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Posts from the ‘Newcastle Investments (NCT)’ Category

Week 107: Back to Commodities

It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that – Warren Buffett

yoyperformance

I’m adding a simple year by year and quarterly performance table to the start of every portfolio update.  I’ve had the on-line portfolio going for over 2 years now, and I find that the chart is less informative the longer the time horizon gets. The quote, which I have mentioned before, is more of a goal than a statement.  Buffett says it’s possible, let’s try to prove him right.

I’ve already written about most of the new stocks that I added in the last month (Ainsworth Lumber, Tronox, Novus Energy,smaller positions in Lightstream Resources and Penn West, and lastly Niko Resources. In this post I will focus on some of the stocks I sold (including most of my large position in YRC Worldwide), and add some thoughts on oil and Canadian oil juniors.

I’m getting this update out a day late so all of the numbers are are of Friday July 19th.

Portfolio Performance

week-107-Performance

Portfolio Composition

week-107The last four weeks of trades are available here.

Read more

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Week 73: A short update

Portfolio Performance

(Note that I am now posting my portfolio composition and list of trades at the end of the post)

Update

This is going to be a short update.  I wanted to get this out over the weekend but did not have time.  The performance snap-shot is as of last Friday, so it does not include the rather impressive moves that occurred yesterday in Impac Mortgage (IMH), Nam Tai (NTE) and Equal Energy (EQU).  To just briefly touch on what happened yesterday, a fund named Iszo Capital announced a 6.2% position in Impac Mortgage after the market closed yesterday.  As for Nam Tai, the company released a video on their website that suggested sales could hit $300 billion per month in the future.  This would be quite the jump from current levels, as the company did $380 million in sales in the third quarter. Read more

Pounding the table on Mortgage Servicing Rights

In my opinion mortgage servicing rights (MSR’s) are the best opportunity in the market right now. The potential is there for returns as much as 30-40% IRR for the companies involved. The companies involved are not trading at premiums that reflect this, and in some cases they are trading at discounts to the market (PHH) or with extremely attractive dividends (Newcastle).

I believe the opportunity is being ignored by a market for three reasons:

  1. The market lumps MSRs in as just another housing play, and housing is still 2-3 years away from recovering
  2. MSR’s are complicated and most market participants don’t want to take the time to understand them
  3. MSR’s have traditionally been a crappy business and over the past 5 years they have been a really crappy business

In order to consistently beat the market I have learned that I have to look for value in typically crappy businesses and be willing to learn complex and sometimes opaque things.  When I started investing I knew nothing about oil and gas.  A few years ago I knew nothing about potash.  A couple of years ago I knew nothing about the pulp industry.  A year ago I knew nothing about regional banking.  And two months ago I knew nothing about mortgage servicing rights.

I continue to go wherever my nose takes me.  And right now it has lead me straight to mortgage servicing rights.

What is a mortgage servicing right?

A mortgage servicing right (MSR) is a list of conditions and responsibilities that are completed in return for a payment.

I’m going to simplify the details, but essentially here is how it works.  When a mortgage company originates a loan, along with the note that binds the borrower to making payments, they get a right to a tiny sliver of interest that will be paid in return for making sure that the money gets from the borrower to the lender (along with some other responsibilities, most of which deal with what happens in the case of delinquency).  Usually this sliver of interest is around 25-50 basis points.  For example, for a loan for $200,000 will include the right to receive $250-$500 a year in return for making sure that the money gets collected from the borrower (among other responsibilities).

Its that sliver of interest that is paid in return for the collection and other servicing duties that is called the Mortgage Servicing Right.

As a mortgage originator you have two choices of what to do with the mortgage servicing right.  You can keep it, in which case you will collect the sliver of interest from now until the mortgage is either  paid off or defaults.  Or you can sell it to someone else in return for cash up front.

Traditionally it has been the preference of small originators to sell the MSR for cash up front. Origination is a cash heavy business and managing cash flow is key.  So while it might be nice to have a steady monthly income flowing in from the MSR, typically the more immediate concern is getting cash on the books right now.

When the originator sells the MSR up front they receive a servicing release premium (SRP).  This sounds like a complicated term but its not.  All a SRP is, is a lump sum payment that is paid in return for the stream of cash flows from the MSR that you are giving up.

If you are interested in an even more detailed explanation of a MSR, there was an excellent discussion paper put out by the FHFA that is accessible here.

