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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).

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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.

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

FT Alphaville did a nice piece on Friday talking about shadow inventory in the United States. To sum it up:

Two things about this graph.

  1. Visible housing inventory is approaching a low not seen in 30 years.
  2. You can’t take a shadow inventory number at face value.  You have to understand how it was estimated.

First a little bit about shadow inventory

I want to talk for a second about shadow inventory. I wrote this explanation about shadow inventory in Letter 23:

Laurie Goodman (who I first learned of from ftAlphaville fame) pegged shadow inventory at 11M (which is an amazing 20% of housing mortgages outstanding).  Mark Fleming pegs it at 2M.  Both analyts are using the same data…How is this possible?  Its all in the assumptions.  Shadow inventory is really just houses that are expected to go into default at some point.  There is nothing particularly nefarious about the concept, even though the name suggests it is some sort of inevitable flood of housing supply.  It may be, but it may not.  It depends on what happens.  Laurie, to come up with her 11M number, assumes a fairly large number of prime mortgage defaults, including some that are currently with LTV (loan to value) of less than 100%.   Laurie also looks at 60 day past due as her “bucket” from which to extrapolate current nonperforming loans.  Mark on the other hand, uses 90 day past due, and does not include currently performing prime mortgage defaults.

I did a bit of investigation and the number used in the above graph is the CoreLogic number, which is the lowball Mark Fleming estimate from the above quote.  According to CalculatedRisk that number is comprised as follows:

Of the 1.6 million properties currently in the shadow inventory, 770,000 units are seriously delinquent (2.5-months’ supply), 430,000 are in some stage of foreclosure (1.4-months’ supply) and 370,000 are already in REO (1.2-months’ supply).

The thing about the shadow inventory is that if what you see is what you get, then we are almost through the worst of it.  Looking at the above categories that comprise the shadow inventory estimate, they total about 1.6M homes.  If there was a little bit of confidence in the housing market, and you began to see sales returning to pre-crisis and pre-boom levels, you would run through those homes quite quickly.

As well, it must be kept in mind that the month-of-supply number is assuming a continuation of a level of sales that is a historically low level.  Rising sales would help eliminate shadow inventory and real inventory much more quickly than the monthsof-supply number might suggest.

The most basic point here is that shadow inventory is not an inevitable houses-on-the-market number like visible inventory is.  Shadow inventory is a “houses that are likely to go on the market” number where the definition of “likely” is a function of whether those home owners have jobs, how low interest rates are, whether the refinancing market is liquid enough to let home owners with high interest rate mortgages refinance to low interest rate mortgages, and probably most ambiguously, what homeowner think about the future prospects of the housing market.

Laurie Goodman and her firm Amherst Securities have some of the most pessimistic numbers on shadow inventory.  She does an excellent job describing the methodology they use at her firm on this conference call.  Amherst ends up with the following estimate of shadow inventory:

This is a huge number.  Much bigger than the 1.6M number that CoreLogic is using.  If Goodman is right then we are years and years away from a housing recovery.

But lets go through this.  Amherst uses 60 days past due to define nonperforming loans.  Reperforming loans are loans that were in default before but aren’t now.  MTM LTV means mark to market loan to value, so a 120 MTM LTV is basically saying that the loan is worth 120% what the house is worth.

I would say that you can make vastly different assumptions about how many loans in each of these categories will default depending on whether you assume the housing market is improving or not.

Somewhat paradoxically the true amount of shadow inventory is going to be determined by the perception of just how much overhang exists in the housing market.  To put that more bluntly, would you walk away from your house right now if you saw the housing market turning up?

You would be a lot less inclined to I think.

And all of this brings us to the US economy

I have two graphs here to prove my point.

When I started dumping stocks and raisigng cash in the late summer and earlier fall it was partially because of my uncertainty about Europe.  But it was also partly because of my concern that the US economy was slowing down again. The big reason for my concern was that the ECRI leading index was falling again.  I am reluctant to be too invested in stocks when this indicator is dropping.   Once it starts to drop, I’m not all that sure that anyone knows when its going to stop.  It could stop and turn around relatively quickly, suggesting a soft patch in  the economy, or it could fall precipitously, indicating a sustained move back into recession.

