Skip to content

Posts from the ‘Mortgage Co’s’ Category

May 6

You can be a Stock Market Genius… by Buying PHH Corp

I swear its the name of a book, not the punchline of an infomercial

You Can Be a Stock Market Genius was written by Joel Greenblatt in 1999.  It is an oft recommended book by value investors.  The recommendations, however, generally come with the following caveat, or something similar in effect:  “Now I know the title is awful but…”

If you can get past the cheesy title and into the meat, the book provides an investor with a wealth of knowledge, focusing on areas of the stock market that are overlooked by the most investors, and explaining how you can find value there.

One opportunity that is discussed at length in the book is the spin-off. A spin-off typically occurs either when the company feels that the sum of the parts is greater than the whole, or when a bad business is overwhelming the perception of a good business.  Usually a spin-off involves two or more businesses that are mostly mutually exclusive from one another.

The basic premise of the spin-off is that the underlying businesses will be realized for a higher value separately then they are being realized for together.  In his book, Greenblatt focuses on the inefficiencies with the spin-off process.  In many cases investors of the original security will be more interested in one of the resulting securities than the other.  In some cases the spin-off will result in one entity that is far smaller than the other, and institutions with size limitations on what they can hold will be forced to sell.  These reasons lead to a lot of selling pressure over a short amount of time, which can depress one of the spin-off companies and lead to a good value situation.

I want to focus here on the basic premise of a spin-off; that the businesses that underly the parent company are undervalued as a whole, and that often there is money to be made simply from the recognition of value brought about by their separation.  The intent of the spin-off is to create value, and often times it works.  There are plenty of examples of company’s whose stock popped on the announcement of a spin-off or divestiture.  With investors being more able to focus on the simpler business structures of the resulting spin-off companies, the value is more readily perceived.

The Spin-off Potential of PHH Corp

I believe that PHH Corp is an ideal candidate for a spin-off or a divestiture that would create significant value for shareholders.  Moreover, even if a spin-off never happens, the value is there to be realized and the market appears to be in the process of reevaluating its worth.

PHH is involved in two businesses that, from what I can tell, have very little efficiencies with one another apart from the fact that both involve money.

  1. Mortgage Origination and Servicing
  2. Fleet Management Services

When I became interested in PHH Corp a few months ago it was because of the Mortgage Origination and Servicing segment.  PHH is one of the few large originators out there that trades publically.  I learned about the company while reading a 13G filing from Hayman Capital, the investment management firm run by Kyle Bass.  Bass took a 7.9% stake in the company.

My initial investment analysis focused on the servicing and origination segment of the business.  I was pretty sure I could see the value that Bass saw, and I will get to that in a minute.  I bought the stock soon after and watched it do well for a couple of weeks.

Well at some point my procrastination was overridden by my curiousity and I thought I better take a look at this Fleet Management business.  To be honest, I didn’t even know what Fleet Management was.  What I was shocked to learn was not only that Fleet Management is a solid, growing business, but that an argument could be made that its value alone could be worth a large percentage of the PHH market capitalization.  I can imagine a scenario where the Fleet Management business is spun off or divested from the mortgage business, with the result being a significant realization of shareholder value.

What is Fleet Management?

The best definition I could find as to what the business of fleet management is all about came from wikipedia:

Fleet management is the management of a company’s vehicle fleet. Fleet management includes commercial motor vehicles such as cars, vans and trucks. Fleet (vehicle) management can include a range of functions, such as vehicle financing, vehicle maintenance, vehicle telematics (tracking and diagnostics), driver management, speed management, fuel management and health and safety management. Fleet Management is a function which allows companies which rely on transportation in their business to remove or minimize the risks associated with vehicle investment, improving efficiency, productivity and reducing their overall transportation and staff costs, providing 100% compliance with government legislation (duty of care) and many more. These functions can be dealt with by either an in-house fleet-management department or an outsourced fleet-management provider.

Its a fairly simple business, and one that has proven to be consistently profitable even through one of the worst recessions ever.

The hidden consistency of Fleet

I went back a few years and looked at the earnings numbers on the PHH Fleet business:

Average earnings from Fleet over the past 6 years have been $0.83 per share of PHH.   Even in the depths of the 2008-2009 recession Fleet delivered respectable earnings.

The Fleet business continued its operational performance in the first quarter of this year and looks ready to break above a $1 per share in earnings for the first time since 2007.

Think about that for a second.  Here you have a business that has shown the ability to earn money consistently, even through what was probably the worst recession of our generation.  It could quick likely earn $1 per share of earnings this year.  Earnings have grown in the high teens for the past 3 years.

What would you value such a business at?  12x earnings? 15x earnings?  Maybe more?

If you use either of those multiples on the average and peak earnings numbers, it becomes clear that the Fleet business is worth something not too far away from the current stock price.  Or in other words, when you are buying PHH you are buying the mortgage business for very little.

Moreover, as one would expect, the Fleet Management business is going to improve along with the economy.  As per last year’s 10-K:

The fleet management industry continues to be impacted by the relative strength of the U.S. economy. As the U.S. economy improves, we expect to see continued improvement in the industry. We believe that improvement in the economic conditions will be reflected in continued growth in our service unit counts.

If the US economy is indeed improving, the Fleet business could turn out to be a cash generating machine.

This all leads to the speculation of whether there could be a spin-off or sale of Fleet from the rest of the company at some point.  A sale of Fleet would provide the cash needed by the servicing business to grow and allow PHH to continue their correspondent lending business at higher levels.  A spin-off would most likely realize value for shareholders, as the value of each individual business would be more easily identified.

There was a question on the Q4 conference call that alluded to the possibility of some sort of divestiture.  Management did not deny it, saying only that it wasn`t an appropriate topic for a public forum.   On the fourth quarter conference call the CEO, Glenn Messina, was asked about the possibility of bidders to the Fleet business (as well as the mortgage servicing business).  His response was:

As it relates to anything regard to Fleet or Mortgage, this public forum is not the place to have any discussions about anything like that. I’m focused on maximizing shareholder value. We’ve laid out our four strategies and that’s what we are going to be pursuing.

That certainly is not a no.

But wait, there’s more!

So a spin-off or sale of Fleet is certainly a possibility.  But that is the not the only source of value hidden within PHH.  PHH is in the business of mortgage origination and mortgage servicing.  The company breaks origination and servicing up into two distinct segments.

Mortgage Origination

Mortgage origination basically consists of finding a person that needs a loan to buy a home, showing that person a list of mortgage options of how they could finance that loan, qualifying the borrower for loan guarantees such as those from the GSE’s, processing the loan (doing all the paperwork) and passing it through to the eventual lender institution (usually to Fannie, Freddie or a bank that will either keep it on their books or sell it to another investor).  PHH takes a cut in the process, or an origination fee, that is typically between 1/2% and 1%.

Mortgage Servicing

Mortgage servicing happens after the loan is made. The servicer is responsible for determining how much the borrower owes and collecting that amount.  If a loan is not being paid then the servicer takes on additional responsibilities such negotiating a workout upon default, looking after the foreclosed property and such.  There are also other contingent responsibilities such as taxes and insurance, depending on the specifics of the servicing agreement.

The natural hedge of servicing and origination

PHH refers to the servicing and origination businesses as a natural hedge of each other.  Why?  Because they are inversely correlated with respect to interest rates.

Let’s say interest rates fall.  What happens?  People that have mortgages at higher rates refinance those mortgages.  That’s great for the origination business.  They are writing up refi’s and taking in the fees.

Not so great for the servicing business. When a mortgage is refinanced the right to service that mortgage no longer exists.  Of course this can be mitigated if PHH is able to originate the refinance and thus takes on the servicing rights for that refi so the old mortgage servicing right (MSR) is replaced with a new one.  PHH has proven to be quite good at “recapturing” loans in this manner.  But there’s no guarantee.

When rates go up and the opposite situation occurs.  Origination suffers, no one is refinancing at the higher rates.   But mortgage servicing rights are not being lost either, and PHH is collecting cash on these rights for longer.

There are a number of developments happening in the mortgage business right now from which PHH stands to benefit.

Origination: Generating consistent earnings, but needs to grow

Since 2008 PHH has had a steady stream of earnings from the mortgage origination business.   However, probably not surprisingly in the current environment, they have not been able to grow the business substantially.  Below are earnings of the business over the past 5 years, as well as for the first quarter of this year.

I believe there are a few opportunities in the origination space that could change the growth profile of the business  The first is if the company could take advantage of the pricing opportunity that exists in correspondent lending.

Correspondent lending

So first of all, what is a correspondent lender?

Consider the following. Imagine a mortgage broker who develops significant business volume, earns the confidence of wholesale lenders who will authorize him to approve their loans, and has accumulated some capital. He can now obtain a credit line from a bank that can be drawn against to fund loans, repaying the loans when they are sold to wholesale lenders. Under the law, the broker has morphed into a “lender” – the type called a “correspondent lender”.

This has been a business the big banks have traditionally taken a large piece of.   Until now.  In August Bank of America reported that they were exiting the correspondent lending business.  Ally Financial, who lends through GMAC, retreated from correspondent lending back in December before recently announcing that they would get back into the business on a limited basis.  Met Life announced that they were winding down their origination business entirely in January.

This isn’t small potatoes.  The above 3 companies were in the top 12 correspondent lenders by volume in the third quarter.

