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Posts from the ‘Newcastle Investments (NCT)’ Category

Mar 9

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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.

Mar 4

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.

Feb 20

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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.

Feb 20

PHH, Newcastle Investments, and mortgage servicing rights

In my week 29 letter I began to talk the opportunity I was seeing in mortgage origination and servicing.

While an uptick in new home building may still be some time away, mortgage origination should benefit over the next year from the refinancing associated with HARP II and from less competition due to the exodus of originators from the ranks brought on by the dismal market conditions.

Mortgage servicing, meanwhile, has been hurt by falling interest rates (remember that as a servicer you get paid as long as the loan is being paid, so refinancing can hurt your business if you can’t reoriginate the refinancing), by uncertainty in the regulatory environment, and by the regulatory capital concerns of banks.  But valuations on mortgage servicing rights are low and with loan quality standards currently high and with interest rates unlikely to go lower, new servicing rights should be a good investment.

I want to delve a little deeper into the  mortgage servicing rights (MSR) part of the business this week.

What is a mortgage servicing right?

A mortgage servicing right is a somewhat complicated little piece of paper of conditions, responsibilities and payments.  For the basic definition I will defer to investopedia:

An MSR is a contractual agreement where the right, or rights, to service an existing mortgage are sold by the original lender to another party who specializes in the various functions of servicing mortgages. Common rights included are the right to collect mortgage payments monthly, set aside taxes and insurance premiums in escrow, and forward interest and principle to the mortgage lender.

In return for these responsibilities, the servicer is entitled to a small piece of the recurring interest payments made by the borrower, usually around 25 basis points (0.25%).

A more investment oriented definition of an MSR comes from kamakuraco, who published an interesting paper on estimating the risk of an MSR, and who define the mortgage servicing right in the terms of a security:

One can approach the valuation of mortgage servicing rights as the valuation of a fixed income (broadly defined) security subject to default risk and prepayment risk.

There are two risks implicit to an MSR; either the mortgage is paid off, or the borrower defaults.  In both cases the payments to the holder of the MSR are no more.

The collapse of the MSR

There was a great discussion two weeks ago on the Lykken on Lending mortgage banking podcast.  Lykken had on Austin Tilghman and David Stephens, CEO & CFO respectfully, both with United Capital Markets.  These fellows are industry experts in the mortgage servicing market.  The discussion begins about a half hour into the podcast.

To take an aside for a second, I have to say that listening to the discussion brought about one of those exciting moments that make investing fun.  I was biking home from work, had my ipod on listening to the broadcast.  The roundtable discussion with the UCM execs came on and the second question, put forth by Alice Alvey, asked why are company’s beginning to retain their own servicing rights when traditionally most originators just sold those rights off for the cash up front?  Austin Tilghman (I think.  He didn’t identify himself) replied with the following:

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.

Andy Schell, Lykken’s partner, then went on to say 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.

Wow.

When I hear that kind of disconnect I immediately think opportunity.  And then I think how can I capitalize on that opportunity.

Defining SRP’s  (there are too many acronyms in this industry)

But first of all, another definition. When a company originates a mortgage, along with that mortgage comes the right to service the mortgage.  That’s the mortgage servicing right.

As an originator you have the option to keep the MSR on your book and service the mortgage through its life in return for the 25 basis point (or thereabouts) premium.

Alternatively you can capitalize the MSR up front by selling it.  In return for selling the MSR you get cash.  The cash you get is referred to as the servicing release premium (SRP).

The acronyms MSR and SRP get used all the time in discussions without definition so its good up front to understand what these two concepts are.

Why SRP’s have collapsed

As David Stephens alluded to above, the value of an SRP has collapsed of late.  A few reasons why this is the case:

  1. There is concern about a regulatory change to make MSR’s a fee for service as opposed to a tacked on percentage of the loan interest (this is preventing new participants from getting into the market but it appears that it is not going to happen)
  2. There is a more nebulous concern about the regulatory environment in Washington in general and what the “unknown unknowns” of future legislation might be
  3. You only get the cash flow stream of an MSR over time whereas you get cash right now by selling the SRP and has of course been a liquidity problem in the industry since 2007
  4. Its a long term commitment to get into servicing.  You can’t just jump in overnight without  getting approvals as a servicer from the regulators and developing the infrastructure to do the servicing
  5. The market for buying and selling servicing is thin at the best of times and especially thin now (because of all the folks getting out of the business)
  6. And that is because… no bank wants to have anything to do with the mortgage industry

The opportunity

The basic investment premise here was well put on the broadcast by Joe Farr, who asked the following question:

With rates at 3.5% or 4% and quality never being better, why is it that that servicing values are close to zero in some cases?

