[VIP] Zillow’s Possible Long Game: Mortgages and iBuyer

It’s VIP Content Week, as I am home for several days without any travel. All that changes next week, but… in the meantime, I thought it worth putting together some posts for subscribers that reflect some of the things I’ve been working on in recent weeks.

One topic that keeps coming up both online and offline is how iBuyers can possibly hope to stay in business with such thin margins. All of them, supposedly, are losing thousands per transaction… and margins are thin, thin, thin: Zillow reported 0.5% post-interest margins on its Homes division recently.

I have long held a theory that the entire iBuyer movement is not about houses, not about spread between buy and sell, and not about commissions. This post from 2016 lays out the theory.

Well, I’ve done a bit of research, and I thought I would present some preliminary numbers to you all along with more of an explanation of my hypothesis. At this point, I would like to remind you that I’m talking about Zillow so much because they’re the only ones who publish their iBuyer numbers. Redfin is a public company, and they do report segment information, but not the level of detail that Zillow has and does. What follows applies to all market maker style iBuyers: Opendoor, Offerpad, Redfin, Zillow and whoever else that buys and sells properties on their own balance sheets.

I’d also like to remind everybody that no one from Opendoor, Zillow, Redfin, Offerpad or anywhere else has ever said anything approaching what I’m laying out. This is pure hypothesis and pure speculation.

But damn, it makes so much sense!

iBuyer is a Mortgage Play

First, let me set the stage a bit.

In 2016, as brokers and agents were starting to panic about how iBuyers were going to take their clients away, I wrote that they don’t need to worry. I thought Opendoor was going for a piece of the trillions of dollars in revenues from some $1,744 trillion in “interest-earning, all loans and leases, gross, secured by real estate, single family residential mortgages” rather than a piece of the $70 billion or so in real estate commissions.

I haven’t changed my mind on that. Though I do need to update the bad math from 2016 a bit. Using a 1% Return on Assets (since interest-bearing loans are assets of a bank) for all banks, then assuming that the “peer group” (500 U.S. banks with the most residential mortgages) is performing at 45% of the average (3.5% ROE vs. 7.82% ROE), let’s say that the big mortgage banks have a ROA of 45 bps or 0.45%.

On assets of $1,744 trillion (in 2016), that’s $7.85 trillion. Not quite the $61 trillion I was thinking in 2016, but a hella lot more than the $70 billion in real estate commissions.

Now, how would iBuyers go about getting a piece of that action? In a phrase, seller financing.

Seller Financing

Let’s be clear at the outset that I am not a RESPA attorney, and even if I were, I am not your attorney. So this is not legal advice in any way shape or form.

We know that Dodd-Frank and the subsequent rules by CFPB imposed some serious restrictions and regulations on mortgage lending practices. The ones we are concerned with have to do with the Loan Originator rule and the exclusions from various regulations for seller financing, in which the owner of the property provides the mortgage to the buyer.

Without getting too buried in the details, we know that the seller financing exclusions mostly have to do with what someone has to do not to be classified as a Loan Originator, who is subject to all of the Dodd-Frank and CFPB regulations, including prohibitions on certain kinds of loans (balloon payments, interest only, etc.). Plainly put, a company cannot offer seller financing on more than three (3) properties a year.

Seller financing also requires a “good faith effort” to determine the borrower’s Ability to Repay.

Having said all that, here’s what we do not know (quoting from this paper from a Florida law firm): whether a private lender using a loan originator as the intermediary can avoid application of Dodd Frank and the requirements set forth therein or whether the actual party making the loan has to be a Loan Originator?

We don’t know because we have not had a large non-bank, non-financial company do seller financing at scale. Seller financing is really the province of individual homeowners or small investors.

Does the government really care all that much if a giant multi-billion corporation risks its own capital to help a buyer finance the purchase of a property that it owns outright? I don’t know, but I’m leaning towards no.

Banks have to worry about their depositors and FDIC and various banking regulations. Zillow and Opendoor do not. The Federal Reserve has to worry about major money-center banks and their stability; I don’t think the Fed worries about large corporations that have no depositors and are not actual banks.