The collapse of the SRP

Of course, to make it worth your while to sell the MSR you need to get a decent amount of cash up front for it.  Traditionally SRP’s have fetched in the neighborhood of 4x to 6x the underlying MSR yearly payment.  Going back to our theoretical mortgage above, if you were receiving $250 a year from the MSR, you might have expected to fetch $1000 (or maybe even $1500 if you are lucky) up front for that income stream.  To the buyer of the SRP it would become a good deal if the mortgage didn’t go into default or get repaid for more than 4 years.  After 4 years they get their money back, and every year after that they get incremental return.  For you as the cash strapped originator that needs to pay your employees and keep yourself liquid to make further originations, the $1000 up front helps you stay afloat and generate further originations.

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.

This comment was followed up by Andy Schell, a co-host on the broadcast.  Schell said that he had recently done an analysis of SRP’s and MSR’s and, in his words, “I couldn’t believe the numbers are so low.”  He reiterated that the SRP’s are in some cases approaching zero.

As an originator, maybe it made sense to sell the MSR in return for a SRP that was 4x or 5x as much as you would get from the MSR in the first year.  But now you are looking at a SRP that is approaching 0 in some cases.  Even in the case of strong originations (good quality loans with low default rates) you aren’t going to get more than 2x the MSR’s yearly return, and are probably going to get somewhere between 1x and 2x.

It doesn’t make as much sense.

Take our example: would you give up an income stream of $250 a year if you were only going to get $350 or at best $500 for it?  If you held it instead you could return double that amount in only 4 years?

Who is selling MSRs at these bargain basement prices?

I think that there are two reasons that MSR’s are getting sold down to such low prices:

  1. The big banks are getting out of the business
  2. The little guys have difficulty getting into the business

The big banks

There are a couple of things going on with the big banks.  First of all,  there are regulatory capital changes about to take place that are going to effect how much capital a bank has to keep on its books to hold an MSR.  Under Basil III requirement of how much capital must be held for an MSE changes dramatically:

One of the biggest changes in capital definitions for U.S. banks involves mortgage servicing rights (MSR). Under Basel III, banks will be allowed to include only a maximum 10% of MSR in their capital measures. Any amount above that is deducted; and then, in combination with financial holdings and deferred tax assets (DTA), that can only be up to 15% of aggregate capital. In contrast, under current rules MSRs are included in capital up to 90% of fair value or book value, whichever is lower.

The second reason is simply the consolidation of the banking industry.  Again referring to David Stephens:

Its the aggregation of the aggregators.  In 2007 an originator might have 20 take outs for the loan they produced.  After the spectacular failures of 2008 and the combination of large companies into even larger ones there may have been 10 takeouts.  Recently we’ve seen BoA and Citi getting out of the market and you can count on one hand the number of people that account for 50% of the market.  And they have their own capacity limitations.  It just gets tougher and tougher to find a takeout and then those that are left are becoming more selective about what they buy.

A third reason that the banks want out of the business is the way that MSR’s are accounted for.  The GAAP accounting standards for MSR’s forces banks to account for them on a mark to market basis.  This means that a bank has to revise the value of the MSR every quarter.  The nature of the MSR is that it is going to be extremely sensitive to interest rates.  If interest rates go down then more borrowers are going to look to refinance their mortgage.  When a mortgage is refinanced the existing mortgage is paid off and the MSR that is tied to the existing mortgage stops paying interest.  So as interest rates go down the probability of prepayment increases, bringing the value of the existing MSR’s on the books down.

Banks have been writing down MSR’s for a number of years now as the Fed does everything in its power to lower interest rates.  They are sick of having to book quarterly writedowns on the MSR assets.  In addition, they have been booking further writedowns because so many mortgages have gone into default over the past 5 years.  If you add to those factors the stigma of being involved too heavily with the mortgage business, you can see why so many banks are either getting out of the business entirely (Bank of America) or scaling back on the business considerably (Citi and JP Morgan).

And there you have it.  A simple supply and demand imbalance where demand for SRP’s has been decimated by the housing collapse have caused a disconnect in servicing valuations.

The little guys

The reason that more originators aren’t keeping the MSR on their books is simple.