There are rumors others are leaving the business. I thought this quote from a Mortgage News Daily article was spot-on:

One can just hear large lenders talking in their boardrooms. “Do we really want to be in this business, given the regulatory, legal, financial, and public relations issues? Where the value of servicing has dropped dramatically in the market, and could drop further depending on Basel III? Where the mortgage insurance tax deductibility has gone away? Where every week brings a new lawsuit – when will we have more attorneys on staff than originators?”

Its a low margin, highly competitive business.   But the opportunity is that it could become less so with some of the big players moving on.

In the 4th quarter PHH announced that they would be reducing their own correspondent lending business.  But even at the time of the announcement they hedged their bet, saying they would remain opportunistic and take advantages of periods of high margins.  With so many other large lenders cutting back or completely exiting from the business, its a good time to be opportunistic.

Here is what management said about the correspondent business on the Q3 2011 conference call:

Yes I’m going let – yes the answer to the question is yes, we think there are better opportunities but once again we’re really pretty opportunistic in that channel. So we pay close attention to margins in that channel. As you know it’s probably the most cost competitive channel, it is the most cost competitive channel that we operate in and we’ve seen some really strange behavior in that market in terms of where margins are being priced. Some of our competitors are in the market, when they are in the market they’re very aggressive in terms of their pricing and then they back off and they’re out of market and that’s why we stay really opportunistic in that market.

On the Q1 2012 call, when questioned about the outlook of the correspondent business going forward, management began to change their tune.  CEO Glenn Messina said the following:

Right now we think by year end we’ll probably ramp it down to about 20% of the total, but yes, I do want to caution everyone. Last quarter I talked about managing the correspondent operations to a cash budget, and given where margins are today, cash cost origination tends to be very low.

So within the right quality parameters, and we’ve established defined quality parameters around who sells loans to us and the quality of their originations, we may flex up or down depending upon what the cash cost originations is.

So basically what Messina is saying is that margins are so good right now that while we originally figured to be ramping down correspondent lending,we would be crazy to do that in this environment.  Analysts have already ratcheted down estimates for the origination business as a whole based on expected declines in the correspondent segment.   PHH is in a good position to now beat those estimates.

Signing up new partners

The second possible growth vehicle for the origination business is a continuation of the success they had in the latter half of last year in signing up some big partners for their origination business.  From the Q3 CC:

We also made significant progress in growing our nationwide sourcing footprint over the past two quarters signing five new private label accounts. The new relationships include Barclays which we mentioned on last quarter’s call and today we’re pleased to announce that we’ve added Ameriprise and Morgan Stanley Private Bank along with two other financial institutions all as new PLS partners.

PHH did also lose one significant client in Charles Schwab last year, but overall the company expects to gain significant production from the new clients over and beyond the lost ones:

We expect the five new PLS accounts in the aggregate based on their 2011 production and taking into account ramp up time and anticipated launch schedules to produce about 7 billion in closing volume in 2012, about double what we predicted for Schwab.

There haven’t been any further announcements of major partnerships since the third quarter.  I imagine that these relationship get reviewed close to year end, so we will just have to wait and see.  Given the propensity for the big banks to scale back and outsource their mortgage business, it seems reasonable to me that PHH will be able to grow its book through further relationships.

HARP II could provide some short term support to origination

HARP stands for the Home Affordability Refinance Program.  HARP II is the name that has been coined for the new version of HARP.  It supersedes the original HARP.  HARP I was a total failure.

The HARP program has helped far fewer borrowers than its proponents estimated — roughly 894,000 borrowers since Aug. 31, 2011. — and many less than the estimated 11 million U.S. homeowners who owe more than their homes are worth.

Why was it a failure?  A few reasons:

1. Put back risk: Basically when a bank participated in the original program they were worried that they would get stuck with the original mortgage.  I think what happens here is that to rewrite the original loan to new terms, the loan is going to be scrutinized.  The banks and other underwriters know that the quality of many of those original documents are sketchy at best and they would rather not have to pull out the skeletons.

2. LTV Limits: This is probably the biggest problem.  The original HARP program dealt with current loans with LTV’s of 80-105.  That was expanded to 125 in 2009, but that still wasn’t enough.  I was surprised by that until I read this:

This should have a big impact in certain parts of Nevada, Arizona, and Florida where many borrowers owe more than 125% of the value of their homes. In Nevada, for example, two thirds of all loans backed by Fannie Mae are underwater, and half of all loans are above the 125% loan-to-value cut-off.

3. Appraisal costs: the borrower had to have an appraisal done to qualify for the original program.  That appraisal could cost $400.  Borrowers were reluctant to take this cost on when there was no guarantee they would be accepted by the program

HARP II aims to correct these mistakes.  The LTV limit is gone.  Appraisals are no longer required.  And banks are protected against the put backs.Says Brian Ye, analyst at J.P Morgan Chase & Co:

“We are of the opinion that there are enough changes to the program that bank servicers could really change their behavior, and this could be one of the first times that the administration has under-promised and over-delivered,”

There is one particular element of the new program that helps out PHH is that servicers get a head start over third party originators.   I confess I don’t know just what of impact this is going to have, but it is interesting and potentially significant, so I think its worth mentioning.  Servicers like PHH have been writing borrowers up for the program since the beginning of the year.   A third party originator cannot submit any documents to Fannie or Freddie until March.   This was done to entice the banks into the program, but the corrollary is that a company like PHH has been able to capture business up front without the competition.

More information on the new HARP program can be found here.

Will HARP II work?

This is, of course, the big question. The program is aimed to attract two million borrowers by the end of 2013.  This would be a little more than twice what the original program attracted.

However if the program works, and if JP Morgan turns out to be right and the administration “under-promised”, there is certainly a lot of room for upside.  According to CoreLogic:

10.9 million, or 22.5 percent, of all residential properties with a mortgage were in negative equity at the end of the second quarter of 2011.  Eight million borrowers with negative equity, or nearly 75 percent of all underwater borrowers, have above market rates. The disparity is even greater for those with severe negative equity. More than 40 percent of borrowers with 125 percent or higher loan-to-value (LTV) ratios have mortgages with rates at 6 percent or above, compared to only 17 percent for borrowers with positive equity.

Apart from the obvious fact that these numbers show just how staggeringly bad housing has become, if you prefer to see the glass half full those numbers also suggest that there are a lot of borrowers out that could benefit from a program like this.

Mortgage Servicing Rights and the Mortgage Servicing Disconnect

I wrote a long article on Seeking Alpha (The Opportunity in Mortgage Servicing Rights) describing the factors that have caused the mortgage servicing industry to fall into disarray.  I am not going to repeat that thesis in detail here.  To summarize its conclusions by way of analogy, the opportunity in the mortgage servicing industry right now is similar to the opportunity in correspondent lending.   Many of the traditional big players in the industry are getting out of the business and that has left a void.  The void has caused servicing valuations to collapse and has opened up the potential for servicers like PHH to take on new business.

PHH Corp is perhaps not the best way to play the valuation gap in servicing rights.  There are other companies like Newcastle Investments, Nationstar Mortgage Holdings, and Home Loan Servicing Solutions that are actively purchasing 3rd Party portfolios of servicing rights on the cheap, and in my opinion stand to gain substantially from their eventual reversion to historical norms.

PHH, on the other hand, does not buy servicing rights outright from 3rd parties.  They do, however, keep the servicing rights of the mortgages they originate, and they do perform subservicing of portfolios owned by others. It is perhaps in the subservicing business where PHH can take advantage of the exit of other large players, developing new relationships as subservicer.  Right now the subservicing business is a fairly miniscule component of the overall servicing revenue (a little less than 3% of total fee revenue in the first quarter) so I am going to leave this as a possibility, but not one to count on.

The other potential opportunity for PHH lies with the effect rising interest rates will have on its existing servicing portfolio.

Interest rates have done nothing but fall for more than 20 years.

At some point this trend is going to reverse.  Rates are going to head upwards.  David Einhorn published an interesting opinion piece this week in the Huffington Post.  He argued that the Federal Reserves policy of zero interest rates and quantitative easing is counter-productive; that it is not enticing risk adverse investors into stocks.  He goes on to argue that if the Federal Reserve were to allow interest rates to rise, you would see investors begin to shy away from the bond market, as what has been a one way winning trade for 20+ years would show signs of waning.

Falling interest rates have been a plague on the mortgage servicing industry.  Every time a borrower refinances, the servicing right associated with the original mortgage ceases.  This has put companies like PHH on a treadmill of generating originations to replenish their servicing pipeline, and forced them to work hard to recapture the borrowers that are looking to refinance.

When interest rates begin to head back up, the opposite scenario is going to prevail.   PHH is going to be left with a servicing portfolio that is chaulk full of low interest rate loans that will not refinance for years.  Everyone who can refinance their mortgage will have already done so.  Meanwhile, the quality of the loans being originated since 2008 is some of the highest it has ever been.  No one has dared make a risky loan in the current environment.

There are 3 risks associated with holding a mortgage servicing right.  The first risk is the risk of refinancing.  The second risk is the risk of default.  The third risk is the risk that the house is put up for sale.  We are in an environment where the first two risks are likely to be lower going forward than they have been for quite some time.  A rise in the risk of the house simply being sold implies an economy that is recovering.   Thisis probably a positive for PHH, as higher home sales will drive it origination business.

The end result is that the servicing portfolio that PHH owns is going to be generating cash for longer than it has in the recent past.  This is going to help PHH grow its portfolio further, for the simple reason that the portfolio won’t have as much turnover.