But from where I sit, it isn’t clear that for large iBuyers like Zillow and Opendoor, whether even that matters. If Zillow or Opendoor, as the owner of thousands of properties, used their own Loan Originators (all of whom are registered with NMLS ) to offer seller financing on their own properties, they appear to be able to offer all kinds of fully amortized mortgages using their own underwriting standards with fairly minimal ATR requirements. There are only 8 required ATR underwriting factors after all and the regulations are pretty reasonable.

It appears entirely feasible that Opendoor and Zillow could actually underwrite QM (Qualified Mortgage) loans since the requirements there are fairly minimal: no negative amortization or IO-only loans, no more than 30 years in length, limits on points and fees, fully-amortizing, and total monthly DTI of 43%.

Speed and Convenience Advantage

The advantage of seller financing, of course, is that as long as the minimal ATR requirements are met, the Loan Originators are registered and in compliance with all of the compensation rules, and some other fairly minimal TILA disclosure rules are met, the iBuyers can use their own underwriting standards that are (a) simpler, and (b) more relaxed than a traditional lender (particularly a bank) would use. Plus, the iBuyers have one gigantic advantage: appraisal.

Quicken Loans with its Rocket Mortgage uses technology to speed up the pre-approval with a rate lock guarantee, and then it goes into the traditional 30-45 days process to actually close the loan. A big chunk of that time is because of the requirement for an appraisal. Every third-party lender has to verify that the property is actually adequate security for the mortgage.

An iBuyer selling its own house and using its own money does not, because it has done the appraisal already at the purchase step, and already knows the condition of the property because it owns the house and because it has renovated that property itself. Again, if the iBuyer was wrong about the value of the property… it lost its own money on a foreclosure. No third parties, and certainly no bank depositors, were harmed.

And since the iBuyer can use its own underwriting standards for its own capital on its own property….

It does not seem crazy to me to think that an iBuyer could go from application to closing in a matter of days, not weeks. They’re already promising to buy a home from a seller in 48 hours with cash on the table; why not put cash on the table for the buyer/borrower in 48 hours?

Imagine being able to find the house you want, apply for a loan online (Rocket Mortgage style), and then have it approved and closed in 48 hours. It’s a mind-blowing thought for anybody who has ever applied for a mortgage, especially in recent years.

Zillow’s Mortgage Opportunity

Now, since Zillow is the only iBuyer company that is reporting any numbers publicly, I have to use Zillow as the example. I imagine Redfin, Opendoor and Offerpad are not that different, but I don’t know.

We already know that Rich Barton has said that their plan is to really use Zillow Home Loans (formerly Mortgage Lenders of America) to offer mortgages on Zillow-owned homes. They are building up systems and technology and whatever else they need to do to make that happen.

We already know that Spencer Rascoff, in discussing the mortgage opportunity, threw out 75% attach rates for new home builders who are able to offer discounts on the home price if the buyer finances through their mortgage company/affiliate. This is from the Q2/2018 earnings call:

So just to give you some napkin math for a second, about 400,000 homes sell a month in the United States. If Zillow Offers is buying and selling, say, 10,000 homes a month, that’s about 2.5%. 2% or so of the market. If we’re doing that type of home buying and selling volume, home builders typically have a 75% attach rate on their in-house mortgage of homes that they’re selling. At a 75% attach rate on 10,000 homes a month at $9,000.00 in revenue per mortgage origination, that’s $67 million a month of mortgage origination revenue, or about $800 million a year.

We already know that Barton has set 5,000 homes purchased (and one assumes sold) per month within 3-5 years as the goal for Zillow Offers.

So here are the very rough, very non-sophisticated numbers:

This is for “conforming” loans. Meaning, they are the most conservative in terms of underwriting, ATR analysis, etc. I assume they will be General QM loans, fully amortizing, 30-year fixed rate, no more than 0.5% in fees and points, and the 4.5% interest rate is within 1% of the APOR rate as of today. Plain vanilla boring.

I have asked a lot of mortgage professionals, and they tell me that Fannie/Freddie conforming QM mortgages sell for a premium of 550-650 bps today. Chris Harris, VP, National Joint Venture Manager, of CMG Financial (one of the largest mortgage lenders in the business) thought that 550bps or so was about where the market was, so I’ll go with his expert judgment.

On those assumptions, further assuming that Zillow just wants to sell the whole loan with servicing rights and everything else, we’re looking at $807 million in annual revenues from Zillow Home Loans.

