Thoughts about my investment in New Residential’s and a look at their MSR Pools
New Residential has performed poorly over the last few weeks. Pretty much since the release of their 3rd quarter results, the stock has tumbled. As I mentioned in my previous post, I think that this move in unwarranted, and I have added to my position significantly at and below $6.
I suspect that the market is lumping in New Residential with all the other mREITs. They are being compared on standard book value metrics and New Residential trades at a significant premium to its book value (20%) while most other REITs trade at a discount to it.
I wouldn’t be surprised if there are algorithms picking up on the book value discrepancy and automatically shorting the higher price to book companies against longs on the lower ones. It would seem like a natural trade – short what is expensive, go long what is cheap, and look for opportunities where the dividend of the long exceeds that of the short.
How will the New Residential / Nationstar Relationship Evolve?
While I am not very concerned about the book value, I am somewhat nervous about what Nationstar evolves into. My biggest concern with New Residential is that Fortress spins apart Nationstar in such a way that there is competition to New Residential and/or New Residential gets left out of that structure for future deals.
I’ve listened to both the Nationstar and New Residential Q3 conference calls a few times. It’s clear that there is something in the works. Nationstar recognizes that holding MSR’s in their corporate tax structure is inefficient. They said they are evaluating alternatives. New Residential (We Edens) said that they are hoping to have some interesting news announced in this regard shortly, with the implication that New Residential will be part of that news.
I feel like New Residential is a bet on Fortress management right now. It’s a bet on their ability to create value for all their constituent companies. They’ve done this in the past. I’ve made a ton of money on Newcastle, on Nationstar, and some on Fortress themselves. So I hold onto New Residential with the expectation that they will be able to creatively add value once again.
Looking at the MSR’s
The drop in the stock and the significant increase in my position has led me to revisit the excess mortgage servicing portfolio that New Residential holds. I looked at a few things.
First, I looked at the cash flows generated by the portfolio and put a multiple on the book value New Residential carries it at. This cash flow multiple is how I have typically seen MSR’s talked about. To calculate the multiple I took the current unpaid principle balance, subtracted the current delinquency rate and calculated what the annual servicing fee to New Residential would be. For 3 of the pools the servicing fee is paid irrespective of delinquencies, so I ignored the delinquency rate in those cases.
In order to come up with an estimate that is consistent with typical MSR valuations, I had to subtract out a value associated with the recapture agreements that New Residential has. Nationstar has been able to recapture anywhere from 20% to 55% of the refinanced loans, and those recaptures continue to generate servicing revenue to New Residential. I thought it was reasonably conservative to hold the recapture agreements at the cost New Residential has them on the balance sheet at, with the understanding that they are likely worth more (maybe much more) because Nationstar has been exceeding the baseline recapture rates in most cases.
Below is my estimate:
I think that a 2.9x multiple is fair (PHH has their MSRs capitalized at 3.4x if you include delinquencies in the same way I did), but there is plenty of additional upside for that multiple as rates rise. I am reminded of the Lykken on Lending broadcast from last year, of which I wrote the following:
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.
I also did some work to determine if New Residentials pools are performing up to expectations. Below are the second and third quarter numbers for total prepayments (CPR), delinquencies (CDR) and recapture rates. Keep in mind that a number of the pools were added in the first quarter or third quarter and so the recapture rates have yet to have the full impact of Nationstar servicing. In these cases it is more indicative to look at the quarter to quarter trend. The inputs columns are the baseline New Residential uses to value the MSR’s.
I really don’t see anything in the numbers or in the trends to be concerned about. On the oldest pools Nationstar is far-exceeding the baseline recapture rates. The prepayment speeds are coming down as the portfolios mature. And we have yet to see the real impact of higher interest rates; for many of these pools the weighted average coupon is in the 4-5.5% range so refinancing remains attractive.
With all of that said
As I said, my position in New Residential has become substantial, almost 20% of my portfolio (from about 4% before the post Q3 earnings drop). My cost basis is $5.97. I plan to hold through the dividend and hopefully through some sort of announcement that restructures their relationship with Nationstar. I don’t plan to hold in this size for much longer for the simple reason that it’s a bit stressful. I don’t like having so many eggs in one basket. But at the moment I believe the risk/reward is favorable so we will see if I am right.