A brief look at the effect of mortgage servicing rights on tangible book

Another effect of rising interest rates is that which it will have on the book value of the servicing assets.

PHH provides an estimate of its tangible book value every quarter as part of its investor supplementary material.  Below is the estimate at the end of the first quarter as well as at year end 2011.

The company is trading at a reasonably significant discount to tangible book, which in itself says something about the unrealized value.  But if you look at the book value a bit closer, you realize that there is a lot of hidden value within the assets on the books.

Baked into shareholder equity is the value of the mortgage servicing assets that PHH carries on their balance sheet.  The servicing asset was carried at $1.3B at the end of the first quarter.  As I already explained, this asset is marked to market every quarter based on interest rates and the perceived threat of prepayment and default of the mortgages underlying the asset.   The asset represents the future value of servicing an unpaid principle balance of $149.6B in mortgages.  According to the latest earnings release, the average yearly fee that PHH receives for servicing those mortgages is 30 basis points, or about $450M of servicing fees per year.  A simple ratio comparing the current value of the servicing right ($1.3B) to the expected income of that portfolio ($450M) tells you that PHH is valuing their servicing portfolio at about 2.9x its yearly servicing income.

I’ve done a bit of research into the matter, and while right now mortgage servicing rights are selling at multiples of anywhere from 1x to 3x the yearly income, in the past servicing rights sold at 4x to even 6x yearly income.  Once servicing rights return to the mean, the book value of PHH will rise substantially.  At 4x servicing book value would rise byapproximately $450M to $34 per share.  At the high end of 6x book value would be $50 per share.

Another way that higher rates help servicing revenues

There is another rather obscure way that higher interest rates are going to improve earnings at PHH.  As part of the mortgages that PHH services PHH is charged with managing escrow accounts that are used to hold funds designated for taxes and inusurance.  PHH receives a benefit for these services by way of receiving the interest on these accounts.  The interest benefit is recorded under the Mortgage Servicing segment accounting item Mortgage Interest Income.

Beginning in 2008 mortgage interest income collapsed.  Since then it has fallen to a fraction of what it was pre-2008.

Taking a look at the PHH 10-K for 2008, when the collapse began, PHH said the following about the reduction in mortgage interest income.

Mortgage net finance income decreased by $86 million (89%) during 2008 compared to 2007, primarily due to lower interest income from escrow balances. This decrease was primarily due to lower short-term interest rates in 2008 compared to 2007 as escrow balances earn income based on one-month LIBOR.

As interest rates rise, the interest associated with these escrow accounts are going to rise substantially.  In 2007 one month LIBOR averaged around 5.3%.  In 2011 it averaged around 0.3%.  When (perhaps if) the economy finally begins to show some strength, LIBOR rates will rise.  To give a sense of this affect on PHH, in 2007 PHH was pulling in almost $3/share worth of revenue from these escrow accounts.  In 2011 that had dropped to $0.30 per share.

The Fannie put back

Since 2007 PHH has had a continual drag on its mortgage servicing income caused by the put-back of mortgages from Fannie Mae.  Over the past couple of years Fannie Mae has been reviewing their loan book for the periods from 2005-present and looking for any breaches in contractual terms, poor underwriting or defective documentation.  When it finds a mortgage that has one of these flaws, it puts it back on the lender.

PHH can fight these repurchase requests, but only up to a point.  Bank of America has been probably the most vigilant in fighting Fannie, and in return Fannie decided not to renew their contract to buy loans from BoA.  Fannie holds the trump card in this battle, and so PHH is going to be pretty much stuck with paying up for many of the repurchase requests put back to them.

Since 2008 PHH has been taking significant writedowns due to the repurchase requests including a big charge at the end of the most recent quarter.

The topic was discussed in depth on the first quarter conference call.  Messina had the following comments:

Based on our ongoing discussions with the GSEs, we believe that by the end of 2012, they may be substantially complete with their review of our seriously delinquent and defaulted related to origination years 2005 and prior, and by the end of 2013, they may be substantially complete with their review of our seriously delinquent and defaulted loans related to origination years 2008 and prior.

Almost 78% of our standing repurchase requests at quarter end are related to the 2005 through 2008 origination years. Given the results of the first quarter, our ongoing discussions with the GSEs, we believe it’s reasonably possible that future losses related to repurchase and indemnification requests may be in excess of our recorded foreclosure-related reserves.

Assuming that the elevated level of repurchase demands that we have recently experienced continues through the end of 2013, and the company’s success rate in defending against such requests declines, and that loss severities on repurchases remain at current levels, the estimated amount of possible losses in excess of our foreclosure-related reserves is $140 million.

The bottom line is that repurchase requests are likely to be a drag on earnings for the next two years.  The company is outlining $140 million in addittional charges, presumably broken up over the next 7 quarters.  This works out to about $20 million a quarter, which is fairly consistent with the level of charges over the past 3 years.

When core earnings matter

Whenever a company publishes core earnings you have to look good and hard at why they are doing so.  You never know what they might be trying to gloss over by eliminating some of the more unsavoury elements of the income statement.

PHH reports core earnings every quarter but they do so for a very good reason.  Core earnings are a far better representation of the company’s profitability than are GAAP earnings.

The problem with GAAP earnings is that they are obscured by changes in the mark to market value of the mortgage servicing right portfolio.  The accounting nature of the servicing right is such that PHH has to write up and down the mark to market value of each right with changes in interest rates.  A servicing right is in many ways no different than an interest only mortgage security.  The biggest risk is the prepayment of the security and with most mortgages this risk is closely tied to interest rates. When rates go down mortgage servicing rights have to be written down in value to reflect this increased risk of prepayment.

The fluctuations on the income statement caused by these mark to market moves are huge.  Up to $400M in some quarters, which for a company the size of PHH (there are only 55M shares outstanding after all), leads to massive moves up and down.  If you look at quarterly GAAP earnings over the past couple years they look like a scatter chart.  Below is a chart of earnings from the mortgage servicing segment that includes the effects of the mark to market adjustment.  With interest rates having fallen so precipitiously in the last few years, PHH has had to take pretty massive GAAP writedowns on their servicing portfolio.  Below are the before tax earnings per share from the mortgage servicing segment.  Much of the swing is the result of the mark to market adjustments to the servicing portfolio.

The reality of the mortgage servicing right is that as long as the company is replenishing the existing pool with more rights from new originations and recaptured refinances then its losing to payoffs, its all good.  As I already noted, PHH is doing that and then some.

The core earnings number that PHH reports is quite simply GAAP earning less this mark to market effect. And if you look at that core earnings over the last few years you can see that they have have been growing consistently and that the current stock price of $17 is not expensive relative to earnings.

So what did Bass see?

Let’s review the core elements of the thesis with PHH:

  1. The company is trading at about 65% of a tangible book value that perhaps undervalues the servicing assets by 25-50%
  2. Core earnings, which are a relevant metric of company profitability, are over $3 per share and growing
  3. The Fleet business itself has the potential to earn $1 per share in 2012 and provides a reasonably steady earnings stream even during recessions
  4. There is upside potential for PHH to take advantage of the current disconnects in the mortgage market, both in servicing and in originations
  5. The potential of a divestiture or spin-off of Fleet from Mortgage or vice versa

The downside is that the stock has moved well off its lows and that because of the sensitivity of the mortgage business to overall economic activity, the share price is volatile.  Bass bought his shares at around $10 and in full disclosure I bought most of my shares in the $12 range, though I have added recently with the break-out above $16.  While I can’t say for certain that PHH will eventually divest the Fleet business, I think that the story has enough elements that even if they don’t, there is plenty of room for upside appreciation in the share price.

Apr 24

2 Comments

Answering questions about Nationstar Mortgage: Part I – Getting to know them

A couple of weeks ago I parsed out the business of Nationstar , stepping through the prospectus the company put out in March, but I never got around to posting what I learned.  While I’m not yet ready to do a full write-up of the company, I want to share that here,  since I have had a fairly large position in the stock for about a month now, but written very little about it.

Often when I am first learning about a company I will ask myself some basic questions about the business and then look through the available materials for answers.  Below are the first 9 questions of what will be a two (or maybe three) part series on the business of Nationstar.

1. What do they do?

The following excerpts are all taken from Nationstar’s prospectus:

  • We have been the fastest  growing mortgage servicer since 2007 as measured by growth in  aggregate unpaid principal balance (“UPB”), having     grown 70.2% annually on a compounded basis.
  • As of  December 31, 2011, we serviced over  645,000 residential mortgage loans with an aggregate UPB of  $106.6 billion (including $7.8 billion of servicing     under contract), making us the largest high touch non-bank     servicer in the United States.
  • Our clients include national and regional banks, government organizations, securitization trusts, private investment funds and other owners of residential     mortgage loans and securities.
  • We service loans as the owner of mortgage servicing rights (“MSRs”), which we refer to as “primary servicing,” and we also service loans on behalf of other MSR or mortgage owners, which we refer to as “subservicing.”
  •  As of December 2011, a GSE ranked us in the top 5 out of over 1,000 approved servicers in foreclosure prevention workouts.
  •  In 2011, we were in the top tier of rankings for Federal Housing Administration-(“FHA”) and Housing and Urban Development-approved servicers, with a Tier 1 ranking (out of four possible tiers).
  • As of December 31, 2011, our delinquency and default rates on non-prime mortgages we service on behalf of third party investors in asset-backed securities (“ABS”) were each 40% lower than the peer group average.

