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Mar 9

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.

If there are fewer homeowners that refinance than the baseline scenario estimates than the cash flow stream goes up
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.

Mar 7

Buying when you don’t want to

The hardest posts for me to write are the one’s where I have to write that I bought a bunch of stocks on a day where the market was down a lot. Its tough because I am worried I will be proven wrong. Its extra tough because I am notoriously early and so I have been wrong many times before.

The market really tanked today and nothing tanked harder than the junior gold and oil stocks. I had lightened up significantly on the gold stocks last week; I exited Canaco Resource, OceanaGold and a significant portion of Aurizon Mine. Unfortunately I used some of the proceeds to buy Pan Orient Energy, which took it on the chin today.

Nevertheless there is some truth to the old adage that the best time to buy stocks is often when you don’t want to. Today I didn’t want to buy anything. I even had half a mind to sell it all and stand away.

But having thought it through, I am having trouble making sense of the idea that this is the start of something big. I have become a convert to the idea that the LTRO has taken out much of the systemic risk potential. The prices of periphery bonds suggest as much; even after today’s shellacking Italian and Spanish bonds sit near their lows. The TED spread and Swap spread hardly moved at all and currently sits at 40 and 27 respectively, well of their highs of 60 and 55. The bank stocks, while hit hard, did not lead the way down in the way they did in August.

It just doesn’t feel to me like it did in August, or in November for that matter, when the fear was palpable. Yes, we are worried about Greece and what is going to happen. But the evidence does not suggest that the big players are that worried. If they were we would see more signals of the stress in the bond market.

Which makes sense. By this point everyone knows about Greece. Everyone who had money at risk with Greece should have been able to figure out how to take it off the table. That yields aren’t rising in the periphery suggests that the real problem, that a Greece default would cause a domino effect, is not in the cards.

What I bought

I’ve had good luck buying Aurizon under $5 in the past and so I did so again today, restoring my full position in the stock. I also bought more Golden Minerals. Golden Minerals is a stock I had been tempted to sell when it got to $10, but I got a little greedy and decided against it, only to watch the stock fall back to $6.80 today, which is not too far away from my original purchase price. The stock is reasonable at these levels; the company has $2 cash on hand per share and a 6Moz gold equivalent resource.

Interestingly, Rick Rule was on BNN yesterday and he had some positive comments on Golden Minerals in this clip (I’m not really sure how to embed video from BNN).

Since last Wednesday its been a swift fall for many gold stocks. My bet here is that the latecomers have been fleshed out and that with stocks like Aurizon and Golden Minerals approaching their 52 week lows once again, we are close if not at the bottom.

I also added to Pan Orient. This will be the last time that I add until I see the stock begin to rise again. For the time being I will sit tight with what I own.

Mar 6

My Thoughts on Equal Energy Activism

The pot was certainly being stirred up around Equal Energy last week. One shareholder, Nawar Alsaardi, singlehandedly engaged the investor base of the company, gathering together a group of shareholders to push for a major change in direction fo the company. According to a recent post on Yahoo! message board, Nawar has signed up a significant number of shares:

In total, we have the support of 29 private shareholders, plus two institutional shareholders, those parties collectively present just under 3 million shares, or 8.5% of the outstanding shares.

I’m pretty sure that is enough to petition for a board member to represent the group.

The proposal

Nawar has posted his proposal for the steps he would like to see Equal take as a slide show on slideshare:

Equal energy

View more PowerPoint from Nawar Alsaadi

The proposal is basically to sell the Canadian assets (Lochend and the Viking) and reduce debt, turning the company into a US based trust that focuses on the Hunton, pays out a dividend, and has the Mississippian as a kicker for growth.

I think its a plausible strategy and I support the move in principle; to pressure management to better promote the company and look for ways to reduce debt. To raise my own personal grievance: if Equal did lose 4,000 acres of prospective Mississippian land to lease expiries (as it seems like they have), that is just not acceptable. 4,000 acres is $10M lost, or around 30 cents a share.

However I am having trouble supporting the specific actions being advocated. I don’t want Equal to sell all their Canadian oil assets. It seems counterproductive to me to sell what amounts to be many acres of undeveloped land with only about 1,100boe/d of mostly oil production when Nawar (and I believe management) feel these assets would only fetch around $80M in their current state.

The problem is that they would be selling mostly undeveloped land. The company is in the business of buying land and de-risking it; that is the basic value-added premise of an oil and gas company. Under Nawar’s proposal Equal would be selling land that is for the most part not de-risked.

If I were management

I approached my decision to support or not support the proposal as if I were management. And if I were management I would put my focus on the oily areas right now. I would attempt to “add value” by proving up locations and increasing production. In particular, the Viking has low drilling and completion costs and you could likely gain a couple PUD locations for every well you pop into the ground. Grow that production and then (maybe) look at selling it once you have reached 2,000+boe/d. At that point you would be able to fetch a much higher price for the land and production, perhaps enough to bring down the debt entirely.

Worried about NGLs and natural gas

My other concern is that the proposal would essentially turn Equal into a natural gas and NGL company. I work on the natural gas side of the business and I am not optimistic about the short and medium term future of natural gas prices.

