"Don't fight the Fed" is an old market saw. This means that markets are vulnerable with the Federal Reserve is raising rates. The Fed is indeed a cloud over the entire mortgage space these days. In the latest Federal Open Market Committee minutes, most participants anticipated beginning the reduction at the end of the year. New Residential Investment (RITM -2.37%) believes that its current business model will allow it to prosper no matter what the Fed does. Does this present an opportunity for investors?
The Fed was a tailwind for the mortgage business last year
In the beginning of the COVID-19 pandemic, the Federal Reserve cut interest rates to the floor and began purchasing $80 billion a month in Treasuries and mortgage-backed securities. They did this in order to stimulate demand in the economy. This activity was a boon for mortgage originators in that it unleashed a wave of mortgage refinance activity. Numerous originators like Rocket (RKT -1.63%) and UWM Holdings (UWMC -3.87%) took advantage of the environment to conduct initial public offerings.
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The Fed is going to be a headwind for the mortgage business going forward.
Now that more and more Americans are getting vaccinated, the economy is recovering. The Federal Reserve is looking to reduce its footprint in the mortgage market. Since the Fed is one of the biggest buyers of mortgage-backed securities, its exit will mean an increase in mortgage rates. It will also mean mortgage-backed securities will decrease in price relative to Treasuries. This is generally bad news for companies like mortgage real estate investment trust New Residential.
Mortgage servicing rights like higher rates
The key to New Residential's strategy to mitigate the effects of the Fed are in its holdings of mortgage servicing rights, or MSRs. These are somewhat esoteric financial instruments, however they have one unusual aspect that sets them apart from virtually every other financial security out there -- they increase in price when interest rates rise. In contrast, bonds fall when rates rise. Stocks fall when rates rise. MSRs don't. So what are they?
Mortgage servicing rights are a byproduct of the mortgage origination business. When a mortgage loan is created, there are two parts to it, the loan and the servicing. When New Residential originates a mortgage, it will sell the loan itself into the market and keep the servicing (aka the MSR) for itself. So what is "servicing?" It is the right to handle the administrative tasks of the loan.
Here is how servicing works. The mortgage servicer is responsible for sending the borrower the monthly bill, ensuring that taxes and insurance are paid, reporting interest paid to the IRS, and dealing with the borrower if they get into trouble and cannot make the monthly payment. The servicer earns 0.25% of the loan amount as a fee per year. If the borrower is like the vast majority of borrowers out there, the servicer has a pretty easy job, and can collect $1,000 a year on a $400,000 loan for sending bills and cashing checks.
The right to service the loan (and collect that fee) is worth something, and it is called a mortgage servicing right. The owner can sell it for cash, or hold it and collect the fees. If interest rates rise, the chance of the borrower repaying the loan early decreases, since it won't make sense to take out a 4% mortgage to refinance a 3% one. The expected life of the MSR increases and that makes it more valuable. This is why it goes up in value when rates rise.
New Residential is betting that when the Fed starts increasing rates, its portfolio of mortgage servicing rights will pick up the slack when its mortgage origination arm does less business. Will it? It is hard to tell, since there are a lot of moving pieces here, but the basic theory is correct.
New Residential is cheap right now
New Residential is trading extremely cheaply right now. It just reported book value per share of $11.27 and the stock is trading at a hefty discount to that. The market is basically ignoring the value of the origination business and valuing New Rez like a garden-variety mortgage REIT. On the earnings conference call, CEO Michael Nierenberg reiterated the company's view that if you assigned an earnings multiple to the mortgage arm, book value per share should be around $13 to $15 per share.
The problem with the entire sector is that investor sentiment is pretty negative given the posture of the Fed. New Rez is a value stock at this point, and given its $0.20 quarterly dividend, it has a yield of about 8.4%. Investors are getting paid pretty well to wait and see if New Residential's bet is correct and mortgage servicing will offset the issues when rates rise. Income investors should take note.
