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?
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.
I’m just starting to explore NSM, and I appreciate your bringing the company to my attention. I found one potential red flag in their bond yields. If their prospects are so bright why are they forced to pay a 9.625% coupon on their $275M senior notes offer that closes tomorrow? That yield is deep into junk territory and prices in a significant default risk. When I see yields like that I tend to shy away from the equity. I see that BAC, WFC, C, KBW, CS all initiated analyst coverage of NSM at buy/outperform and that makes sense if they are the institutions buying the privately placed bonds available only to qualified institutional investors, and also if they underwrote the NSM public share offering. The institutions want me to buy to line their pockets and I’m going to have to dig to find the bearish case argument for NSM. The bearish case is out there, the 9.625% is strong evidence of high risk, now it’s up to me to discover exactly what those downside risks are and decide if I want to buy equity despite those risks.
I already pointed out the biggest one I found…