2. How do they generate revenues and earn income?

Nationstar has two businesses. They originate mortgages, and they service mortgages.  The mortgages that they service are split between those that they originate, those that they purchase the servicing rights to, and those that the contract out subservicing to.

Nationstar refers to servicing that they own as primary servicing.  They refer to mortgage servicing rights that they don’t own as subservicing.  With primary servicing Nationstar takes a sliver of interest each month in return for performing servicing duties.  With secondary servicing, Nationstar receives a contracted fee in return for performing the servicing.

This is an excerpt from the prospectus describing the primary servicing business:

We have grown our primary servicing portfolio to $45.8 billion in UPB as of December 31, 2011 (excluding $7.8 billion of servicing under contract) from $12.7 billion in UPB as of December 31, 2007, representing a compound annual growth rate of 37.8%.

There has been noticeable growth in what could be thought of as a hybrid subservicing business. In this business model Nationstar enters into agreements like the ones they made with Newcastle in the fourth quarter of last year and first quarter of this year.  Speaking generally of this strategy in the prospectus:

We acquire MSRs on a standalone basis and have also developed an innovative model for investing on a capital light basis by co-investing with financial partners in “excess MSRs.”

Nationstar partnered with Newcastle on two mortgage servicing right portfolios. One of the portfolios has an unpaid principle balance of $63B, while the other has an unpaid principle balance of $9.9B.

These two investments are significant relevant to the existing subservicing portfolio.

We have grown our subservicing portfolio to $53.0 billion in UPB as of December 31, 2011 by completing 290 transfers with 26 counterparties since we entered the subservicing business in August 2008.

Below are excerpts from the prospectus describing the origination business.

  • We are one of only a few non-bank servicers with a fully integrated loan originations platform to complement and enhance our servicing business.
  • In 2011, we originated approximately $3.4 billion of loans, up from $2.8 billion in 2010.
  • We originate primarily conventional agency (GSE) and government-insured residential mortgage loans and, to mitigate risk, typically sell these loans within 30 days while retaining the associated servicing rights.
  • Our originations efforts are primarily focused on “re-origination,” which involves actively working with existing borrowers to refinance their mortgage loans. By re-originating loans for existing borrowers, we retain the servicing rights, thereby extending the longevity of the MSR

3. How big is Nationstar’s servicing business?

Nationstar ended 2011 with UPB of $99B.

The company has shown quite impressive growth in servicing assets over the last 3 years.  Unpaid balance owned more than doubled from the year end 2009 to 2010, and was up another 50% from year end 2010 to year end 2011.

4. What will be the upside of the recent servicing deals that Nationstar has done?

In 2011 Nationstar produced 24 cents of earnings, or about $20M, on an average unpaid balance servicing balance of $81B over the year.  However, 24 cents is not representative of the true earnings of the company.  That number  includes losses from non-recourse legacy assets that are pooled as variable interest entities on the balance sheet.  It also includes changes in valuation of servicing rights that is not generally considered a core expense to servicers.  I am going to spend my second installment talking about earnings, but for the purposes of answering this question, lets just go with the roughly correct estimate of 80 cents (or $70M) of core earnings for 2011.

They have since done two deals with Newcastle, one for $63B UPB and the other for $9.9B UPB.  They participated with a 35% interest for those deals.  So they’ve added another $25B to their UPB, not including that for the full loan amount of $73B they are doing the subservicing.  They have also added $18B in UPB at the end of 2011 in a deal with a Merrill Lynch affiliate.  So in total they have added an UPB of $43B in the last 4 months.

My work on Newcastle suggested that they would get $14.8M the first year on the 9.9B deal.  They should be able to get $110M on the full $73B in the first year.  So Nationstar is going to get $60M from the same deal.

Plus Nationstar is going to collect 6 bps on the full deal so that is another $43M.

I don’t know any of the details of th reverse mortgage deal with Merrill but presumably based on the size of the deal Nationstar should be able to generate in the area of $60M to $80M from it.

Total income from the three deals comes to somewhere between $160-$180M.

The company had revenue from servicing of $280M in 2011 so these deals are not inconsequential, being worth in the neighbourhood of a 60% increase in servicing revenues.

5. What revenue should we expect out of the KB Homes deal?

KB Homes and Nationstar recently reached an agreement whereby Nationstar would take on the role of preferred borrower.  Historically KB Homes had its own in-house originator:

KBA Mortgage originated residential consumer mortgage loans for 67% of our customers who obtained mortgage financing during the period the unconsolidated joint venture operated in 2011. In 2010, KBA Mortgage originated such loans for 82% of our customers who obtained mortgage financing during that year.

In Q1 KB Homes had new orders for 1,197 homes versus 1,302 homes the previous year.  Homes delivered in Q4 were 1,150.  So let’s say that KBH sells 1,200 homes per quarter.

The average selling price of the homes sold was $219,000 for Q1.  The price was $205,700 a year earlier.  On the CC they said “Going forward, we expect our average selling price to continue to increase and to exceed an average of 240,000 for the year.”

Assume $220,000 per home and 1,200 homes per quarter  that together and you have a total balance of $264M per quarter.

So let’s assume NSM captures 50% of origination and that has a 20% down payment on average.   That would add $419M of unpaid balance per year to NSM.  Which isn’t that significant to total UPB for a single year.

It is significant origination volumes though.  The company has the following origination statistics over the past 4 years.

So this is another $400M or 12% of originations.  And if they can capture a greater percentage it could be double that.

6. How many of the loans is Nationstar recapturing through re-origination?

One of the questions I am interested in answering both for my investment in Nationstar and for my investment in Newcastle is how good Nationstar is at keeping its servicing clients.  if a servicer can retain clients that are refinancing their mortgages it makes it far easier to sustain strong growth.  In the case of Newcastle, it will mean a longer stream of cash flow on the servicing rights they have bought in partnership with Nationstar.

We recaptured 35.4% of the loans we service that were refinanced or repaid by the borrower during 2011 and our goal for 2012 is to achieve a recapture rate of over 55%. Because the refinanced loans typically have lower interest rates or lower monthly payments, and, in general, subsequently refinance more slowly and default less frequently, these refinancings also typically improve the overall quality of our primary servicing portfolio.

Newcastle has made the assumption of a 35% recapture rate on the servicing packages it has invested in.  This compares favorably with Nationstar’s average recapture rate in 2011.

7. How many shares did they do in the offering?

They are offering 16.7M shares.  After the offering they will have about 87M shares outstanding.  At the current price of $14.50 the market cap is $1.26B

Before the offering Nationstar was wholely owned by Fortress Investment Group through one of their private equity funds.  Fortress remains the majority holder in the company with 70M shares, or about 80% of the shares outstanding.

8. How much of the offering did they spend on the Newcastle deal?

They spent $115M on the Newcastle deals.  They offered $233M worth of shares.  So they spent about half of it.

9. How much debt do they have?

Next…Part II

In the next installment I am going to look at the earnings power of Nationstar and how there are a number of GAAP accounting rules that are fogging up what would otherwise be considered to be an attractive valuation.

Mar 23

5 Comments

Pounding the table on Mortgage Servicing Rights

In my opinion mortgage servicing rights (MSR’s) are the best opportunity in the market right now. The potential is there for returns as much as 30-40% IRR for the companies involved. The companies involved are not trading at premiums that reflect this, and in some cases they are trading at discounts to the market (PHH) or with extremely attractive dividends (Newcastle).

I believe the opportunity is being ignored by a market for three reasons:

  1. The market lumps MSRs in as just another housing play, and housing is still 2-3 years away from recovering
  2. MSR’s are complicated and most market participants don’t want to take the time to understand them
  3. MSR’s have traditionally been a crappy business and over the past 5 years they have been a really crappy business

In order to consistently beat the market I have learned that I have to look for value in typically crappy businesses and be willing to learn complex and sometimes opaque things.  When I started investing I knew nothing about oil and gas.  A few years ago I knew nothing about potash.  A couple of years ago I knew nothing about the pulp industry.  A year ago I knew nothing about regional banking.  And two months ago I knew nothing about mortgage servicing rights.

I continue to go wherever my nose takes me.  And right now it has lead me straight to mortgage servicing rights.

What is a mortgage servicing right?

A mortgage servicing right (MSR) is a list of conditions and responsibilities that are completed in return for a payment.

I’m going to simplify the details, but essentially here is how it works.  When a mortgage company originates a loan, along with the note that binds the borrower to making payments, they get a right to a tiny sliver of interest that will be paid in return for making sure that the money gets from the borrower to the lender (along with some other responsibilities, most of which deal with what happens in the case of delinquency).  Usually this sliver of interest is around 25-50 basis points.  For example, for a loan for $200,000 will include the right to receive $250-$500 a year in return for making sure that the money gets collected from the borrower (among other responsibilities).

Its that sliver of interest that is paid in return for the collection and other servicing duties that is called the Mortgage Servicing Right.

As a mortgage originator you have two choices of what to do with the mortgage servicing right.  You can keep it, in which case you will collect the sliver of interest from now until the mortgage is either  paid off or defaults.  Or you can sell it to someone else in return for cash up front.

Traditionally it has been the preference of small originators to sell the MSR for cash up front. Origination is a cash heavy business and managing cash flow is key.  So while it might be nice to have a steady monthly income flowing in from the MSR, typically the more immediate concern is getting cash on the books right now.