Thing is, Spencer Rascoff said $9,000 in revenue per mortgage origination; the above numbers are showing only $2,700 per origination. So either my assumptions are off and my math is wrong, and we’re looking at something more like $2.8 billion in annual revenues, or Spencer was being overly optimistic.

EDIT: An astute reader pointed out my math error, so I have updated the spreadsheet. Thank you Spencer! Looks like my assumptions are actually showing a whopping $18K per mortgage originated, so almost double the $9K that Spencer Rascoff mentioned in the earnings call.

That’s a nice chunk of change at only 5,000 homes bought and sold per month. At the 10,000 homes bought and sold per month as Spencer mentioned in the earnings call, we’re at $1.6 billion in annual revenues just from mortgage.

Non-QM Loans? Servicing Rights?

But what makes it even more interesting is the idea that Zillow (or any other iBuyer with a mortgage business – cue Redfin and Opendoor), as a seller-financier at scale, using its own underwriting to risk its own money, might be able to make the kind of loans that other lenders either can’t or won’t.

Think about the legions of 1099 workers, like real estate agents and gig-economy workers, who have the financial wherewithal to make mortgage payments… if only they could get a loan. What about those who have a bankruptcy filing four years ago, but are back on track for the past 24 months? Are traditional lenders going to take a risk on them? Maybe, maybe not. But Zillow can. Maybe the DTI ratio is over the 43% that QM mortgages require, but Zillow feels comfortable doing business with them, at a higher interest rate.

The phrase these days for these kinds of loans is “non-QM” instead of “subprime” because many of these loans are anything but subprime. There are no NINJA loans, no stated income loans, etc. Many of these are high quality fully-amortizing loans, but for creditworthy borrowers who have non-standard situations, such as business owners.

In this context, this interview in HousingWire with Jaye Craft at Citadel Servicing Corporation is of great interest:

Q. What CSC products are specifically geared for borrowers who have non-traditional income?

A. CSC rolled out the One Month Bank Statement program in 2018 and it has become our No. 1 program for self-employed borrowers who are unable to show traditional income streams. The One Month Bank Statement satisfies the ATR requirements completely while providing adequate income documentation.

Satisfies the ATR requirements completely, you say!

And this interview from Mortgage Orb with Tom Millon, CEO of Computershare Loan Services U.S., should trigger thoughts:

Q: How difficult is it to modify existing technology infrastructure and the processes for non-QM loans – in other words, is there a difficult conversion process in order to be able to originate and underwrite these loans?

Millon: Good question. It’s true that there are not a lot of systems designed for non-QM underwriting, at this point. It’s basically like jumbo loan underwriting with a few additional overlays. And it’s a largely manual process. So, it’s very expensive. But as this market grows, I expect to see the technology vendors start to introduce some non-QM solutions. Or, we might create better solutions in-house, as we go, automating some of the processes. It’s still in the early stages, in terms of technology solutions helping out with the non-QM process.

Huh… you know who happens to be really good at technology solutions? And has thousands of some of the best computer scientists, engineers, and data scientists in the world working for them? Google! Yes, true, but also Zillow, Redfin and Opendoor.

What we know is that higher interest rates = more valuable mortgages for MBS pools, as long as the risk can be managed. Chris Harris of CMG Financial thought that the range might be around 750bps, but warned that with non-QM, it’s much more difficult to say because it really depends on a number of factors, such as interest rate, credit score, type of loan, etc. etc. But as a general rule, higher risk = higher interest rates = more valuable to investors so I’m going to roll with that as the assumption for now.

Furthermore, servicing rights have some value as well particularly for non-QM loans, because of something known as “Excess Servicing Rights”. In plain language, Excess Servicing Rights is the spread between the mortgage rate and the coupon rate that has to be paid to the note owner/MBS investor.

From Investopedia:

Mortgage excess servicing is the percentage of the monthly cash flow that remains after the cash flow has been divided into a coupon and principal payment for the mortgage backed securities (MBS) holder. This servicing fee typically goes to the servicer of the loan and is possibly a guarantee fee for the underwriter of the MBS.

For example, in a typical MBS deal, if the interest rate on a mortgage is 8%, the MBS holder might receive 7.5%, the servicer of the mortgage receives 0.25% and the MBS underwriter gets 0.15% This leaves the remaining 0.10% (8% – 7.5% – 0.25% – 0.15% = 0.10%) as excess servicing.