The move down ended at the end of the last year, and the last few weeks the uptrend has shown itself to be persistant.  Such persistance must be noted.

The second graph is simply jobless claims.  Jobless claims are the single best indicator of the health of the economy.  You simply can’t deny that claims are heading down, and that the trend down is accelerating.

Growth in an economy builds on itself.  Growth begets growth.  Taking it back to the housing market, I think that these early signs of true growth in jobs could begin to snowball into a housing market.  Jobs beget stabilizing housing prices which begets greater housing activity, which begets rising prices, which begets falling inventories (and non-materializing shadow inventories), which begets the need to build new homes which begets more jobs. And so on.

Economies as large as the US economy do not turn on a dime.  But when they turn a lot of the viscious cycles that had amplified the downturn become virtuous cycles that amplify the move up.   I am of the mind that we may be in the process of making such a turn right now.

Indaba Capital Values Gramercy Capital

Well it wasn’t a great week for my stocks, but there was a bit of interesting news after the bell tonight with regard to Gramercy Capital.

Indaba Capital filed a schedule 13-D. 13-D is a form stating beneficial ownership.  It needs to be filed by any owner of shares with more than a 5% ownership.  At times it is used as a way of publicizing letters to management.  That was Indaba’s intent today.

Indaba published as an exhibit in the 13-D a letter with two objectives.  First, it asked management to pay the accrued unpaid dividend to preferred shareholders and second, it made the first steps toward their nomination of a  new board member.

I would expect Gramercy to begin to pay the accrued dividends at some point soon, but I can only speculate what managements plans are.  As to the board member, I don’t really see this as terribly important to the stock price.  So the essence of the letter was perhaps interesting, but did not seem to me to be terribly material to the near term future.

What was interesting were the exhibits provided in the appendix.

Indaba provided the details to a similar unit by unit valuation as what was done by Plan Maestro a few months back.  They came back with very similar results.

So according to Indaba Gramercy is somewhere between 30% and 130% undervalued in comparison to its net asset value.  Not bad.

I lightened up on Gramercy this week along with a lot of other stocks.  But I have to say that I find the stock quite enticing still, its cheap, its value is more disassociated than most to the main driver of the market (Europe).  With gold wobbling and my thesis that gold stocks would continue to do well even as the world does not wobbles with it, I think its worth me thinking about whether I should be reallocating capital back into Gramercy and away from some of these gold holdings.

My Attempt to Understand Gramercy’s CDO-2006

Gramercy Capital finished up on the week while the rest of the market slumped.  The reason is the continuing recognition by the Street that the company’s settlement of Realty opens the door of potential.

What the news of the settlment does is it allows investors to begin to evaluate the company based on what is left without having to wonder what they might eventually have to subtract.  And what is left is a company with a lot of cash, a number of commercial real estate holdings on their balance sheet, a management fee that more than covers Realty expenses, and the equity level stakes in 3 CDO’s filled with primarily commercial real estate securities, 2 of which are paying back significant sums of cash.

Let’s Go Back to the Beginning

I came across Gramercy by way of a few degrees of separation.    I actually happened on the analysis from another site, Above Average Odds (AAO).    I had originally discovered AAO when I was scouring the net researching Equal Energy.  Above Average Odds agreed with me that Equal Energy was undervalued, and just as importantly they recognized the value in the up-and-coming Mississippian play that the market was (and is continuing) to ignore.   Their work, in particular their early understanding of the potential of the Mississippian, impressed me enough to continue to follow the site.

Well as it turns out Equal has been the poorest of my oil and gas stocks (I should really know better than to invest in debt laden juniors), though the value is still there.  But that’s another story… the point here is that the Equal Energy story led me to a future post from AAO on Gramercy Capital. This post was not written by AAO but my another blogger, PlanMaestro, who writes his own blog called Variant Perceptions.  When I initially bought Gramercy, I did so on the basis of the analysis written up by PlanMaestro.

At the time I did some leg work of my own to wrap my head around the story.  I read through the 10-K (which was actually the 2009 10-K) and sifted through posts on yahoo and investors hub.  It was clear to me that the stock was cheap, that the risks were not as high as perceived, and that was enough for me to buy a piece in the company.