When the originator sells the MSR up front they receive a servicing release premium (SRP).  This sounds like a complicated term but its not.  All a SRP is, is a lump sum payment that is paid in return for the stream of cash flows from the MSR that you are giving up.

If you are interested in an even more detailed explanation of a MSR, there was an excellent discussion paper put out by the FHFA that is accessible here.

The collapse of the SRP

Of course, to make it worth your while to sell the MSR you need to get a decent amount of cash up front for it.  Traditionally SRP’s have fetched in the neighborhood of 4x to 6x the underlying MSR yearly payment.  Going back to our theoretical mortgage above, if you were receiving $250 a year from the MSR, you might have expected to fetch $1000 (or maybe even $1500 if you are lucky) up front for that income stream.  To the buyer of the SRP it would become a good deal if the mortgage didn’t go into default or get repaid for more than 4 years.  After 4 years they get their money back, and every year after that they get incremental return.  For you as the cash strapped originator that needs to pay your employees and keep yourself liquid to make further originations, the $1000 up front helps you stay afloat and generate further originations.

A little over a month ago I wrote about a great discussion on the Lykken on Lending mortgage banking podcast.  Lykken had Austin Tilghman and David Stephens, CEO & CFO respectfully of United Capital Markets, on the program for an interview.  These fellows are industry experts in the mortgage servicing market.  The discussion begins about a half hour into the podcast.   Here is a particularly relevant comment from Stephens on the current state of the SRP market:

Prior to the meltdown the price paid for an SRP [servicing release premium] was generally 5x or more of the [mortgage] service fee.  That multiple dropped to 4x a few years ago and we are hearing that its dropped to 0x in some cases today.

This comment was followed up by Andy Schell, a co-host on the broadcast.  Schell said that he had recently done an analysis of SRP’s and MSR’s and, in his words, “I couldn’t believe the numbers are so low.”  He reiterated that the SRP’s are in some cases approaching zero.

As an originator, maybe it made sense to sell the MSR in return for a SRP that was 4x or 5x as much as you would get from the MSR in the first year.  But now you are looking at a SRP that is approaching 0 in some cases.  Even in the case of strong originations (good quality loans with low default rates) you aren’t going to get more than 2x the MSR’s yearly return, and are probably going to get somewhere between 1x and 2x.

It doesn’t make as much sense.

Take our example: would you give up an income stream of $250 a year if you were only going to get $350 or at best $500 for it?  If you held it instead you could return double that amount in only 4 years?

Who is selling MSRs at these bargain basement prices?

I think that there are two reasons that MSR’s are getting sold down to such low prices:

  1. The big banks are getting out of the business
  2. The little guys have difficulty getting into the business

The big banks

There are a couple of things going on with the big banks.  First of all,  there are regulatory capital changes about to take place that are going to effect how much capital a bank has to keep on its books to hold an MSR.  Under Basil III requirement of how much capital must be held for an MSE changes dramatically:

One of the biggest changes in capital definitions for U.S. banks involves mortgage servicing rights (MSR). Under Basel III, banks will be allowed to include only a maximum 10% of MSR in their capital measures. Any amount above that is deducted; and then, in combination with financial holdings and deferred tax assets (DTA), that can only be up to 15% of aggregate capital. In contrast, under current rules MSRs are included in capital up to 90% of fair value or book value, whichever is lower.

The second reason is simply the consolidation of the banking industry.  Again referring to David Stephens:

Its the aggregation of the aggregators.  In 2007 an originator might have 20 take outs for the loan they produced.  After the spectacular failures of 2008 and the combination of large companies into even larger ones there may have been 10 takeouts.  Recently we’ve seen BoA and Citi getting out of the market and you can count on one hand the number of people that account for 50% of the market.  And they have their own capacity limitations.  It just gets tougher and tougher to find a takeout and then those that are left are becoming more selective about what they buy.

A third reason that the banks want out of the business is the way that MSR’s are accounted for.  The GAAP accounting standards for MSR’s forces banks to account for them on a mark to market basis.  This means that a bank has to revise the value of the MSR every quarter.  The nature of the MSR is that it is going to be extremely sensitive to interest rates.  If interest rates go down then more borrowers are going to look to refinance their mortgage.  When a mortgage is refinanced the existing mortgage is paid off and the MSR that is tied to the existing mortgage stops paying interest.  So as interest rates go down the probability of prepayment increases, bringing the value of the existing MSR’s on the books down.

Banks have been writing down MSR’s for a number of years now as the Fed does everything in its power to lower interest rates.  They are sick of having to book quarterly writedowns on the MSR assets.  In addition, they have been booking further writedowns because so many mortgages have gone into default over the past 5 years.  If you add to those factors the stigma of being involved too heavily with the mortgage business, you can see why so many banks are either getting out of the business entirely (Bank of America) or scaling back on the business considerably (Citi and JP Morgan).

And there you have it.  A simple supply and demand imbalance where demand for SRP’s has been decimated by the housing collapse have caused a disconnect in servicing valuations.

The little guys

The reason that more originators aren’t keeping the MSR on their books is simple.

  1. They need the cash up front and they can’t wait a couple of years to recoup it
  2. They don’t have the cash to make the start-up investments to get into the business

We are in a period where originations are strong because of the strong refinancing activity that has been brought about by low interest rates.  This creates more pressure on the smaller originators to sell their MSR’s and realize the cash up front.  Meanwhile the drop in SRPs creates what is almost a snowball effect.  Getting less cash for the MSR’s you sell precipitates the need to sell more of your MSR’s in order to meet your cash needs.

It is also not an easy process to get approved as a servicer if you are an originator that has traditionally sold off your MSRs but you want to begin holding them on your books.  According to Tilghman:

Its not an easy process.  Some started the process a couple of years ago, had their approvals in place for this market opportunity.  It is daunting though… there is a huge backlog at Ginnie Mae and at the GSE’s… the people we talk to says this is still incredibly slow and its taking months for companies to get approvals.  We talked to one subservicer and he as 20 companies waiting for approvals. And frankly we are talking to 30 companies that 6 months ago weren’t interest in owning MSRs and are now looking to get approvals. 

Selling at the bottom

The irony is that all this selling is taking a place at a time when underwriting standards have never been better.

The quality of the servicing has never been better, low interest rates, tough underwriting, good appraisals, those are the positives.  A lot of potential for the servicing to gain value in the future when rates go up, but most importantly to have it in place when rates go up as a hedge against your production dropping maybe 80%.

As the servicer of a mortgage, there are 3 things you don’t want to see:

  1. The house get sold
  2. The loan get refinanced
  3. The borrower defaults on the loan

There isn’t much that can be done about number one.  But two and three are functions of the market and of loan quality, and they are notably strong right now.

Interest rates are probably as low as they are going to get.  This has led to the boom in housing refinancing that I mentioned earlier.  The refinancing boom has been a hit to servicers who have seen their MSR’s stop paying out when the house gets refinanced.  The upside of this is that the new loans being put on the books are unlikely to be refinanced for some time.  Rates are more likely to go up than down.  The opportunity is there to realize servicing revenues on new loans for a significant period time.

Banks were hit hard when subprime borrowers walked away from their homes.  Because loans weren’t getting paid, neither were the servicing fee.  Compounding the problem, servicing rights often have clauses whereby the servicer incurs additional responsibilities when the borrower goes into the foreclosure chain.

Now we have the opposite scenario.  Lending standards are so tight that only the most fool-proof borrowers are able to get loans.  The risk of default should be greatly reduced.  The result again is for the MSR to stay on the books, paying out cash, for longer.

The risk of regulation

The main risk to the thesis that I see is regulation.  There was a lot of concern that that the FHFA was going to change the servicing model for agency servicing model, either by reducing the fee that a servicer received or by changing the structure to a fixed fee that was independent on loan value.  The FHFA put out a talking paper to talk about the proposed changes back in September of last year.

In its talking paper, FHFA once again floats the idea of paying a set dollar amount for servicing loans, while keeping open to the idea of maintaining a minimum servicing fee model similar to the current structure, but one with a reserve account option. “The reserve account would be available to offset unexpectedly high servicing costs resulting from extraordinary deteriorations in industry conditions,” the talking paper notes.

There was a lot of resistance against the proposed ideas, particularly from the smaller servicers, who said that the reduced servicing premium would basically squeeze them out of the business. The FHFA recently stepped back from the proposals, but they have yet to put an end to the discussion completely.  Tilghman said the following about the matter:

We are continuing to be disturbed that the FHFA refuses to clearly state the servicing compensation issue that it is off the table.  The responses to their December proposal were 80% against any change or for a moderate change and yet they will not acknowledge that and continue to leave open the potential for that issue.  If they understood the markets and were serious about competition well frankly that is going on as we speak, they’d provide certainty and they would kill the issues that have no substantive support. 

How to invest

Finding companies to take advantage of the opportunity hasn’t been easy.  The two obvious one’s that I have owned since the start are Newcastle Financial (whichI have written about here) and PHH Corporation (which I have written about here).

There are also a couple of new IPO’s for companies looking to take advantage of the opportunity.  Both Nationstar Mortgage Holdings (NSM) and Home Loan Servicing Solutions (HLSS) have had IPO’s in the last month

Nationstar is a well established servicer that had been held by Fortress Investment Group (FIG). Nationstar looks to be in the same vein as PHH; an originator with a large servicing business. Nationstar also has a large subservicing business, which means that they take on the servicing responsibilities for servicing rights held by other companies in return for a fee.