The obvious question is what interest rate is the MBS investor willing to accept for higher risk non-QM MBS. For my purposes, I thought a 1% gap (25bps for basic fee, 75bps for Excess) seemed reasonable given the low interest rate environment we’re in. If someone is offering 6% coupons on a bond, I imagine a lot of investors would find that interesting when 30-year Treasuries are below 2% (as of this writing).

So here are those numbers, again, rough and unsophisticated:

Now we’re looking at $1.15 billion in annual revenues from mortgages alone and annual servicing revenue and steady servicing cash flow of $11.2 million (less whatever defaults and prepayments and the like). Again, if we think that Spencer Rascoff was stating Zillow’s actual goals of 10,000 homes (2% of the market)… the numbers start to get kinda crazy.

Plus, servicing rights have all kinds of ancillary benefits, like maybe knowing when a borrower might be thinking about refinancing, or knowing when they’re late on payments…. Maybe that borrower might want to sell the home to Zillow and downsize? And take on a new Zillow Home Loans mortgage with a new amortization curve, which can be sold once again?

And Finally… Zillow MBS?

If Zillow does get to be that kind of size, making thousands of mortgages every month, I don’t think it’s crazy to think that Zillow might decide to simply securitize those mortgages rather than selling the loans piecemeal to companies who assemble mortgage portfolios.

I’ll just say that the math and the assumptions get kinda crazy here, once you get into securitization. But I will make the observation that private label MBS was really big business before the Bubble burst. In 2006, private label MBS was almost 60% of the market, with a value of $1.2 trillion. Then the market pretty much vanished overnight during the crash. But as the housing market recovers, so is the private label MBS market.

I suspect that there are still a lot of bankers on Wall Street who remember how to do these, who have retained the expertise and the contacts (things like private insurance) to get them done. And I imagine they’d be pretty hungry to do a $3 billion Zillow MBS offering every quarter.

For that matter, it isn’t as if Zillow is lacking in finance talent or the money to hire the best financial talent. I could imagine Zillow deciding to cut out the underwriter entirely, hire some of these smart Wall Street guys and gals with experience in private label non-QM MBS, and go to market directly. Even more money in their pockets then.

In Closing

I think this is the ultimate long game for Zillow, for Redfin, for Opendoor, for Offerpad, and for any other market maker type of iBuyer. Sure, the laws and regulations are somewhat unsettled, but if anyone is going to test whether large institutions can do seller financing at scale using their own Loan Originators and using their own capital, I think Zillow will be the one to test it. The rewards are just too big to ignore.

And speaking of capital, it should be pointed out that any kind of successful loan sale or securitization should lower the cost of capital for the iBuyer significantly which makes that part of the business more profitable and even more cost-competitive. Given how much of a drag on Zillow Homes profitability comes from interest costs of its revolver, that could end up being a pretty big game changer on that side of the house.

The new equation for a fully-realized iBuyer model then is not “Buy Low, Sell High” on a home. It’s more like, “Buy home, convert it to a mortgage, sell/securitize mortgage, buy home, convert it to a mortgage… rinse, repeat” all the while making billions every time the cycle completes.

So, what do you think? I know there are some VIP readers who are members of the priesthood of high finance. Does this seem like a reasonable thesis to you or not?


1 thought on “[VIP] Zillow’s Possible Long Game: Mortgages and iBuyer”

  1. ROB,

    You got me smiling. Very interesting! I guess there’s a market for everything so ZG labeled pools of mortgages will find buyers (investors). The key to will be to watch key hires.

    As you said: “I suspect that there are still a lot of bankers on Wall Street who remember how to do these, who have retained the expertise and the contacts (things like private insurance) to get them done. And I imagine they’d be pretty hungry to do a $3 billion Zillow MBS offering every quarter.”

    If we see 50 and 60 year old ex-First Boston, KP, Goldman, Bear Stearns and Lehman mortgage guys coming to ZG – you’re theory will be confirmed. They will need them. We should also keep in mind that the mortgage bond market was central to the last debacle – one that brought down 4 of the 5 mentioned firms.

    What a great idea ROB! You win for discovering the largest market 🙂


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