The COVID-19 crisis wreaked havoc on the mortgage real estate investment trust (REIT) sector, and most companies in the sector have had to write down book value and cut their dividends. For the most part, the agency REITs that specialize in mortgages guaranteed by the U.S. government were able to maintain their business models, but those that concentrate outside the government-guaranteed space have had to change their investment strategies.
Mortgage REIT New Residential (NYSE: NRZ) was one of those companies, and it has made possibly one of the biggest transformations.
The transformation and a massive mortgage refinancing wave
New Residential entered 2020 as a REIT that specialized in the non-government-guaranteed space. The company held legacy non-guaranteed mortgages and used them as collateral for securitizations. The company also had a lending arm that focused on the nascent market in non-guaranteed mortgages, known in industry vernacular as non-QM lending. Finally, it concentrated on mortgage-servicing rights.
As credit tightened in March and April, the company experienced margin calls and was forced to liquidate assets into declining markets. The company wrote down book value, cut its dividend, and changed its strategy.
The New Residential of today is completely different.
First, New Residential continues to sell its non-government-guaranteed mortgages and is building up a portfolio of government-guaranteed, mortgage-backed securities. In other words, New Residential's future mortgage-backed securities portfolio will more closely resemble AGNC Investment (NASDAQ: AGNC) than the New Residential of old.
Second, the mortgage banking arm of New Residential is in the midst of a massive refinancing boom. The company exited the non-QM lending business and is now focusing on mortgages that are guaranteed by Fannie Mae, Freddie Mac, or the U.S. government. On the earnings call, New Residential management forecast that it will originate between $45 billion and $50 billion in mortgages in 2020. In other words, the operating company will be a much bigger source of earnings for the company going forward.
Mortgage servicing is another source of operating income
Mortgage servicing will continue to be a focus for the company. Mortgage-servicing rights (MSRs) represent compensation for handling customer payments, ensuring that investors are paid, and managing delinquencies. This is one of the few financial assets that increase in price as interest rates rise. This dynamic will benefit New Residential once rates rise because the mortgage-origination business will decline as refinance opportunities dry up.
The servicing book acts as a hedge for the origination business. In addition, New Residential is currently pursuing a recapture strategy in which it will respond to payoff requests by soliciting the borrower for another mortgage. This is a way of making lemonade out of lemons. New Residential may lose the mortgage-servicing right, but it will still potentially get a new loan and a new servicing arrangement out of the refinancing.
Assets plus operating income equals a book value in the mid-teens
New Residential reported the book value at the end of the second quarter was $10.77 a share, a slight increase from the $10.71 it reported at the end of the first quarter. This reflects two things: First, we are still awaiting a recovery in non-government-guaranteed mortgage pricing. The Fed stepped into the mortgage market in April, which benefited guaranteed mortgages but didn't do anything for non-guaranteed mortgages. Second, it reflects continued issues in the servicing market, where forbearance policies instituted by the government are depressing valuations and servicing runoff. Servicing valuations are about the cheapest ever and represent a potential source of growth in book value.
The operating company is another potential source of book value as well. On the second-quarter conference call, New Residential CEO Michael Nierenberg explained the book value math:
This is a sheet we'd like to talk about our implied book value. Stated book value $10.77. If you look at our operating company and put some multiple on the earnings, if you take our earnings for our pre-tax earnings estimate for 2020 which we estimate to be between $750 million and $800 million and put approximately a three multiple on that that will give you enterprise value of something a little bit north of $2 billion. If you take that and then if you add the implied value of that $4 per share, our implied book value is between $14 and $15 per share.
Note that New Residential is trading at around $7.80 per share, which is a 28% discount to that generally accepted accounting principles (GAAP) book value. The company has $1 billion in cash and liquidity, and 95% of its liabilities are no longer subject to daily "mark-to-market" margin calls. The company will be much more insulated if we have another credit crisis. The substantial discount to book value probably will disappear as New Residential sells off more of its older, non-guaranteed mortgages. The company also has a 5% dividend yield.
In many ways, this aspect of the business looks pretty similar to PennyMac Financial Services (NYSE: PFSI), which has been on a tear this year as mortgage originators are making money hand over fist. New Residential entered the crisis as a non-agency mortgage REIT, which had a servicing arm and specialized in non-QM lending. It exits the crisis looking more like a combination of the old New Residential, AGNC Investment, and PennyMac Financial Services. It is now a completely different company and should be looked at as such.
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