Jumping into another Mortgage Servicer

On Tuesday the financials broke out and that breat out has continued through the week. A quick look at the KRE shows that the trend has been up since the end of December and that the move this week took them decisively above the July-August levels just before the break down occurred.

Along with the plain vanilla regionals, a number of the mortgage specialists that I have leaned towards are showing strength. Newcastle Investments continues to move higher. PHH Corp is flirting with $15. I’m pleased that these stocks are responding so well; as they continue to do so I will continue to add to my positions.

As it is I have bought the breakout over the last few days by buying a new bank and a new mortgage originator/servicer. On Wednesday I initiated a position in Shore Bancshares.The bank is trading at about 1/2 of book value and looks to be slowly turning around its admittedly elevated delinquent loan book.  And just yesterday I initiated a new position in a recent IPO called Nationstar Mortgage Holdings.

Nationstar Mortgage Holdings

I have been stepping through the Prospectus on Nationstar. It is available here .

I’m pretty excited about the company. I have been looking for another pure play on the mortgage servicing rights thesis. Newcastle is not a bad way to go, and PHH Corp looks good, but Nationstar looks like another cheap alternative to get leverage to an early turn in the US housing market and to the pricing disconnect of mortgage servicing rights.It appears to be trading at about 17x last year’s earnings (ex the MSR adjustments), and I expect that with the growing servicing portfolio (they have grown at a 70% rate for the last 3 years), and with deals like the one they are doing with Newcastle, that those earnings are going to go up substantially.

The company has been privately owned by Fortress Investment Group (another company I want to look at), which is a private equity firm. Fortress is the same firm that is involved with Newcastle.  Apparently someone at Fortress is seeing the same thing I see in the mortgage servicing right business.

Fortress did the IPO of Nationstar at $14 but interestingly will remain a large majority shareholder at 81%. I have no doubt that Fortress made the IPO because of the opportunity they see to capitalize on the mortgage servicing industry.

Newcastle Investments

And since we are speaking about mortgage servicing, yesterday Newcastle also made the predictable announcement that they would raise their dividend from 15 cents to 20 cents for the first quarter.  I find it kinda fascinating how the stock jumps on these dividends increases.  They also left the door open for further increases and further investment into MSR’s.

Kenneth M. Riis, Newcastle’s CEO commented, “I am pleased to announce our second common dividend increase since it was reinstated in the second quarter of 2011. Our ability to increase our dividend is a result of deploying capital at attractive returns and improving our overall operating results. As we complete new investments, we expect our operating results and cash flows to improve further.”

I don’t know if there will be another share offering but I don’t really see any other way for Newcastle to “complete new investments”. Any offering could mean a short term down draft in the shares. But with an investment opportunity like mortgage servicing provides right now, I would argue that raising capital is a good thing over the long run.

Remember that the MSR’s that Newcastle has invested in thus far are expected to return 20% IRR based on the expectation that 20% of those loans will refinance or default every year. That’s the base case. Yet we are in a period where refinancing and defaults could begin to fall substantially, which would drive up the IRR of the servicing. In my opinion the potential for an IRR far beyond the base case is significant.

The current Opportunity in Mortgage Servicing Rights

I’m going to say it again.  MSR’s are a HUGE market disconnect right now.  The disconnect is being brought about by a combination of regulatory changes that have made MSR’s unnattractive from the Tier I capital perspective and from a legacy business of bad loans that many of the banks are stuck with.  The result is that most of the biggest players traditionally in the MSR industry are stepping back and some (Bank of America for example) are getting out completely.  This has left the industry undercapitalized, which has resulted in a collapse of pricing of mortgage servicing rights.  The rights have traditionally traded for 4-6x their coupon; today they are trading at less than 2x.  Newcastle has done its recent deals at around 2x.  And this mispricing has happened at a time when the industry fundamentals for servicing have never been better.  Loan quality is high because standards have become very tight, and with rates so low the potential for significant refinancings has dwindled.

No one else seems to be noticing this. I feel like a loan wolf.  Nevertheless I remain convinced that this is a great opportunity.

In the mean time I will continue to take advantage of the silence and keep adding to Newcastle, to PHH, and now to Nationstar.