But I didn’t really delve as deeply as I do with most of my investments.  I think the reason was that the inner workings of a CDO seemed quite opaque to me, and so I found it kind of intimidating to jump into that pool.  This weekend I decided to get a better grasp of the CDO and in particular Gramercy’s CDO’s.  On Friday night I printed out the information that was available (a set of the March 2011 managers reports for CDO-2005 and CDO-2006 that someone was so kind to post on googledocs), waited until everyone had fallen asleep, and sat down with a drink and an open ended time frame that I wasn’t going to bed until I understood how these things worked.

It actually didn’t take too long.

In retrospect, I regret not having done a more thorough analysis sooner.  It prevented me from recognizing just how much potential this stock has.  And while I own a good chunk of the stock right now, I would have undoubtably bought more if I had spent the time to actually understand the CDO’s sooner.

So what did I learn?

The first thing I learned is that CDO’s are not as complicated as their reputation makes them out to be.  And Gramercy’s CDO’s are even less complicated then most.  As with most seemingly inaccessible subjects,  the opaqueness of a CDO revolves around the inaccessibility of the language (mostly acronyms) used.  To put it simply, there are a bunch of indsutry lingo used and who the heck knows what they mean.  But once you know those definitions you realize the concepts are actually quite straightforward.

Before I talk about the Gramercy CDO’s in particular, I’m going to point to a few basic primers on what a CDO is and how it works.

First, this video and this video are both great.

Ok, so lets look at Gramercy’s CDO’s.  I’m going to focus here in this post on CDO-2006.  CDO-2005 and CDO-2006 are, the sense of structure, the same.  If you understand how the one works you understand the other.  Same structure, with each one comprised of different loans and securities.  Now there are a few impotant differences between the two in terms of performance, but I will discuss that more at the end.

Onto GKK CDO-2006!

So when Gramercy created CDO-2006, they got together $1B of investment capital, put it into what is called a special purpose vehicle (which is just a fancy name for what effectively amounts to a holding company), and bought $1B worth of commercial mortgage securities.

The $1B of investment capital was obtained by the selling of notes that were divided up into classes (or tranches) based on the seniority of who would be paid back first.  The tranches created and the amount of notes in each tranche were:

The highest tranche (1A A-1) gets paid back first.  But the highest tranche also receives the lowest return.

And here we get to the first interesting point about CDO-2006.  The interest paid to the notes.  To put it plainly, the interest being paid to these notes is a steal.  Below I have snipped the interest being paid on each tranche of notes for the March quarter.

All of these notes are tied to 3 month LIBOR.  If you look at the largest (and highest rated) tranches, their spread to LIBOR is small.  Thus, with LIBOR rates non-existent right now, the interest paid for the capital is equally small.  I’m sure that in 2006 when the world was rocking these notes seemed like a reasonable investment, but right now they seem like very low returns for the risk of investing in US commercial real estate.

Which is all the better for Gramercy.

What about going forward?  Well, who am I to predict the future, but one thing that does make it easier to predict is when you are told what it is going to be.  The Fed said they are keeping rates look for 2 years.   There’s little to think that the economy could accelerate so quickly as to put the Fed’s word in doubt.  I think its safe to say that’s Gramercy’s extremely low cost debt funding train is going to continue.

Below is what 3 month LIBOR has done over the last year.

Looking at the first quarter report, the CDO paid out $1.5M in interest to the tranches not held by Gramercy.  That means that they are paying an annualized $6M interest in return for the access to $900M of capital.

When you think about what’s really going on here you have to admit its a little crazy.  Compare what Gramercy is getting capital for to your typical high yield industrial company (think Tembec and their issue of longer term debt at 9+%).  Gramercy is getting a tremendous deal here.   And its all non-recourse.

In CDO-2006 Gramercy owns the J and K notes, as well as the preferred.  These would be considered to be the equity level tranches.  The J and K notes pay higher interest than the senior tranches at about 3.5% and 7%, but it is the preferred that is the real money maker.  The preferred keeps all the excess interest beyond what needs to be paid to the more senior notes.  When you are investing $1B in real estate and pay out less than 1% for that capital, there tends to be a lot of excess interest.

Below are the interest payments to the J, K and preferred for the March quarter:

The CDO paid out $7.6M in the quarter to Gramercy in the first quarter.  About $30M annually.