Fortress Investment Group is also an interesting idea. FIG owns about 80% of Nationstar. That puts FIG’s investment in Nationstar at a value of about $900M. If you look at FIG, the stock is at $3.75 right now and fully diluted Class A and Class B shares are a little less than 500M. So just roughly here, FIG has a market capitalization of $1.875B, meaning that Nationstar alone is worth half the market cap. FIG has about $43B in total assets under management so in the grand scheme of things Nationstar shouldn’t be that big of a part of FIG.

It’s a situation that brings up your spidey senses. Is the value of Nationstar sneaking in under the radar of FIG shares? The problem is that I can’t be sure yet. I am looking at FIG right now and it’s a tough slog; its difficult to get the details about what they actually own and what the value actually is because of the nature of their corporation of funds structure. You can do a search through the 10-K and the name Nationstar isn’t mentioned once. But I’m going to keep investigating. FIG smells to me like one of those 5-bagger opportunities, but I just don’t understand the company enough yet to say for sure.

Finally, Home Loan Servicing Solutions is a spin-off of Ocwen Financial. Having read the prospectus, it appears that HLSS will be a income vehicle. They are going to buy up the MSR’s currently on Ocwen’s books in return for a portion of the servicing fee. Ocwen would still do the servicing on the mortgages (acting in the capacity of subservicer) and in return they would be paid a base fee plus an incentive fee that is structured to entice Ocwen to keep as many of the borrowers current as possible.

It’s a similar sort of deal to what Newcastle and Nationstar are doing. Its structured a bit different, with the main difference being because the loans involved are subprime and not agency. Servicing subprime loans has an extra aspect that doesn’t occur with agency loans. When you are dealing with subprime loans, the servicer is responsible for putting up money in the short term when the payments are late. This means that the servicer has to have access to a credit facility, (or some other sort of funding) that they can borrow from when they need to cover payments. And that funding costs you in interest.

Now admittedly my understanding on this isn’t completely clear yet, but from what I’ve read I don’t think the servicer is ultimately on the line for payments they put up. They are eventually reimbursed, either from the borrower when the payment is made, or from other payments in the pool if the mortgage goes into foreclosure and the payment will never be made. But they do have to put up cash in the interim.

So along with the servicing commitments, HLSS is taking over a number of credit facilities that had previously belonged to Ocwen. In this case they are commercial paper facilities, and they provide access to the short term credit that HLSS needs to have so it can cover any late payments to the pool. HLSS has to pay the interest on these facilities and that comes out of their profits

So that’s the downside of a subprime deal versus an agency deal. The upside of a subprime deal is that HLSS is taking a bigger piece for less up front than Newcastle did. HLSS is getting 32.5 bps in servicing fees and, based on the Dec 31st estimate of fair value, they will only pay 41 bps up front. In the first Newcastle deal, which was all agency, Newcastle paid 60bps and is getting 29 bps in servicing fees. In the second Newcastle deal, which was only 25% agency and 75% private label, Newcastle paid 42 bps. Its not clear to me whether Newcastle is going to have to manage the cash on the private label, but given the cheap price I wouldn’t be surprised.

I am looking for more ideas in the mortgage servicing sector. Please comment or write me (liverless@hotmail.ca) if you have any ideas.

 

In my opinion mortgage servicing rights (MSR’s) are the best opportunity in the market right now.  The potential is there to return as much as 30-40% IRR for the companies involved. The companies involved are not trading at premiums that reflect this, and in some cases they are trading at discounts to the market (PHH) or with extremely attractive dividends (Newcastle).

Mar 9

1 Comment

How much can Newcastle Investments make from its MSR deals?

When I started to write this post a couple of days ago, Newcastle had a single $44M investment in mortgage servicing rights.  On Tuesday the company announced a second MSR deal worth significantly more ($170M).  Rather than have to re-write my post from scratch, I am instead going to focus here on the original $44M MSR deal.  I will look at the larger, subsequent deal in another post.

Newcastle and MSR’s

I got interested in MSR’s after having become a regular listener to the Lykken on Lending mortgage lending broadcast.  I have listened to a number of episodes where the mortgage professionals on the program describe the disconnect in the mortgage servicing world right now and the opportunity it has created with mortgage servicing rights.  I invested in both PHH and Newcastle with the hope that that I can capitalize from this disconnect.

I have already written extensively about what a Mortgage Servicing Right is in this previous post.

The first MSR deal

In both their first and second forays into the mortgage servicing rights, Newcastle made a deal with Nationstar. Nationstar is a mortgage servicing company.  The specifics of the deal, as put forth by Newcastle in a recent presentation, are as follows:

  • The deal is for the mortgage servicing right of a pool of mortgages with a $9.9B unpaid balance
  • Nationstar will be the servicer of the loan portfolio and will invest alongside Newcastle, purchasing a 35% interest in the Excess MSR
  • Newcastle will not have any servicing duties, advance obligations or liabilities associated with the portfolio
  • Newcastle received a private letter ruling from the IRS that allows for treatment of an Excess MSR as a good REIT
  • Asset and the income that Newcastle generates from the deal will qualify as REIT income and not be subject to double taxation

The mortgage servicing right for the package of mortgages is, on average, 35 basis points per year of the unpaid balance.  Of that 35 basis points, 6 basis points will go directly to Nationstar to cover the cost of the servicing.  The other 29 basis points will be split between Newcastle and Nationstar 65/35.

It’s a good deal for both companies.  Nationstar participates in a much larger mortgage servicing package than they would have been able to purchase with their own cash.  They also participate in some of the upside of the MSR.  Newcastle gets a high return investment that does not require them to develop any mortgage servicing abilities in house.

The Upside

Newcastle says that they are expecting a baseline return from the investment of 20.9%.  That’s a great number, but what I equally interested in is whether there is upside to that number.

In particular, Newcastle is assuming the following:

  • 30% recapture rate.  This means that Newcastle thinks that Nationstar can recapture 30% of the mortgages that go up for refinancing.  If a mortgage goes up for refinancing and is captured by Nationstar, it remains in the pool.  As Newcastle has suggested rather optimistically on their conference calls a couple of times, if you could recapture 100% of the mortgages that go to refinancing, you would have a perpetual money making machine
  • 20% CPR.  CPR stands for Constant Prepayment Rate.  This term defines the number of mortgages that go up for prepayment short of their term.  There are two reasons a mortgage will be prepayed early.  Either the owner refinances or the owner defaults on the loan

Its worth pointing out that so far the 1 month CPR on the pool of mortgages Newcastle has purchased is 9.7%. The 3 month CPR is 7.3%.  However, you have to expect that the CPR is going to increase rather substantially over the next couple of years.  Why?  Because of the government’s HARP II program, which allows homeowners with upside down mortgages to refinance those mortgages.  Presumably this program is going to garner a lot of interest from folks with high loan to value amounts and you are going to see a refinancing spike.

Newcastle has actually modeled the effect of HARP II assuming a spike in prepayments to 30% for the duration of the program (until December 2013). That 20% number that I mentioned is actually a weighted average over the life of the MSR’s.  Newcastle provided the following chart to show how they are accounting for the spike in refinancings expected due to HARP II.

Newcastle also provided the following HARP II assumptions in the appendix:

Modeling the Baseline

I always find it useful to create my own models, so that I can understand the dynamics at play and see what the cash flow really is.  I started off by trying to match to the baseline assumptions  put together by Newcastle.  That scenario and the assumptions provided by Newcastle in the footnote are below:

My model came up with the following:

 Model Validation

How close is my model to the model that Newcastle is using?  The primary differences between my model and the one Newcastle is using are that my model is done yearly (versus a monthly model completed by Newcastle) and I did not try to break out the increase in CPR due to HARP II, instead just using the weighted average 20% throughout the entire period modeled.

I made a comparison of the cash flow estimated by my model for each of the scenarios that Newcastle illustrated on Slide 8 of their presentation.  My results along with the original Newcastle estimates are shown in the table below.  All amounts are in millions.

Close enough.

What does the model tell us?

The first point illustrated by the model is how much the cash flow changes from year to year.  This is not a fixed return investment.  The cash flow from an MSR is heavily weighted to the front end.  The Year 1 and Year 2 cash flow decrease substantially as you move forward.  While its always good to get paid out quickly, it also means that we have to be careful with respect to what we define as a sustainable dividend based on that cash flow.   I’m not entirely sure whether a REIT like Newcastle has any say in the matter (they may just have to distribute 90% of their cash flow irrespective of how that cash flow stream may decline in the future, I’m not sure, I haven’t done the work to understand the rules of the REIT structure in the US carefully).  But if Newcastle pays out the full $14M+ in the first year, the cash flow stream is going to decline substantially in subsequent years and Newcastle is going to have to find equivalent return investments to sustain that cash flow.

Investments that return 30%+ of capital in the first year don’t exactly grow on trees.

The second point is simply that the dividend hike should be significant.  At even $12M, that is a hike of 12 cents per share, or 20% higher than the current 60 cent dividend.

A closer look at the upside

There are two potential sources of upside on the MSR’s.

  1. If there are fewer homeowners that refinance than the baseline scenario estimates than the cash flow stream goes up
  2. If more of the refinancing homeowners are retained than the baseline scenario estimates than the cash flow stream goes up

Newcastle already looked at the sensitivity to cash flow in their presentation, but they only showed a cumulative cash flow comparison.  I am interested in seeing what the cash flow is in those first couple of years, because that is what is going to influence the dividend in the short term.

