New residential betting service may beat the Fed

“Don’t fight the Fed” is an old market saw. When the Federal Reserve starts to raise rates, the markets are vulnerable, especially right now, in the area of ​​mortgages. In the latest Federal Open Market Committee minutes, most participants predicted that the Fed would start cutting its purchases of Treasuries and mortgage-backed securities at the end of the year. New residential investment (NYSE: NRZ) believes its current economic model will allow it to thrive no matter what the Fed does. Thanks to a somewhat obscure asset, they may be right.

The Fed was a positive wind for the mortgage industry last year

At the start of the COVID-19 pandemic, the Federal Reserve cut interest rates to the bottom and began buying $ 80 billion per month in treasury bills and mortgage-backed securities, all for stimulate demand in the economy. This activity has been a boon to mortgage originators, triggering a wave of mortgage refinancing activity. Many designers like Rocket and UWM Holdings took advantage of the environment to conduct IPOs.

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But going forward, the Fed will become a headwind for the mortgage industry.

As more Americans get vaccinated and the economy begins to recover, the Federal Reserve seeks to reduce its footprint in the mortgage market. Since the Fed is one of the largest buyers of mortgage-backed securities, its exit will cause mortgage rates to rise, while lowering the prices of mortgage-backed securities relative to Treasuries. This is generally bad news for companies like New Residential Mortgage Real Estate Investment Trust.

Mortgage management fees like higher rates

New Residential’s strategy to mitigate the Fed’s effects relies on its holdings of Mortgage Management Rights, or MSRs. These somewhat esoteric financial instruments have an unusual aspect that sets them apart from virtually all other financial securities: unlike stocks and bonds, they to augment price when interest rates rise.

Every newly created mortgage has two parts: the loan itself and the service – the right to handle the administrative tasks of the loan and get paid for it. When New Residential issues a mortgage, it will sell the loan itself in the market and keep the service – aka the MSR – to itself.

Mortgage agents send the borrower their monthly bill, make sure taxes and insurance are paid, report the interest paid to the IRS, and deal with the borrower if they have issues and can’t make the payment. monthly payment. In return, the servicer earns 0.25% of the loan amount per year. If the borrower is like the vast majority of borrowers, the service agent has a fairly easy job, raising $ 1,000 per year on a $ 400,000 loan to send out bills and cash checks.

The right to repay the loan (and collect these fees) is worth something. The owner can sell this mortgage management right for cash, or keep it and collect the fees. If interest rates rise, the chances that the borrower will prepay the loan decreases, as it does not make sense to take out a 4% mortgage to refinance a 3% mortgage. With borrowers likely to need services for a longer period, the expected life of the MSR increases. This is why its value increases along with the rates.

New Residential is betting that when the Fed starts raising rates, it can create fewer mortgages, but its portfolio of mortgage management rights will take over. It’s hard to say if this will happen, as there are a lot of moving parts here, but the basic theory is correct. Keep in mind that mortgage management rights are usually not a large part of New Residential’s balance sheet. It holds $ 4.2 billion in mortgage management rights, which represents approximately 11% of assets. New Residential plans to hold them as an asset and collect management revenues. When rates rise, the value of the portfolio will rise, which will hopefully offset lower mortgage origination income.

New residential is cheap right now

New Residential is currently trading at an extremely low price. He just declared a book value per share of $ 11.27 and the stock is trading at a steep discount. The market fundamentally ignores the value of the origination business and values ​​New Rez as a garden type mortgage REIT. On the earnings conference call, CEO Michael Nierenberg reiterated the company’s view that if you assign a multiple of earnings to the mortgage branch, the book value per share should be around $ 13 to $ 15. $ per share.

The problem with the industry as a whole is that investor sentiment is quite negative given the Fed’s stance. New Rez is a value stock at this point, and considering its quarterly dividend of $ 0.20, it has a yield of over 8%. Investors are paid pretty well to wait and see if New Residential’s bet is correct and the mortgage service will compensate for the problems when rates rise. Income investors should take note.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

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