One thing that is worth pointing out is that the CDO delivered these returns while holding $158M of its assets in cash.  For the sake of interest, lets just do a back of the napkin calculation of how much more interest the company could generate if they put that cash to work at similar interest rates to the assets they already have.

Total interest distribution was $9.1M on total performing CDO assets of $881M.  So interest was an annualized 4.1% of assets.  The $158M of cash at 4.1% would generate another $6.5M per quarter.  All this would go straight to the preferred.  So potentially, the 2006 CDO has the opportunity to almost double its return to Gramercy.

Moreoever, my understanding is that a lot of CRE loans are closer to the 6% range.  So a 4.1% assumption is likely quite conservative.

At any rate there is the potential to make a lot of money from CDO 2006.

There is however, a limited amount of time forthe cash to be invested.  Both CDO-2005 and CDO-2006 are structured such that there is a window in which new cash (from principle payments) can be put towards new investments.  After this period ends, once a loan is paid back the proceeds need to be used to pay back the note holders, starting with the most senior first.  For CDO-2005 that time has passed.  For CDO-2006 that has passed as well, but it passed in July of this year.  So we don’t know yet what investments Gramercy has made with the cash.  Hopefully its something that pays good interest.

The other stipulation on both CDO-2005 and CDO-2006 is that they both must pass a number of tests before money can be passed on to the equity tranches.   The CDO has to pass what is called an overcollateralization test and an interest coverage test.

Both of these tests are straightforward and are exactly what their names suggest.  In the case of the overcollateralization test all of the assets currently held by the CDO are added up, any delinquent assets are given a recovery value, and that number of total assets is divided by the amount of notes that has to be repaid.  This is done for the various tranches, so for the lower tranches the upper tranches are included in the amount because they will be paid first.  Thus, the overcollateralization test for the lowest tranches (F/G/H) is the hardest to pass.

CDO-2006 passed the overcollateralization test in the March quarter.

The defaults are an interesting story in themselves.  You can see from the above tables that the defaults are being valued at a little over 25% of their whole value. Its interesting to see why this is the case.  Here is a list of the defaulted loans/securities from the same managers report:

Ok, so first of all, the 3 CDO notes from Gramercy 2007 can be ignored.  CDO-2007 is a lost cause, and so the fact that these 3 notes are being valued at about 10% is probably right.

Taking a Bit Closer Look at the Defaults

To get a sense of what these defaulted securities might be, let’s look instead at the largest default.  Fiesta da Vida.  A bit of searching turns up a court document from a couple of weeks ago that describes the current state of the loan:

Gramercy Investment Trust versus Lakemont Homes Nevada

The documentis the ruling of an appeals court to the original decision that Lakemont Homes Nevada owes Gramercy for the loan they were made by them.

The story is:

Fiesta da Vida, LLC, owned real property located in Riverside County which was to be developed by FDV Investment LLC. In order to obtain financing for the project, title to the property was transferred to FDV Investment LLC (the borrower). The borrower was an entity managed by Lakemont Homes, Inc., a California corporation. On March 30, 2007, Gramercy lent $35 million to the borrower, and the loan was secured by a deed of trust. The loan agreement provided that it would be governed by the laws of the State of New York.

But then real estate in California collapsed and Lakemont Home didn’t repay the loan.  So Gramercy went to court.

On February 3, 2010, Gramercy made a motion for summary adjudication of issues as to the second cause of action against two of the Lakemont defendants.4 On May 20, 2010, the court granted the motion. Judgment in favor of Gramercy was entitled in the amount of $33,537,994.65, plus costs. On July 22, 2010, Lakemont appealed.

The interesting ending to this saga is that the apellate court ruling on the appeal affirmed the judgement in favor of Gramercy.

So what does this all mean?  I don’t know enough to say.  While the court affirms that Gramercy should get their money back, for that to happen the money has to be there.  I did some searching for Lakemont Homes and FDV Investment LLC, who seem to be the borrowers here, and I can’t find more than a name referencing the company.

And when I look at Riverside real estate prices, it doesn’t give me the warm fuzzies about the area (these are residential prices mind you):

On the other hand, one would think that for Gramercy to spend the time in court there must be some carrot they are chasing.  We shall see.

Anyways, I digress…

What is CDO-2006 Made of?