  1. They need the cash up front and they can’t wait a couple of years to recoup it
  2. They don’t have the cash to make the start-up investments to get into the business

We are in a period where originations are strong because of the strong refinancing activity that has been brought about by low interest rates.  This creates more pressure on the smaller originators to sell their MSR’s and realize the cash up front.  Meanwhile the drop in SRPs creates what is almost a snowball effect.  Getting less cash for the MSR’s you sell precipitates the need to sell more of your MSR’s in order to meet your cash needs.

It is also not an easy process to get approved as a servicer if you are an originator that has traditionally sold off your MSRs but you want to begin holding them on your books.  According to Tilghman:

Its not an easy process.  Some started the process a couple of years ago, had their approvals in place for this market opportunity.  It is daunting though… there is a huge backlog at Ginnie Mae and at the GSE’s… the people we talk to says this is still incredibly slow and its taking months for companies to get approvals.  We talked to one subservicer and he as 20 companies waiting for approvals. And frankly we are talking to 30 companies that 6 months ago weren’t interest in owning MSRs and are now looking to get approvals. 

Selling at the bottom

The irony is that all this selling is taking a place at a time when underwriting standards have never been better.

The quality of the servicing has never been better, low interest rates, tough underwriting, good appraisals, those are the positives.  A lot of potential for the servicing to gain value in the future when rates go up, but most importantly to have it in place when rates go up as a hedge against your production dropping maybe 80%.

As the servicer of a mortgage, there are 3 things you don’t want to see:

  1. The house get sold
  2. The loan get refinanced
  3. The borrower defaults on the loan

There isn’t much that can be done about number one.  But two and three are functions of the market and of loan quality, and they are notably strong right now.

Interest rates are probably as low as they are going to get.  This has led to the boom in housing refinancing that I mentioned earlier.  The refinancing boom has been a hit to servicers who have seen their MSR’s stop paying out when the house gets refinanced.  The upside of this is that the new loans being put on the books are unlikely to be refinanced for some time.  Rates are more likely to go up than down.  The opportunity is there to realize servicing revenues on new loans for a significant period time.

Banks were hit hard when subprime borrowers walked away from their homes.  Because loans weren’t getting paid, neither were the servicing fee.  Compounding the problem, servicing rights often have clauses whereby the servicer incurs additional responsibilities when the borrower goes into the foreclosure chain.

Now we have the opposite scenario.  Lending standards are so tight that only the most fool-proof borrowers are able to get loans.  The risk of default should be greatly reduced.  The result again is for the MSR to stay on the books, paying out cash, for longer.

The risk of regulation

The main risk to the thesis that I see is regulation.  There was a lot of concern that that the FHFA was going to change the servicing model for agency servicing model, either by reducing the fee that a servicer received or by changing the structure to a fixed fee that was independent on loan value.  The FHFA put out a talking paper to talk about the proposed changes back in September of last year.

In its talking paper, FHFA once again floats the idea of paying a set dollar amount for servicing loans, while keeping open to the idea of maintaining a minimum servicing fee model similar to the current structure, but one with a reserve account option. “The reserve account would be available to offset unexpectedly high servicing costs resulting from extraordinary deteriorations in industry conditions,” the talking paper notes.

There was a lot of resistance against the proposed ideas, particularly from the smaller servicers, who said that the reduced servicing premium would basically squeeze them out of the business. The FHFA recently stepped back from the proposals, but they have yet to put an end to the discussion completely.  Tilghman said the following about the matter:

We are continuing to be disturbed that the FHFA refuses to clearly state the servicing compensation issue that it is off the table.  The responses to their December proposal were 80% against any change or for a moderate change and yet they will not acknowledge that and continue to leave open the potential for that issue.  If they understood the markets and were serious about competition well frankly that is going on as we speak, they’d provide certainty and they would kill the issues that have no substantive support. 

How to invest

Finding companies to take advantage of the opportunity hasn’t been easy.  The two obvious one’s that I have owned since the start are Newcastle Financial (whichI have written about here) and PHH Corporation (which I have written about here).

There are also a couple of new IPO’s for companies looking to take advantage of the opportunity.  Both Nationstar Mortgage Holdings (NSM) and Home Loan Servicing Solutions (HLSS) have had IPO’s in the last month

Nationstar is a well established servicer that had been held by Fortress Investment Group (FIG). Nationstar looks to be in the same vein as PHH; an originator with a large servicing business. Nationstar also has a large subservicing business, which means that they take on the servicing responsibilities for servicing rights held by other companies in return for a fee.

