New Position in Cherry Hill Mortgage (CHMI)
I was going to put this in my update post but its gotten a little long so I thought I’d pop it out on its own. I’ve talked a lot about New Residential and how much I like mortgage servicing rights as a play on a stronger economy and on rising rates. Well a few weeks ago a fellow who follows the blog wrote me about Cherry Hill Mortgage, a company that, like New Residential, is a REIT that holds mortgage servicing rights. It took me a few weeks to find the time to look at the company and another week afterthat for it to really sink in just how cheap it was comparatively. But once it did I felt compelled to take a position.
It was a bit of unfortunate timing; I had to sell about 25% of my (albeit unreasonably large) position in New Residential to fund the purchase. I wasn’t comfortable going on margin to fund the purchase. So I took that New Residential position down from 20% to 15%. Of course the day after I sold New Res at $6 the stock popped to $6.30. Maybe my sacrifice to the gods of trading was appreciated.
Nevertheless, in the long run I hope to be well compensated for my position in Cherry Hill. Cherry Hill is being spun out of the mortgage originator Freedom Mortgage. Soon after the IPO, the company purchased two pools of mortgage servicing rights from Freedom Mortgage. I ran some quick numbers and it looks like the company paid a reasonable price for these assets. In the table below the assets have been valued at cost:
NOTE: It was pointed out to me that in my original table I had ignored the servicing fee that Freedom Mortgage takes. I have updated the table to reflect this fee.
The company paid for the portfolios using the proceeds from the IPO, which was done at $20 per share. Thus the company’s current stock price, at $17.50, is at a discount.
Equally worth noting is that, unlike a similar valuation that I did for New Residential a couple of weeks ago, I have made no allowance here for the recapture agreement that Cherry Hill has with Freedom Mortgage. Cherry Hill participates in a standard recapture agreement whereby as long as Freedom refinances the loan, the servicing right stays on Cherry Hill’s books. According to Cherry Hill’s prospectus, “for the period from January 1, 2011 to June 30, 2013, Freedom Mortgage’s monthly weighted average recapture rate with respect to FHA and VA mortgage loans in its servicing portfolio was 75%“. So clearly there is significant value associated with the recapture agreement.
Finally, Cherry Hill has a flow agreement with Freedom to co-invest with between 65% to 85% of Freedom’s ongoing originations and to co-invest between 40% and 85% on any bulk agreements that Freedom makes. Freedom originated over $13 billion in loans in 2012 and $9.5 billion in H1 2013. If Cherry Hill takes a 50% stake in say 75% of Freedom’s originations, and if we assume something of the order of $15 billion of originations going forward, that would be about $5.5 billion of UPB per year. This would be more than enough to cover prepayments on the existing business, making the business sustainable.
Of course the important detail that has yet to be decided in all of this is the price of that flow business. And admittedly, the management structure does not perhaps bode for the best deal for Cherry Hill. Below is the ownership structure of both Freedom Mortgage and Cherry Hill.
Freedom Mortgage is owned 100% by Stanley Middleman, whereas Middleman only owns 13.3% of Cherry Hill. So it remains to be seen whether Middleman is willing to make deals that are constructive for both parties.
Nevertheless the stock looks worthwhile to me. The loans do not look terribly different than what New Residential is involved in. They are similar LTV’s and FICO’s. One positive attribute of the Cherry Hill portfolios is that the weighted average interest rate is 3.1%, which is quite low and bodes well for a long-lived asset with minimal refinancing potential. One aspect of the pools that I still have to research is that the vast majority of them are Veteran Affairs or VA loans, and I’m not sure whether there are specific characteristics of these loans that need to be considered. If anyone has comments about this I’d be open to hearing them.
Reminiscences of a Stockblogger 
The judge might rule on Rescap settlement on Wednesday. For MBI
Brian Iannarone, MAI CCIM
Northeast Regional Director
Wells Fargo RETECHS
190 River Road 3rd Floor
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Thanks – will be watching closely.
I really appreciate your blog and learn a great deal about the various businesses you evaluate.
With respect to Mortgage Servicing companies I would like to know if you can suggest a good primer for someone who’s new to understanding and valuing such companies?
Would you suggest jumping right into the annual reports of such companies or is there any intro material you’d suggest?
Thanks for this wonderful blog.
I wrote an article on Seeking Alpha a year and a half ago that talked about them in general. I would look at that article and the links I made to other material. There are also a couple of Lykken on Lending broadcasts that I have linked to on the blog that talk about MSRs in detail. If you do a search for those they will help you as well. Also go through the 10K/prospectus of NRZ and CHMI – there is lots of info there. Sorry but I don’t have any great primers beyond that; I cobbled together what I know by reading bits and pieces here and there.
In reading through their registration statement, it appears that the manager will be taking a 1.5% fee per year (1.5% on stockholders equity). Unlike NRZ, there does not appear to be an incentive fee based on performance (FFO, EPS, etc).
I would have to argue that a fee structure like this encourages the owner to take steps to increase book value over the long term (at least more so relative to an incentive fee focused on FFO). Coupled with the fact that the owner of Freedom Mortgage Company has a 13.3% stake in CHMI, I think there is a strong incentive to do deals between CHMI and Freedom Mortgage that generate long-term growth of book value for CHMI.
Typically companies will not foreclose on VA loans because its just bad press. Nobody wants to see a wounded soldier be kicked while they are down. Because of this these loans can lie dormant whilst sucking all the life and money out of their portfolios.
I didn’t know that. Thanks for the info.
If I remember correctly, Cherry Hill Mortgage not only invests in MSR but also Agency MBS. I don’t remember what the allocation percentage is but a large percentage is Agency MBS. I don’t know what the cost of capital for the company is but investing in Agency MBS’s are value destroying for the pretty much any company (unless you can borrow at an insanely low interest rate and you have a lot of debt) and I remember doing the calculations and figuring that the company is currently trading at about a 10-15 multiple on forward earnings. What are your thoughts on the asset allocation of Cherry Hill Mortgage? Obviously buying MSRs are value creating but selling equity which has a expected return of 8-10% and turning around and putting a large portion of your capital in Agency MBS which returns something like 4% will destroy the value that investing in MSR has created. What are your thoughts?
Not sure what you mean. They will lever their MBS portfolio 8:1 using repo like everyone else in that space. How is that value destroying?
I’m wrong. Sorry about that.
“According to Cherry Hill’s prospectus, “for the period from January 1, 2011 to June 30, 2013, Freedom Mortgage’s monthly weighted average recapture rate with respect to FHA and VA mortgage loans in its servicing portfolio was 75%“. So clearly there is significant value associated with the recapture agreement.”
I would be cautious about extending this assumption to the MSR tied to Pool 2 (the VA ARMs). The underlying loans were issued by a 3rd party (I believe Mortgage Investors Corp. of Florida based on data from Ginnie Mae). In addition, the loans are ARMs, while the majority of Freedom Mortgage issuance has been fixed rate 30yr mortgages.