To which Austin replied:

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.

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.

Who is going to benefit?

So I own a bunch of PHH now.  They are big time servicer and the MSR’s on their books are valued at about 2.7x.  Clearly from a book value perspective PHH has some upside  to that servicing valuation if interest rates begin to rise and they can value that servicing at something closer to 5x.   Servicing values have had to take major writedowns over the past 3 years as defaults have increased and more importantly, as interest rates have fallen, raising the possibility of refinancing.  I found that really interesting table of the writedowns taken by some of the major banks over the past 3 years in the Kamakura report that I mentioned earlier:

That is nearly $30B in writedowns over the past 3 years for the 8 major banks.  Wow.

Remember that the writedowns are being taken in part because the current MSRs are expected to refinance at a faster rate.   PHH has, in the past, managed to retain most of their servicing rights that get refinanced by being the originator on those refinancings.  So its perhaps a little misleading to value those servicing rights at 2.7x.

To get an idea of impact of a revaluation of those MSRs on teh PHH books to a 5x servicing fee multiple:

Ok, so that’s a pretty big impact on the accounting end.

As I already mentioned, PHH has proven that they can produce more MSR’s then they lose even during times where a large amount of the MSR’s are refinancing.  The new MSR’s replacing the old MSR’s are of a much higher quality.  By high quality I mean that these MSR’s are connected to mortgages that are being financed at extremely low rates (and therefore where the chance of early repayment is low) and within a market where credit quality is extremely restrictive (meaning the chance of default is low).  This doesn’t seem to be reflected anywhere in the books.

So PHH has some upside as MSR come back into favor.  That’s good.  But there are two problems with using PHH as the vehicle to play the MSR disconnect:

  1. They don’t have the cash right now to take advantage of the disconnect in price and buy up MSR’s on the cheap.  What I really need is a company with lots of cash and a savvy management team that recognizes that there is an opportunity in the market and you have to jump in.
  2. They are an originator, so when the MSR’s begin to recover their value its going to be on the heels of rising interest rates which will hurt the PHH refinancing business.  In other words, PHH will never have all cylinders firing at once.

What I really need is a company with lots of cash and a savvy management team that recognizes that there is an opportunity in the market and you have to jump in.

Enter Newcastle Investment

I have owned Newcastle investment in the past.  In fact, I owned them as recently as last summer, but I sold them in one of my “sell everything because who the hell knows what is happening in Europe” moments. At the time, I owned Newcastle because they, much like Gramercy Capital, had a large disconnect between the NAV of their managed CDO portfolio and the share price.

I’m not going to go through that CDO valuation right now because I want to talk about the MSR business that Newcastle is branching out into.  I probably will in the next few weeks, just to get a better idea of the value proposition here.  In the mean time the best places to find a comprehensive analysis of Newcastle’s CDO business are on the Gator Capital blog and the analysis by PlanMaestro on variantperceptions here and here.

The essence of these analyses is that if you add up the CDO business and cash at corporate, subtract out the preferred’s and other debts, you get a company with an NAV of about $5-$5.50 per share.  So your net asset value is something pretty close to the current share price.

Here’s the crux then.  Of that $5-$5.50 per share net asset value, about $205M (or a little less that $2 per share) was cash at the end of the third quarter.  The potential upside exists if Newcastle can turn that cash into a cash producing asset that has a value greater than the face value for which it is purchased.

NCT gets into the MSR business

On its third quarter conference call Newcastle made the announcement of the change in direction.  The company was getting into the mortgage servicing business.  The company said it would be making major investments into MSR’s over the next few quarters (one of which they have already since announced).  The reasons that they decided to make the switch in strategic direction was:

  1. They felt the MSR business offered the best risk adjusted returns out there
  2. The existing core business of CDO creation was basically dead

Interestingly, Derek Pilecki, who writes the Gator Capital blog, dumped NCT when the news was announced.  While I am of the mind that getting into the servicing business right now is a savvy move, I recommend reading his final analysis of (and reasons for selling) Newcastle here for a contrary point of view.