Let’s look at the first case.

To pick a rather significant deviation from the base case I am going to assume that the total CPR, so the total number of mortgages in the mortgage pool that refinance, comes in at 8% rather than the 20% weighted average assumed by Newcastle.

If this occurs I get the following cash flow profile.

Note that the ROR increases to about 40%.

What is interesting is that the scenario shows how, as one might expect, the cash flow in later periods is effected much more than the cash flow in the earlier periods.   This makes sense as I am really just adjusting how many of the original borrowers are lost in subsequent years.

So the conclusion that can be drawn is that changes in the CPR affect the later years cash flow, but they do not influence the current year’s cash flow significantly.  While my analysis was done at lower CPR’s, the same can be said if you looked at a much higher CPR.  Assuming that Newcastle is strictly bound to pay out a dividend on this years cash flow, that  dividend would be similar under a wide range of CPR scenarios.  Of course the sustainability of that dividend could fairly widely depending on the actual CPR that occurs.

In the second scenario I am going to assume that the recapture rate ends up being significantly higher than the 35% estimate that Newcastle assumes.  I’m going to assume 55%.

How valid is this? Funny you should ask.  As chance would have it Nationstar is doing an IPO at the moment.  As part of the IPO prospectus the company had the following to say about its recapture rate:

 A key determinant of the profitability of our primary servicing portfolio is the longevity of the servicing cash flows before a loan is repaid or liquidates. Our originations efforts are primarily focused on “re-origination,” which involves actively working with existing borrowers to refinance their mortgage loans. By re-originating loans for existing borrowers, we retain the servicing rights, thereby extending the longevity of the servicing cash flows, which we refer to as “recapture.” We recaptured 35.4% of the loans we service that were refinanced or repaid by the borrower during 2011 and our goal for 2012 is to achieve a recapture rate of over 55%. Because the refinanced loans typically have lower interest rates or lower monthly payments, and, in general, subsequently refinance more slowly and default less frequently, these refinancings also typically improve the overall quality of our primary servicing portfolio.

So its a valid target.  Here are the numbers at 55%:

The cash flow really isn’t that sensitive  to changes in the recapture rate.  The change in cumulative cash flow is about $10M over the 24 year period.  The change in IRR is between 2% and 3%.

What are the assets?

The last thing I looked at were the assets involved in the transaction. Newcastle provided, as a supplement to their mortgage servicing presentation, a summary of the assets that were acquired in the original Newstar deal.

The loan package has a decent but not great average FICO score of 687.  Typically, subprime has been considered to be below 640, whereas FICO scores above 700 are considered to be excellent lending opportunities.  This loan package is somewhere in the middle.

I was a little surprised that full documentation loans only accounted for 52% of the loans in the package.  I also am not sure what to make of the “% Delinquent 30 days but making some payment”.  46% seems to be an awfully big number, but maybe that is not uncommon? On the other hand, the one and three month CPR seems to be quite good, and the high loan to value, meaning that the loans are basically the same value as the house right now, will make it more difficult to refinance in the future.

The bottomline  is that I need to investigate the asset quality further, and to some extent, just watch closely how it plays out.  I’m still learning this whole mortgage business, and so I have more questions than answers right now.  I’ve raised a few questions here, and I will report back when I have some answers.

Bottomline

The bottomline is that Newcastle is getting a high return investment (IRR of 20% on the base case) that is going to pay out the majority of the cash in the first few years.  The investment also has some upside if the refinancing surge predicted to coincide with the HARP II program falls flat.   There is also upside if interest rates rise, making refinancing less attractive to borrowers.

The investment should allow Newcastle to make a substantial dividend increase (one that should increase even more with the announced second MSR deal that has been made).  In the recent past it appears that the stock price of the company has followed the dividend reasonably closely; when the hike to 60 cents was made the stock moved quickly into the $5-$6 range.  A hike to 72 cents is likely based on the first MSR deal alone.  I haven’t worked through the numbers on the second MSR deal but I imagine a substantial hike higher is in the cards.

In my opinion the company has proven themselves extremely shrewd by getting into the MSR business when they did.  I have pointed out in the past that much of the buzz in the mortgage brokerage business right now is around how MSR’s are trading ridiculously cheap and how can one get into the business.  Lykken on Lending, a radio broadcast I have mentioned in the past, has done 4 programs in a row dedicated to understanding the MSR industry.  Every one of those broadcasts (the last of which was so good that I plan to do a short synopsis of tomorrow) reiterated the point that the opportunity in MSR’s right now is unprecendented.  The quality of the loans has never been better, the refinancing surge over the past couple of years makes it likely that those loans will stay on the books for longer, and the prices for MSR’s are trading at extremely low multiples, a disconnect that has been caused by so many of the big banks getting out of the busines (Bank of America, which was previously the largest mortgage servicer, being the most commonly sited example).

Newcastle may not be a 10 bagger, but with a 10% payout right now and a high payout coming, I think it will prove to be a very profitable investment for me.

Feb 20

PHH, Newcastle Investments, and mortgage servicing rights

In my week 29 letter I began to talk the opportunity I was seeing in mortgage origination and servicing.

While an uptick in new home building may still be some time away, mortgage origination should benefit over the next year from the refinancing associated with HARP II and from less competition due to the exodus of originators from the ranks brought on by the dismal market conditions.

Mortgage servicing, meanwhile, has been hurt by falling interest rates (remember that as a servicer you get paid as long as the loan is being paid, so refinancing can hurt your business if you can’t reoriginate the refinancing), by uncertainty in the regulatory environment, and by the regulatory capital concerns of banks.  But valuations on mortgage servicing rights are low and with loan quality standards currently high and with interest rates unlikely to go lower, new servicing rights should be a good investment.

I want to delve a little deeper into the  mortgage servicing rights (MSR) part of the business this week.

What is a mortgage servicing right?

A mortgage servicing right is a somewhat complicated little piece of paper of conditions, responsibilities and payments.  For the basic definition I will defer to investopedia:

An MSR is a contractual agreement where the right, or rights, to service an existing mortgage are sold by the original lender to another party who specializes in the various functions of servicing mortgages. Common rights included are the right to collect mortgage payments monthly, set aside taxes and insurance premiums in escrow, and forward interest and principle to the mortgage lender.

In return for these responsibilities, the servicer is entitled to a small piece of the recurring interest payments made by the borrower, usually around 25 basis points (0.25%).

A more investment oriented definition of an MSR comes from kamakuraco, who published an interesting paper on estimating the risk of an MSR, and who define the mortgage servicing right in the terms of a security:

One can approach the valuation of mortgage servicing rights as the valuation of a fixed income (broadly defined) security subject to default risk and prepayment risk.

There are two risks implicit to an MSR; either the mortgage is paid off, or the borrower defaults.  In both cases the payments to the holder of the MSR are no more.

The collapse of the MSR

There was a great discussion two weeks ago on the Lykken on Lending mortgage banking podcast.  Lykken had on Austin Tilghman and David Stephens, CEO & CFO respectfully, both with United Capital Markets.  These fellows are industry experts in the mortgage servicing market.  The discussion begins about a half hour into the podcast.

To take an aside for a second, I have to say that listening to the discussion brought about one of those exciting moments that make investing fun.  I was biking home from work, had my ipod on listening to the broadcast.  The roundtable discussion with the UCM execs came on and the second question, put forth by Alice Alvey, asked why are company’s beginning to retain their own servicing rights when traditionally most originators just sold those rights off for the cash up front?  Austin Tilghman (I think.  He didn’t identify himself) replied with the following:

Prior to the meltdown the price paid for an SRP [servicing release premium] was generally 5x or more of the [mortgage] service fee.  That multiple dropped to 4x a few years ago and we are hearing that its dropped to 0x in some cases today.

Andy Schell, Lykken’s partner, then went on to say that he had recently done an analysis of SRP’s and MSR’s and, in his words, “I couldn’t believe the numbers are so low.”  He reiterated that the SRP’s are in some cases approaching zero.

Wow.

When I hear that kind of disconnect I immediately think opportunity.  And then I think how can I capitalize on that opportunity.

Defining SRP’s  (there are too many acronyms in this industry)

But first of all, another definition. When a company originates a mortgage, along with that mortgage comes the right to service the mortgage.  That’s the mortgage servicing right.

As an originator you have the option to keep the MSR on your book and service the mortgage through its life in return for the 25 basis point (or thereabouts) premium.

Alternatively you can capitalize the MSR up front by selling it.  In return for selling the MSR you get cash.  The cash you get is referred to as the servicing release premium (SRP).

The acronyms MSR and SRP get used all the time in discussions without definition so its good up front to understand what these two concepts are.

Why SRP’s have collapsed

As David Stephens alluded to above, the value of an SRP has collapsed of late.  A few reasons why this is the case:

  1. There is concern about a regulatory change to make MSR’s a fee for service as opposed to a tacked on percentage of the loan interest (this is preventing new participants from getting into the market but it appears that it is not going to happen)
  2. There is a more nebulous concern about the regulatory environment in Washington in general and what the “unknown unknowns” of future legislation might be
  3. You only get the cash flow stream of an MSR over time whereas you get cash right now by selling the SRP and has of course been a liquidity problem in the industry since 2007
  4. Its a long term commitment to get into servicing.  You can’t just jump in overnight without  getting approvals as a servicer from the regulators and developing the infrastructure to do the servicing
  5. The market for buying and selling servicing is thin at the best of times and especially thin now (because of all the folks getting out of the business)
  6. And that is because… no bank wants to have anything to do with the mortgage industry

The opportunity

The basic investment premise here was well put on the broadcast by Joe Farr, who asked the following question:

With rates at 3.5% or 4% and quality never being better, why is it that that servicing values are close to zero in some cases?