One consideration that rarely gets mentioned when discussing the relative merits of oil versus natural gas is that natural gas and the slightly heaver NGL’s are quite a bit easier to get out of the ground than oil is. They exist, for the most part, as a gas in the reservoir. There is plenty of energy within the fluid that does the work to lift them out. Its just an inherently easier process then trying to get the heavier hydrocarbons out.

This is why its always going to be easier to drill and find natural gas than it is to drill and find oil. It is also why I am far less skeptical about the long term performance of gas shales and tight gas reservoirs where horizontal multifracs have been used to produce the formation, than I am of the oil shales.

The second point, which is more immediate, is that everybody and their dog is drilling the snot out of any play that is liquids rich right now. One has to wonder whether there will be a propane glut or a butane glut coming down the pipe (sorry, bad pun).

The third point is that rising NGL production is as much about separation techniques as it is about finding the resource. There are plenty of NGL’s that are being passed through the pipeline with the methane simply because it hasn’t been economic to knock them out. With methane at $2.50 and some of the heavier hydrocarbons significantly higher, its getting economic to do a more thorough job of separation.

There was an excellent First Energy piece on Deep Cut Gas Plants a couple of weeks ago. FE said the following:

Deep cut gas plants are field gas processing plants that have a special processing capacity to extract more liquids. On average, deep cut plants in Alberta extract 3.7x more liquids for a given volume of gas than ‘shallow cut’ plants. This is because of their special processing units and because these plants are located in the areas in the basin where gas is more liquids-rich

First Energy listed the following deep cut plants either under construction or under consideration in Alberta:

Now to be fair, all this is Alberta centric information. I don’t have information on the supply/demand dynamics of NGL’s in Oklahoma. Nevertheless, its a North American market and I suspect the price differentials of a given hydrocarbon can only be stretched so far from market to market.

The bottomline

My basic point is more qualitative than it is quantitative. I don’t like the direction the NGL market is going, and if I were managing a company like Equal that had oil assets and ng/NGL assets, I would be reluctant to part with the oil assets. Getting back to the “if I were management” theme, if I were in charge of Equal the first thing I would do is commission a study of the NGL market in Oklahoma, make sure I understood the dynamics of that market, and from there decide if I should be selling off some or all of the Hunton assets before NGL prices begin to slide.

But the oily assets. I just find that a tough proposition to support. I wish the others the best and if it works out I will eat my crow pie. But I have to stick with what I see that lies ahead here and I just wouldn’t want to create a natural gas, NGL company right now.

Mar 4

Week 35: Continuing to Move away from Gold: Out of OceanaGold, Canaco Resources, into Pan Orient Energy, Newcastle Investments

Portfolio Performance

Portfolio Composition:

Trades:

Sold the Gold Sell-off

This was the week where I got fed-up with gold stocks doing nothing and began to sell them en masse. I completely eliminated my position in OceanaGold, and in Canaco Resources. I dramatically reduced my position in Aurizon Mines, and somewhat reduced my position in Lydian International.

I do have to wonder whether the $90 drop in the price of gold was orchestrated. Interestingly, mention of such a possibility came from a rather unlikely place on Thursday, as I was sent the following excerpt from Dennis Gartman, who was quoting from a friend “near the centre of the events”:

Whether or not the plunge was orchestrated, I had to start removing dead weight from my portfolio and this provided a good excuse. As the price of gold fell and OceanaGold and Canaco Resources began to crack, I asked myself what am I still doing in these stocks? I couldn’t come up with a good answer so I sold.

In the case of OceanaGold and to a lessor extent in the case of Aurizon Mines, the catalyst that could move the share price higher remains somewhat in the distance. I am not seeing anything like the takeover frenzy that has been predicted by some, and so these stocks become waiting games; lined with the hope that either the market catches onto the name and bids it up, or that some sort of (lucky) catalyst emerges. I have not had very much luck investing on such hopes in the past.

In the case of Canaco Resources, I re-read my analysis of Magambazi. That analysis got a lot of attention during the early part of the week as it was posted on Stockhouse (by some guy who seems to be taking credit for doing the work – sigh). While I still question whether there is an error in my analysis, I do think I raised enough questions about the deposit, and enough uncertainty about the eventual resource estimate to be somewhat wary of the NI 43-101 that will be out shortly. I decided to step aside until that resource comes out, or the share price falls back to the point where I feel like the downside is priced in.

Adding to Newcastle, Pan Orient, Leader Energy Services

The other part of my reasoning for selling some of the gold names is I see better alternatives elsewhere. With oil at $100 per bbl I would rather be involved in oil companies with near term catalysts (Pan Orient) and service companies poised to take advantage of the move to drilling for more oil (Leader).

In the case of Newcastle, I listened to the fourth quarter conference call and reviewed the companies slides on mortgage servicing rights. This appears to be an opportunity that has been overlooked by the market. Newcastle is investing money into MSR’s with potential rates of return exceding 20%. If they inded capture these sort of returns, I expect a significant dividend increase and a move in the share price to around $10. I will write-up some of my findings with Newcastle later this week.