Update: Ocwen & New Residential

In this issue of The Institutional Risk Analyst, we compare two major players in the residential mortgage servicing space, New Residential (NYSE:NRZ) and legacy servicer Ocwen Financial (NYSE:OCN). Although valuations in the mortgage sector have soared since April of 2020, these two firms have not fully benefitted from the low interest rate environment to the same degree.

The first difference to note is that NRZ is an externally managed REIT and OCN is a legacy distressed servicer and former thrift holding company. NRZ is managed by Fortress Investment, which is a unit of Japanese hedge fund Softbank (OTC: SFTBY) run by the notorious speculator Masayoshi Son. As we noted in the past, NRZ appears to be controlled by manager Fortress.

Both firms are lenders, investors in loans and servicing, and issuers of mortgage-backed securities backed by residential mortgages. And both firms are uniquely tied together by a series of asset sales over the past several years. WGA LLC served as and advisor to OCN from 2017 through 2019. Over the past 12 months, OCN’s equity underperformed to the upside (+24%). NRZ badly lagged the mortgage group to the downside (-43%) after a near-death experience last April.

Thanks to the low interest rate environment over the past year and also some considerable operational effort, both OCN and NRZ have seen significant increases in lending volumes. OCN reported $30 billion in total originations in Q4 2020, up three-fold from the $6.9 billion in Q1 2020. NRZ saw originations rise to a lesser extent to $23 billion in Q4 vs $11.4 billion in Q1 2020. The graph below comes from the OCN Q4 2020 earnings presentation.

For both lenders, lending margins continue to normalize after the record secondary market spreads seen during 2020. Average margins for OCN were expected to be at 77bp in Q4 vs 149 bp in Q2 2020. Total margins reported by NRZ were 185bp in 2020 vs 156bp in 2019 and 287bp in Q2 2020.

Significantly, OCN recently has just announced a deal with Oaktree Capital Management to acquire MSR that OCN will then subservice and provide loan-recapture services. There are two pieces to the deal: a $250 million subordinated debt capital investment in OCN and a ~ $200 million contribution to a MSR Asset Vehicle (MAV) to acquire MSRs. The Oaktree-controlled MAV will lever to ~ $460m in total capital to support $60 billion in UPB.

As we noted in a recent comment (“Update: Commercial & Residential Real Estate, MSRs”), lending profits are likely to decline during 2021 as competition for a dwindling pipeline of purchase and refinance loans will push secondary market spreads lower. Most issuers we have contacted in the past several weeks report shrinking mortgage backlogs. That said, there remain a number of sources of new purchase and refinance opportunities, in particular as loans currently under forbearance become current and can be sold into the secondary market.

Neither NRZ nor OCN are known as particularly strong lenders, thus the extraordinary performance seen in 2020 must be treated as a welcome anomaly. The next trade, reading the Q4 2020 earnings reports from both issuers, is clearly focused on MSRs as prepayments slow and interest rates perhaps rise from the lows of last year. Yet while OCN has recently raised significant outside capital, for NRZ the situation is more difficult since the REIT as a pass-through vehicle cannot retain significant capital.

Although NRZ was a significant issuers of non-QM loans in 2019, in 2020 that market essentially evaporated. As a result, the bulk of the new issuance by NRZ in 2020 was in conventional and government MBS. Indeed, one of the biggest deployments of capital by NRZ in Q4 2020 was the purchase of $3.9 billion in agency MBS, hardly a trade that is likely to enhance earnings given the negative returns in that asset class due to high prepayment rates on MBS. The chart below is from the NRZ Q4 2020 earnings presentation.

The biggest expense facing both NRZ and OCN at present is the runoff of MSRs due to prepayments on MBS and loans held in portfolio. The high rate of prepayments on the NRZ portfolio drove servicing revenue negative $213 million in Q4 2020. The pressure on NRZ to maintain and grow its common dividend has compelled the REIT to grow leverage on its book to 3.6x at the end of 2020 compared with 2.8x as of September 2020. Meanwhile, OCN (and other issuers, of note) is deliberately taking down leverage below 1x as management calls in legacy term debt.

One of the big questions facing both NRZ and OCN is whether they can add to their servicing business in the face of record levels of prepayments on MBS. So far, both firms have managed to originate and/or buy MSRs sufficient to keep their portfolios stable or even slightly growing. But if you look at the calculation of book value for NRZ, for example, income from loan origination and servicing, and investment results at $1.25 per share, just barely exceeded the $1.08 per share in cash flow losses on the MSR.