Fortress Investment Group is also an interesting idea. FIG owns about 80% of Nationstar. That puts FIG’s investment in Nationstar at a value of about $900M. If you look at FIG, the stock is at $3.75 right now and fully diluted Class A and Class B shares are a little less than 500M. So just roughly here, FIG has a market capitalization of $1.875B, meaning that Nationstar alone is worth half the market cap. FIG has about $43B in total assets under management so in the grand scheme of things Nationstar shouldn’t be that big of a part of FIG.

It’s a situation that brings up your spidey senses. Is the value of Nationstar sneaking in under the radar of FIG shares? The problem is that I can’t be sure yet. I am looking at FIG right now and it’s a tough slog; its difficult to get the details about what they actually own and what the value actually is because of the nature of their corporation of funds structure. You can do a search through the 10-K and the name Nationstar isn’t mentioned once. But I’m going to keep investigating. FIG smells to me like one of those 5-bagger opportunities, but I just don’t understand the company enough yet to say for sure.

Finally, Home Loan Servicing Solutions is a spin-off of Ocwen Financial. Having read the prospectus, it appears that HLSS will be a income vehicle. They are going to buy up the MSR’s currently on Ocwen’s books in return for a portion of the servicing fee. Ocwen would still do the servicing on the mortgages (acting in the capacity of subservicer) and in return they would be paid a base fee plus an incentive fee that is structured to entice Ocwen to keep as many of the borrowers current as possible.

It’s a similar sort of deal to what Newcastle and Nationstar are doing. Its structured a bit different, with the main difference being because the loans involved are subprime and not agency. Servicing subprime loans has an extra aspect that doesn’t occur with agency loans. When you are dealing with subprime loans, the servicer is responsible for putting up money in the short term when the payments are late. This means that the servicer has to have access to a credit facility, (or some other sort of funding) that they can borrow from when they need to cover payments. And that funding costs you in interest.

Now admittedly my understanding on this isn’t completely clear yet, but from what I’ve read I don’t think the servicer is ultimately on the line for payments they put up. They are eventually reimbursed, either from the borrower when the payment is made, or from other payments in the pool if the mortgage goes into foreclosure and the payment will never be made. But they do have to put up cash in the interim.

So along with the servicing commitments, HLSS is taking over a number of credit facilities that had previously belonged to Ocwen. In this case they are commercial paper facilities, and they provide access to the short term credit that HLSS needs to have so it can cover any late payments to the pool. HLSS has to pay the interest on these facilities and that comes out of their profits

So that’s the downside of a subprime deal versus an agency deal. The upside of a subprime deal is that HLSS is taking a bigger piece for less up front than Newcastle did. HLSS is getting 32.5 bps in servicing fees and, based on the Dec 31st estimate of fair value, they will only pay 41 bps up front. In the first Newcastle deal, which was all agency, Newcastle paid 60bps and is getting 29 bps in servicing fees. In the second Newcastle deal, which was only 25% agency and 75% private label, Newcastle paid 42 bps. Its not clear to me whether Newcastle is going to have to manage the cash on the private label, but given the cheap price I wouldn’t be surprised.

I am looking for more ideas in the mortgage servicing sector. Please comment or write me (liverless@hotmail.ca) if you have any ideas.

 

In my opinion mortgage servicing rights (MSR’s) are the best opportunity in the market right now.  The potential is there to return as much as 30-40% IRR for the companies involved. The companies involved are not trading at premiums that reflect this, and in some cases they are trading at discounts to the market (PHH) or with extremely attractive dividends (Newcastle).

Newcastle Investment Dividend Ratio

I’m not much of a dividend investor.  Maybe when I get older I will covet the security of knowing I’m getting 3-4% back from the company every year.  But not now.  Right now that 3-4% doesn’t seem like a lot to me.  I’m certainly not going to be changing my lifestyle any time soon on a 3-4% return.  I’m trying to build capital and to do that I need to have a few home runs, not a bunch of sacrifice flies.  I certainly don’t put in as much work as I do so I can make a couple more points than the rest of the mutal fund / index fund / ETF crowd.  Dividends don’t normally excite me.

When a dividend gets to 10%. like Newcastle’s is, then it starts to pique my interest.  But just barely.   10% still doesn’t cut it.  If the best I can do is 10%, than I still think I should quit and hire an adviser.  That’s my thinking anyways.

So when I bought Newcastle, it was with the understanding that the dividend was a nice feature, but not the reason to buy the company.  The reason to buy the company is because I think the price of the shares are going to go up.