Newcastle believes that there are significant returns that could be realized from MSR investments.  From the SeekingAlpha Q3 conference call transcript:

We are still very optimistic that the returns on an unleveraged basis will be kind of mid-teens even mid-20, so very compelling in any environment but in particular with all the certainly in the world if we get something that is a big deal for us.

Newcastle went on to describe something that the fellows from UCM pointed out on the Lykken broadcast; how banks are basically dumping their servicing business on the cheap.  Again from the  transcript of the 3rd quarter conference call:

Banks in the U.S. are very focused on regulatory capital, on regulatory risk, on just the perception of headline risk, [and this has] made them more likely to be source [of MSR supply]

To get into the business Newcastle is partnering with an originator and servicer (Nationstar) and Nationstar will be performing the actual servicing.  I think that Newcastle can be thought of as a silent partner that is putting up the cash.   Again, the problem with MSR’s is that you have to have the cash to put up, and while most originators are running a tight cash flow, Newcastle has ample cash to take advantage of the investment.

Newcastle has also received approval from the IRS that MSR’s can receive the same favorable taxtreatment as other REIT assets.

That they had to clarify approval demonstrates the “first mover” status that Newcastle holds.  Newcastle is early on in the game, being one of the first REIT’s to take advantage of this opportunity.  As one of the analysts put it on the Q&A, Newcastle is “leading the way”.

What’s the upside?

The upside to Newcastle is a big increase in the free cash flow that the REIT can generate.  Before getting into the MSR business, Newcastle was generating around $80M of free cash flow (FCF).  At a 20% return on the $200M of unrestricted cash (using the assumption that the company puts all its free cash into the MSR business), you are looking at FCF of another $40M.  Given the current market capitalization of $600M that puts NCT at a 5x free cash flow multiple. The company paid about a $60M common share dividend in the third quarter, so clearly another dividend hike would be likely.

The company announced their first MSR deal with Nationstar in a December 13th news release.  In it the company reiterated the return metrics:

  “I am very pleased to announce our first investment in Excess Mortgage Servicing Rights. This is a watershed investment for us in this sector. We expect this investment will generate approximately a 20% unleveraged return and total cash flows of over 2 times our investment. I am excited to be investing alongside Nationstar, a premier mortgage servicer and originator. Residential mortgage servicing is a large market and we currently see a strong pipeline of similar investments at very attractive returns.”

The deal was for $44M.

In my opinion, apart from the basic cash flow expected there is unrealized value in these MSR assets.  For one, because Newcastle is partnering with an originator in Nationstar, there is a good chance that a decent percentage of the MSR’s that the company is investing in will be refinanced through Nationstar.  Newcastle was quick to point out that refinanced mortgages remain in the portfolio and continue to cash flow to Newcastle.  The refinanced value is not included in the value of the MSR.  Newcastle estimated the following refinancing rate on the Q3 call (from the SeekingAlpha transcript again):

So our experience at Nationstar on our agency pools that we service which is a material amount of loans is that we’ve had recapture rates in the kind of low-to-mid 30% (inaudible) over the past six months, and that’s obviously significant, we think and we’re hopeful that with a little bit of focus, we could increase that to 40%, 50% at the extreme end of it, not that I’m predicting this, because it wouldn’t be prudent, but at the extreme end of it, you can capture a 100% of the loans that prepays, then you would have really the perpetual money machine right, as the IO would stick around, the extra service will stick around forever, but even at recapture rates at 20%, 30%, 40%, 50%. It has a terrific impact in terms of the volatility of the MSR and that’s (inaudible) investment profile looks like.

Second, as I already pointed out, recent and new MSR’s are being collected from mortgages that have been financed at historically low rates and in an era of extremely strict lending criteria.  There is little chance that these mortgages are going to default and little chance that they will be refinanced any time soon.  In other words these are high quality assets.

Its kind of a weird perfect storm here; you have a situation where the asset quality has never been better at a time when nobody wants the asset.  While I suppose its not clear exactly what the quality of the MSR’s Newcastle is investing in are, if one presupposes a little faith in the management team (which has after all had the foresight to see an opportunity that many others have not yet seen), you might draw the conclusion that Newcastle is getting into high quality assets at a fraction of their underlying value.

Anyways if you add it all up I think NCT is on to something here.  I bought a position in the stock and plan to add to incrementally as the stock moves up and my thesis is proven right.

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