OCN under CEO Glenn Messina has largely stabilized its business model and seems set for modest growth now that the relationship with Oaktree is in place. The biggest assets of OCN, in our view, is the servicing capacity this issuer has available, especially in distressed assets, and the veteran operating team. If OCN can grow its servicing book and position itself as an alternative to price leaders such as industry giant Cenlar FSB, then the added value of high touch distressed servicing capacity will emerge.

Unlike OCN, which has integrated itself with the PHH business it acquired in 2018, NRZ continues to struggle with its business configuration. As a REIT, NRZ cannot have taxable operating businesses above a certain size limit without running afoul of IRS rules. Yet the purchase of Shellpoint in 2018 solved some considerable business issues, particularly being able to acquire Ginnie Mae MSRs. Now, however, NRZ has publicly stated the intention to spin off Shellpoint, a decidedly second-tier issuer and servicer of residential mortgages.

“With rates plummeting to historic lows last year, our 2018 acquisition of NewRez, formerly known as Shellpoint Partners, put us in a position to consolidate our servicing and grow our origination business,” NRZ CEO Michael Nierenberg told investors. “This has helped to offset some of the amortization we have seen in our MSR portfolio and help to grow earnings for our company.”

The acquisition of Shellpoint in 2018 solved an operational problem for NRZ, but also created a problem because the lender is constrained as the taxable appendage of an externally managed REIT. NRZ now proposes to solve this dilemma by spinning off the lender into an IPO. But the market for mortgage IPOs is cooling rapidly. On the subject of an IPO for Shellpoint, Nierenberg commented:

“We continue to evaluate what a total separation would mean to the company, meaning NRZ or -- and New Res. So if we think that it will create more value for shareholders by separating the company and bringing it into the public markets it's something that's absolutely on the table. As you've seen from some of the recent either attempts or IPOs that have come out with some of our friends and peers on the mortgage company side, some of them have gone okay, others have not gone as well.”

Both OCN and NRZ spend a lot of time talking about the potential benefit of rising interest rates for the value of MSRs. We agree with that view, but wonder how and when we will see a significant increase in interest rates given global trends in the opposite direction. Also, there is the stated policy of the FOMC to continue purchases of MBS. We worry that lending volumes may slow in 2021 and with shrinking secondary market margins, but MSR valuations may remain under pressure even as investor interest in the asset class grows apace.

“There is not a lot of yields in the market,” Nierenberg told investors this week with respect to modest, < 3% gross yields available in non-QM lending. “We don't want to chase everything that's out there. We're going to continue to maintain higher levels of cash and think about ways that we could be deploy capital in an accretive way. I did point out that we think MSRs here are very, very cheap.”

We agree with Nierenberg that MSRs are relatively cheap given the interest rate environment, but we also note the huge amount of capital and operational resources that are focused on the opportunity in 1-4 family residential mortgages. Every player in the mortgage sector is talking about increased market share in lending and servicing. And every player is adding staff and operations resources to make it all happen before the opportunity passes.

Yet when volumes start to fall, whether due to rising interest rates or simply burn-out in terms of available lending customers, the capacity building process will also be reversed and cost-cutting will become the new mantra. Veteran mortgage industry consultant Joe Garret wrote to his clients recently:

“We don’t want to scare anyone, but this is a good reminder of just how much volume can drop. Remember 2018 when you were wondering if you should find a new career? The majority of our clients don’t have a contraction plan for when rates someday go back up and loan volume goes down. If you do have such a plan, how about addressing the possibility that rates drop? What if rates drop to 1% in 2022? If you hold too much servicing relative to your expected volume, you could be in trouble.”

The fact that NRZ uses the overly-pessimistic production projections from the Mortgage Bankers Association to justify its view of short-term upside in MSR valuations is suspect in our view. We expect volumes to be significantly higher than the MBA estimates, but on lower margins. This means that firms such as OCN and NRZ will be making less on lending, but MSR valuations may not rise as much as expected by either NRZ or OCN – until lenders start to focus again on asset management instead of manufacturing new assets.

Bottom line is that both NRZ and OCN have benefited from the low interest rate environment and have strengthened their balance sheets and income statements since April’s market meltdown. Consider the fact that OCN is up 24% over the past 12 months, this after doing a reverse split in 2019. NRZ is down 43% over the past twelve months and bellwether Penny Mac Financial Services (NASDAQ:PFSI) is up 63% over the same period. As usual, the market is right in relative terms, but for reasons that most professional equity managers neither know nor understand.

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