Walking through my Mistakes with Walker and Dunlop

With the earnings plate of stocks I own full to the brim, it was a bit of a tough week to be away.  The consequence was that I was not able to review many of the reports and conference calls until this weekend, and in a few cases the stocks suffered significant drops in the interim.

This was the case for Walker & Dunlop, the commercial mortgage originator that I’ve owned for the last four months.  In my original and follow up post on the company I described the investment thesis as being based in part on the continuation of their history of growth as a multi-family lender, and in part based on their relatively recent relationship with Fortress Investment Group, who I expected to open a few new doors for the company.

One door was opened in the first quarter with the initiation of an $850 million bridge lending program aimed at borrowers who would eventually qualify for Fannie, Freddie, CMBS or HUD channels.  This is a solid step for the company as it opens up another destination for its originations, but at 8% of loan volumes its not a game changer.

Meanwhile two other doors remain shut.  The company has shelved its mortgage REIT IPO for the time being because, not unexpectedly, the market is not favorable to REIT IPO’s.  And the CMBS platform that the company had talked about launching has been delayed because they could not work out terms with their original partner and are now in the process of bringing new partners on-board.  Color on both of these developments in available in the conference call transcript.

But what really killed the stock was that they lowered origination guidance for the year from $10-$12 billion to $9-$11 billion, and gave color on the reduction that, while candid, painted an uncertain landscape for 2014.

What I really missed with this idea are the changes in the regulatory regime that are underfoot, and how those changes are affecting Walker & Dunlop’s multi-family lending.  The vast majority of Walker & Dunlop’s origination volume is done through the GSE’s and through HUD (Fannie Mae at 30%, Freddie Mac at 24%, and HUD at 16%).  In March 2013 the FHFA, which has authority over the GSE’s, issued lending caps for Fannie and Freddie.  The caps were 10% below their 2012 volumes. Meanwhile HUD’s commitment authority ran out once already this year in March, and is expected to run out again in third quarter.  While Congress will undoubtedly increase the commitment authority, in the mean time HUD lending slows (I thought the consequence is described quite well in this article).

While Walker & Dunlop downplayed these developments on their first quarter conference call, I should have taken notice that the spirit, if not the immediate impact, was not a positive development and portended to an uncertain future.  The point that is underscored is that housing remains in the crossfires of government, that moves by the Federal government and its agencies right now tend to be driven by budgetary demands rather than market demands, and that Walker & Dunlop has a business that still depends to a large extent on government housing programs.

The other problem that arises is that multi-family lending by Fannie and Freddie is small in relation to single family lending, and thus decisions by Congress and the FHFA that affect multi-family lending are not always made with an eye of what is best for the space.  To give one example, reforms to the GSE’s have discussed the introduction of private capital to take the first loss position.  This is already the case with Fannie and Freddie’s multi-family business, yet it appears no distinction has been made for this in discussions.

This is the sort of thing that makes you wonder whether the eventual solution for housing will be the best decision for the multi-family lending space.

The bottom line is that the trend is toward change and that creates uncertainty about Walker & Dunlop’s future.  They will probably be fine in the long run, the company has shown itself to be quite capable, but getting from here to there could be painful.

The company is trying to diversify into private capital markets, but the second quarter was a stumble on both the REIT and the CMBS launch.  Thus they remain heavily dependent on government agencies whose source of funding is not stable.  This leaves important questions like: will the FHFA reduce lending to Fannie and Freddie by another 10% in 2014?  Will recent comments by Obama about replacing the GSE’s result in a smooth transition or will there be disruptions?  And will HUD continue to be a stop and go lending destination as it continually runs up against its commitment limit?

These are tough to answer and, had I been around during the week to listen to the call and give some serious thought to the thesis, I probably would have jettisoned the entire position by 10am on Thursday.  As it was I sold nothing on Thursday and only about 15% of my position on Friday, and that was based more on sticking to my rules (I generally sell down positions once they become 20% losers) than any analysis I had done at that point.   For the rest I am left making a decision about a company that has fallen 20% in the last 2 days but with an outlook that gives me no conviction.

So I’m not really sure what I am going to do at this point.  One thing I will definitely not be doing is adding to my position.  But I’m not sure how much I am willing to sell down here at $14.  Even with the reduced guidance and the uncertainty, the company is making strides towards increasing its capital markets exposure and it is not expensive on an earnings basis.  Ideally I would like to exit my position on a bounce back to the $16 range, take my 10% loss and move on.  But we’ll see.  Much like the multi-family business, the situation is fluid.