The last thing that I want to talk about is what the CDO-2006 is actually comprised of.  Luckily, this information is all available in the managers report (note: I originally had posted a breakdown in loan data that I was told was better left un-posted.  What remains is the general aspects of the loans, which is still sufficient for drawing the conclusions I looked to draw).

The CDO contains 54 different investments as of the end of March.  Most of these are whole loans, while the rest are collateralized mortgage products.  You can see the breakdown in the table below:


A few points that I made note of as a perused the contents of CDO-2006:

  • Many of the loans are simple first lien loans against a property.
  • There are 3 Gramercy CDO-2007 notes in CDO-2006.  These were bought in 2009.  They are lower tranches (would either be mezzanine or equity) and so I think they are dead in the water.  I wonder why they bought these?
  • The three biggest whole loans on their books $48M, $45M, $42M.  So they are not overly leveraged to any particular CRE property.

One point that is worth spending some time on is just what type of CMBS and CDO’s are owned by CDO-2006.  The first thing I note is that of the CMBS and CDO’s owned, all except for the NSTAR 2006 carry interest rates of above 5%.  This is good as long as they are performing (which most of them are).  But it also implies that these are very low tranches and may not see full recovery.  So lets look for a second at what the ratings are on these notes.  I made the following table from a larger table provided in the report.  I reduced it to only include CMBS and CDO’s.


Moody’s ratings system is as follows (taken from Wikipedia):

It looks like $92M of the securities are not investment grade (includes 2 securities not rated by Moody’s but by S&P).

What does this mean for Gramercy?   The tranches of notes that Gramercy owns are the lowest, and they make up the final $96M of the total notes sold.  So to eventually recover principle on the CDO, Gramercy needs some of these non-investment grade securities to pay up.

That’s not an impossible task, particularly considering that many of the non-investment grade securities are at ratings on the cusp of investment grade (Ba1, Ba2 and Ba3).

One final piece of information about the properties owned that is relevant is where these properties are.  You can go through the list individually to determine this information, but some general location information can also be gleaned by a few of the CDO requirements tests.  CDO-2006 has some requirements about how much real estate can be owned in any particular state.  As part of the managers report there are a number of tests to see whether these requirements are met.  These tests, and the amounts owned in the central loan states, are in the table below:

So What did I Learn?

This started off as a mostly educational exercise for me.  I wanted to understand how a CDO worked and CDO-2006 was my lab rat.  And I think I achieved my goal.  I now have a much better understanding as to what a CDO is comprised of, what its liabilities are, how its interest is paid, and what how its solvency and liquidity tests are calculated.

As it more specifically applies to Gramercy, I learned the following:

  • The interest that the CDO is paying on much of the $1B in capital makes this extremely cheap money
  • The equity tranche of CDO 2006 is much more leveraged to performance than I anticipated.
  • The cash level that CDO-2006 had in March is perhaps the most important element of the CDO.  That cash could be converted into significant extra dividends to the Gramercy owned preferred once that cash is put to work
  • The eventual recovery of principle in CDO-2006 depends on the recovery of a number of CMBS and CDO securities that are not currently investment grade and so full recovery is no sure thing.

What’s Next?

the next thing I want to write-up is CDO-2005.  As I said at the start, the structure of CDO-2005 is similar to CDO-2006.  However, there are key differences in their current state.  CDO-2005 was, for quite some time, failing its overcollateralization tests.  But it was just barely failing, and there was a news release at the beginning of August that it had begun to pass again.  Now I need to spend some more time crunching the numbers on CDO-2005, but as a first pass it looks to me like the CDO should return between $5M to $6M quarterly to the holder of the preferred shares once the over-collateralization test is passed.

See the thing is, when the CDO fails its overcollateralization, all the interest to equity gets diverted to paying off principle of the senior notes until the test begins to pass again.  So Gramercy hasn’t gotten anything from CDO-2005 for quite some time.  If I’m right about my numbers (and please take them with a grain of salt at this time because i have not gone through CDO-2005 in the detail I did CDO-2006) then that is another $20M to $25M in yearly cashflow to Gramercy.  That is 40-50 cents per share, which is nothing to scoff at.

But that is yet another story.  This post was about CDO-2006 and learning about how CDO’s work.  I think I’ve said enough about that already.