To which Austin replied:

Its the aggregation of the aggregators.  In 2007 an originator might have 20 take outs for the loan they produced.  After the spectacular failures of 2008 and the combination of large companies into even larger ones there may have been 10 takeouts.  Recently we’ve seen BoA and Citi getting out of the market and you can count on one hand the number of people that account for 50% of the market.  And they have their own capacity limitations.  It just gets tougher and tougher to find a takeout and then those that are left are becoming more selective about what they buy.

And there you have it.  A simple supply and demand imbalance where demand for SRP’s has been decimated by the housing collapse have caused a disconnect in servicing valuations.

Who is going to benefit?

So I own a bunch of PHH now.  They are big time servicer and the MSR’s on their books are valued at about 2.7x.  Clearly from a book value perspective PHH has some upside  to that servicing valuation if interest rates begin to rise and they can value that servicing at something closer to 5x.   Servicing values have had to take major writedowns over the past 3 years as defaults have increased and more importantly, as interest rates have fallen, raising the possibility of refinancing.  I found that really interesting table of the writedowns taken by some of the major banks over the past 3 years in the Kamakura report that I mentioned earlier:

That is nearly $30B in writedowns over the past 3 years for the 8 major banks.  Wow.

Remember that the writedowns are being taken in part because the current MSRs are expected to refinance at a faster rate.   PHH has, in the past, managed to retain most of their servicing rights that get refinanced by being the originator on those refinancings.  So its perhaps a little misleading to value those servicing rights at 2.7x.

To get an idea of impact of a revaluation of those MSRs on teh PHH books to a 5x servicing fee multiple:

Ok, so that’s a pretty big impact on the accounting end.

As I already mentioned, PHH has proven that they can produce more MSR’s then they lose even during times where a large amount of the MSR’s are refinancing.  The new MSR’s replacing the old MSR’s are of a much higher quality.  By high quality I mean that these MSR’s are connected to mortgages that are being financed at extremely low rates (and therefore where the chance of early repayment is low) and within a market where credit quality is extremely restrictive (meaning the chance of default is low).  This doesn’t seem to be reflected anywhere in the books.

So PHH has some upside as MSR come back into favor.  That’s good.  But there are two problems with using PHH as the vehicle to play the MSR disconnect:

  1. They don’t have the cash right now to take advantage of the disconnect in price and buy up MSR’s on the cheap.  What I really need is a company with lots of cash and a savvy management team that recognizes that there is an opportunity in the market and you have to jump in.
  2. They are an originator, so when the MSR’s begin to recover their value its going to be on the heels of rising interest rates which will hurt the PHH refinancing business.  In other words, PHH will never have all cylinders firing at once.

What I really need is a company with lots of cash and a savvy management team that recognizes that there is an opportunity in the market and you have to jump in.

Enter Newcastle Investment

I have owned Newcastle investment in the past.  In fact, I owned them as recently as last summer, but I sold them in one of my “sell everything because who the hell knows what is happening in Europe” moments. At the time, I owned Newcastle because they, much like Gramercy Capital, had a large disconnect between the NAV of their managed CDO portfolio and the share price.

I’m not going to go through that CDO valuation right now because I want to talk about the MSR business that Newcastle is branching out into.  I probably will in the next few weeks, just to get a better idea of the value proposition here.  In the mean time the best places to find a comprehensive analysis of Newcastle’s CDO business are on the Gator Capital blog and the analysis by PlanMaestro on variantperceptions here and here.

The essence of these analyses is that if you add up the CDO business and cash at corporate, subtract out the preferred’s and other debts, you get a company with an NAV of about $5-$5.50 per share.  So your net asset value is something pretty close to the current share price.

Here’s the crux then.  Of that $5-$5.50 per share net asset value, about $205M (or a little less that $2 per share) was cash at the end of the third quarter.  The potential upside exists if Newcastle can turn that cash into a cash producing asset that has a value greater than the face value for which it is purchased.

NCT gets into the MSR business

On its third quarter conference call Newcastle made the announcement of the change in direction.  The company was getting into the mortgage servicing business.  The company said it would be making major investments into MSR’s over the next few quarters (one of which they have already since announced).  The reasons that they decided to make the switch in strategic direction was:

  1. They felt the MSR business offered the best risk adjusted returns out there
  2. The existing core business of CDO creation was basically dead

Interestingly, Derek Pilecki, who writes the Gator Capital blog, dumped NCT when the news was announced.  While I am of the mind that getting into the servicing business right now is a savvy move, I recommend reading his final analysis of (and reasons for selling) Newcastle here for a contrary point of view.

Newcastle believes that there are significant returns that could be realized from MSR investments.  From the SeekingAlpha Q3 conference call transcript:

We are still very optimistic that the returns on an unleveraged basis will be kind of mid-teens even mid-20, so very compelling in any environment but in particular with all the certainly in the world if we get something that is a big deal for us.

Newcastle went on to describe something that the fellows from UCM pointed out on the Lykken broadcast; how banks are basically dumping their servicing business on the cheap.  Again from the  transcript of the 3rd quarter conference call:

Banks in the U.S. are very focused on regulatory capital, on regulatory risk, on just the perception of headline risk, [and this has] made them more likely to be source [of MSR supply]

To get into the business Newcastle is partnering with an originator and servicer (Nationstar) and Nationstar will be performing the actual servicing.  I think that Newcastle can be thought of as a silent partner that is putting up the cash.   Again, the problem with MSR’s is that you have to have the cash to put up, and while most originators are running a tight cash flow, Newcastle has ample cash to take advantage of the investment.

Newcastle has also received approval from the IRS that MSR’s can receive the same favorable taxtreatment as other REIT assets.

That they had to clarify approval demonstrates the “first mover” status that Newcastle holds.  Newcastle is early on in the game, being one of the first REIT’s to take advantage of this opportunity.  As one of the analysts put it on the Q&A, Newcastle is “leading the way”.

What’s the upside?

The upside to Newcastle is a big increase in the free cash flow that the REIT can generate.  Before getting into the MSR business, Newcastle was generating around $80M of free cash flow (FCF).  At a 20% return on the $200M of unrestricted cash (using the assumption that the company puts all its free cash into the MSR business), you are looking at FCF of another $40M.  Given the current market capitalization of $600M that puts NCT at a 5x free cash flow multiple. The company paid about a $60M common share dividend in the third quarter, so clearly another dividend hike would be likely.

The company announced their first MSR deal with Nationstar in a December 13th news release.  In it the company reiterated the return metrics:

  “I am very pleased to announce our first investment in Excess Mortgage Servicing Rights. This is a watershed investment for us in this sector. We expect this investment will generate approximately a 20% unleveraged return and total cash flows of over 2 times our investment. I am excited to be investing alongside Nationstar, a premier mortgage servicer and originator. Residential mortgage servicing is a large market and we currently see a strong pipeline of similar investments at very attractive returns.”

The deal was for $44M.

In my opinion, apart from the basic cash flow expected there is unrealized value in these MSR assets.  For one, because Newcastle is partnering with an originator in Nationstar, there is a good chance that a decent percentage of the MSR’s that the company is investing in will be refinanced through Nationstar.  Newcastle was quick to point out that refinanced mortgages remain in the portfolio and continue to cash flow to Newcastle.  The refinanced value is not included in the value of the MSR.  Newcastle estimated the following refinancing rate on the Q3 call (from the SeekingAlpha transcript again):

So our experience at Nationstar on our agency pools that we service which is a material amount of loans is that we’ve had recapture rates in the kind of low-to-mid 30% (inaudible) over the past six months, and that’s obviously significant, we think and we’re hopeful that with a little bit of focus, we could increase that to 40%, 50% at the extreme end of it, not that I’m predicting this, because it wouldn’t be prudent, but at the extreme end of it, you can capture a 100% of the loans that prepays, then you would have really the perpetual money machine right, as the IO would stick around, the extra service will stick around forever, but even at recapture rates at 20%, 30%, 40%, 50%. It has a terrific impact in terms of the volatility of the MSR and that’s (inaudible) investment profile looks like.

Second, as I already pointed out, recent and new MSR’s are being collected from mortgages that have been financed at historically low rates and in an era of extremely strict lending criteria.  There is little chance that these mortgages are going to default and little chance that they will be refinanced any time soon.  In other words these are high quality assets.

Its kind of a weird perfect storm here; you have a situation where the asset quality has never been better at a time when nobody wants the asset.  While I suppose its not clear exactly what the quality of the MSR’s Newcastle is investing in are, if one presupposes a little faith in the management team (which has after all had the foresight to see an opportunity that many others have not yet seen), you might draw the conclusion that Newcastle is getting into high quality assets at a fraction of their underlying value.

Anyways if you add it all up I think NCT is on to something here.  I bought a position in the stock and plan to add to incrementally as the stock moves up and my thesis is proven right.

« Older Entries
Follow

Get every new post delivered to your Inbox.

Join 34 other followers