctly.
The REITs most exposed to this change are non-agency REITs such as Two Harbors Investment (TWO), which invests in mortgage-backed securities that aren’t backed by the federal government. Other REITs exposed to this change have large portfolios of mortgage-servicing rights such as Nationstar Mortgage Holdings (NSM).
Tough times for mortgage servicers
Servicers are required to make principal and interest advances to security holders, even if the borrower doesn’t pay. They could find themselves with cash flow problems if there’s a big shock. In fact, after the financial crisis, big agency REITs such as Annaly Capital Management (NLY) and American Capital Agency (AGNC) rallied while REITs with large MSR portfolios got hammered. Mortgage servicing rights valuation multiples are extremely low at the moment. Servicers like Ocwen (OCN) and Walter (WAC) have seen their stock prices decimated. Many investors piled into mortgage servicing rights in anticipation of the Fed tightening. Mortgage servicing rights are similar to interest-only strips that increase in value as interest rates rise. The global bond market rally caught them off-sides.
Investors who would like to trade in the mortgage REIT sector might want to look at the iShares Mortgage Real Estate Capped ETF (REM). For related analysis, check out Market Realist’s Real Estate Investment Trusts page.