The COVID-19 crisis has been difficult for most real estate investment trusts (REITs), especially mall REITs and mortgage REITs. While mall REITs struggled due to tenants' inability to pay rent, the mortgage REIT sector was clobbered by illiquid markets as margin calls swept through the industry. Every mortgage REIT was affected, and just about every one was forced to cut its dividend.
New Residential (NYSE: NRZ) made some drastic changes in its business model due to the dislocations in the mortgage market. The company has said it will announce its second-quarter earnings on July 22. Here is what I am looking for.
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A wholesale change of business model
New Residential completely changed its business model during the months of April and May. The company was known for focusing on originating mortgages that cannot be guaranteed by the U.S. government. These loans are called non-qualified (Non-QM) loans, and they are usually targeted to self-employed borrowers who have lots of tax deductions that understate the borrower's actual ability to make the mortgage payments. During the month of April, non-QM loans fell 10 to 15 points, and New Residential decided to exit the business. It will still originate mortgages; however, the company will focus on government-guaranteed mortgages. Since COVID-19, credit has tightened dramatically, and there simply isn't much investor appetite for these loans.
Servicing is a bigger feature of the company now
New Residential has a much larger focus on servicing mortgages. Mortgage servicing assets are interesting assets in that they are one of the few bond-type investments that increase in value as interest rates rise. Essentially, the mortgage servicer collects the monthly payment from the borrower and makes sure that the payment is routed to the investor, that the taxes and insurance are paid, and that any delinquencies are dealt with when borrowers stop paying. The servicer is then paid 0.25% of the loan's balance per year for taking care of this. Ordinarily, this is a boring business.
Mortgage servicers were given an additional headache when the CARES Act mandated forbearance for pretty much anyone who asked for it. Since servicers are generally required to make up for any missed payments, they can find themselves with huge cash demands if delinquencies tick up dramatically. The government has at least placed a limit on advancement requirements, but it still affected the value of mortgage servicing rights. There was a period where Federal Housing Administration (FHA) and Veterans Affairs (VA) servicing was more or less worthless.
For New Residential, I want to get an idea of what the servicing book's delinquencies are, and what percentage of the portfolio entered into a forbearance agreement. Since servicing is such a big part of New Residential's business, and delinquencies are a big driver of servicing valuations, we need to get a sense of how delinquencies are trending. The Mortgage Bankers Association is reporting that the number of loans in forbearance is declining, albeit modestly.
Origination will help, but can the company transition?
The other number I want to see is origination volume. Almost every mortgage banker right now is inundated with loans, and profits are high. Will New Residential's pivot into government-backed origination increase volumes? If so, then it should have steady cash flow that it can use to reduce debt, which is still on the low side at 1.5 to 1.7 times. Mortgage originators are hot right now, as Quicken readies its IPO and PennyMac Financial is firing on all cylinders.
New Residential is a complicated stock, and it might not be suitable for all investors. The dividend fell from $0.50 to $0.10, and periodic market shocks like we've seen during the pandemic can force companies to de-leverage their portfolios at the worst possible time. Investors should probably give this one some time to see how the new business model works out.
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