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.