Of course…. Newcastle is a REIT the main driver of the share price is the dividend.  So the two are intertwined and therefore I need to understand the relationship.

As the dividend goes, so goes the stock price

I went back through the last 6 years of Newcastle’s 10-K’s and came up with the following graph that helps illustrate how closely the dividend and stock price are linked.

Here is what I found:

The stock price is clearly linked to the dividend.  In most cases (as you would expect) the stock price leads the dividend.

The stock price usually falls within a broad range of 8x to 12x the dividend.  It depends if times are good or if times are bad.  Right now, times are improving, so perhaps a move to 12x is not out of the question.

I haven’t run the numbers in full on the second MSR deal that Newcastle announced.  Until I do I won’t be able to say what I think the dividend will eventually be.  But to ballpark, based on a sustainable cash flow of 10 cents per share from the first dividend, and given that the second deal is roughly 4x larger than the first, I think that a sustainable dividend in the 80-90 cent range is not unreasonable.  Tacking on a 10x to 12x multiple and we get a share price range of somewhere between $8 and $11.

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.

  1. If there are fewer homeowners that refinance than the baseline scenario estimates than the cash flow stream goes up
  2. 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.

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.

Week 33: Admitting the possibility of a bull market

Portfolio Performance

Portfolio Composition:

Weekly Trades:

Posts this week:

Can’t Stay Away: Arcan Resources and Second Wave Petroleum

PHH, Newcastle Investments and Mortgage Servicing Rights

Shadow Inventory and how an improving US Economy begets an Improving Housing Market begets and Improving US economy begets….

PHH and one way to bet on a turn in the US economy

Jumping on the Bandwagon

As I wrote about earlier, I am coming around to the view that the US economy will perform reasonably well over the next few quarters.

Now let us not confuse the short term with the long term here.  I don’t for a moment think that the longer term issues in the US have been solved.  The situations in Europe, in Japan, and in the US are very similar.  There are massive storm clouds on the horizon, and those coming storms are causing the winds to pick up and the boats of the economy to waver in the seas.  But the storms themselves have not yet reached us, and so while we may have bouts of turbulence brought on by rising winds, or even, as in the case of Europe in November, sudden gusts that threaten to capsize the rigs, the actual storms are still a little ways off in the distance, far enough  that we can pretend at times that they are not there.

Now appears to be one of those times.

The LTRO seeming to have stabilized the banks of Europe in the near term.

TED Spread:

Italian 10 year:

Spanish 5 Year:

The economies of the European periphery, while entering what has to be an inevitable and deep recesion, are still far enough away from the consequences of these (maybe 2-3 more quarters) that we can ignore that more bailouts or a mass exodus from the euro is close at hand.

Finally, there can be no doubt that the numbers in the US are picking up some steam of late.  How long will this continue?  Perhaps not too long, but who is to say.

More specifically, the housing sector has been beaten to such a pulp in the past few years, and the stocks involved have taken such a beating, that even a stabilization at these low levels (both prices and activity) may lead to a substantial uptick in the share prices.

Always on the look-out for a bull market

So while I don’t really believe it can last over the long term, that doesn’t mean I can’t take advantage of it.  In the absence of the arrival of a true storm (like what happened in 2008), there is always some bull market somewhere.  You just have to find it.

Where am I looking?

  1. US Regional and Community Bank stocks
  2. Mortgage Servicing companies
  3. Oil stocks with large resources that can take advantage of Hz-multifrac technology to exploit those fields

I still don’t know what to think of gold. There is a bull market out there, but only for select stocks (see Atna and Argonaut Gold for a couple of examples).

Buying into Newcastle and buying more into PHH

As I wrote earlier, I believe that the mortgage servicing business provides a unique opportunity right now, and while I have started a position in Newcastle Investments in response to that, I expect to increase that position substantially over the coming weeks.  I have also turned PHH Corporation into one of my largest positions.

I’ve already talked about both of these investments ad nauseum in the last couple posts so I am not going to reiterate those theses here.  What I will say is that I am becoming more and more cozy with the mortgage market bottoming idea and I would expect that you will see more of my capital make its way over to this market in the coming weeks.  I am already looking for an opportunity to exit OceanaGold and reduce my position in Aurizon Gold.  The proceeds are likely to either go into PHH or NCT, or into another mortgage leveraged corporation that I find.