Updated: Feb 5, 2022
November 3, 2021 | New Residential Investment (NRZ) reported Q3 2021 earnings yesterday, providing an important window into developments in the mortgage industry. Unlike Mr. Cooper (COOP), NRZ reported higher gain on sale margins in Q3 2021. Revenue almost doubled from Q2 2021, but expenses also increased and, of note, servicing revenue was flat sequentially despite the close of the acquisition of Caliber Home Loans in August.
Source: NRZ Q3 2021
When NRZ closed the acquisition of Caliber, this added significantly to the firm’s top line as well as increased its mortgage servicing rights (MSR) portfolio. That said, the brisk rate of loan prepayments still visible in the industry took $421 million off the value of the NRZ MSR portfolio in the first nine months of 2021. These servicing assets as well as loans and MBS simply vanished in a cloud of prepayments, like magic. And no surprise, NRZ is still trading at book value.
Source: NRZ Q3 2021
A big question facing NRZ and other mortgage lenders and investors is the rate of prepayments going forward. Since 2020, prepayments on NRZ assets soared to over 30% annual rates on average spread across the firm’s portfolio. NRZ claims that originations exceeded MSR run off in Q3 2021, something the firm shares with COOP and other market leaders, but only due to great efforts in terms of recapturing refinance opportunities.
Source: NRZ Q3 2021
“During Q3’21, average portfolio speeds slowed for the third consecutive quarter but remain well above historical averages and have room for continued improvement as refinance burn-out continues,” NRZ states. “Newly created MSRs that are being added to our portfolio have a lower WAC and higher lifetime value than those paying off.” Well, maybe. If the Fed lowers rates again, those loans will prepay too.
We have observed previously that NRZ and other hybrid REITs do not have the luxury of being picky when it comes to asset purchases. When your book is running off at 25% per annum, buying or creating new assets is your one and only task. And you must replace assets that prepay before you can log any incremental growth, one of the unfortunate effects of the radical asset purchase policies of the US central bank. Thanks to Jerome Powell and the rest of the FOMC, we have asset price inflation, but zero or even negative duration in markets, sending asset returns falling towards the zero bound.
“Of course, it was not so long ago that lenders had primary-secondary spreads around 50 bps and lenders made more from the MSR’s monthly cash flows than they did on originating and selling a loan,” says Mike Carnes, Managing Director, Capital Markets MSR Valuation Group, at Mortgage Industry Advisory Corporation (MIAC). “Now we are making more from origination than from the MSR. This has created incentives for buyers to pay premiums for MSRs in the hope of recapturing some of the refinancing from a pool of loans.”
The folks at NRZ claim to have recapture rates in the ~ 70 percent range, but they are doing the calculation incorrectly – a common enough problem in the mortgage industry. For the record, the mortgage industry standard for calculating a recapture rate for an MSR portfolio is defined as:
Recapture rate = recapture fundings / all payoffs
Nothing is excluded. A good recapture rate across the industry is 20-25%. Some of the larger nonbank shops in the government sector get into the high 30s or better. Thus the restrictions on streamline refis of VA loans, for example, imposed by Ginnie Mae in a desperate but ultimately futile effort to slow prepayments on MBS.
Folks like NRZ, however, apparently look at payoffs where they can match a new loan to the same borrower on the same property, i.e, a refinance. In the adjusted recapture rate, the denominator is ONLY REFI’s vs all payoffs. IOHO, that’s cheating. But we digress.
While some observers believe that prepayment rates are likely to fall back down to 2020 levels, we remain skeptical of such statements. The simple reason is that the FOMC is unlikely to change the target rate for Fed funds until at least 2023, if ever.
NRZ points to estimates of the 10-year Treasury reaching 2.5% yield by 2023. We politely disagree and note that dollar swap spreads are inside Treasury yields from five years on out. Do you think there is brisk demand for dollar assets? Hmm?
We’d be very surprised to see the 10-year Treasury breaking 2% or even maintaining current levels given the strong bid for risk-free dollar collateral. Also, any slowdown in the US economy will force a choice between supporting employment or fighting inflation. The former, politically speaking, is the only part of the Humphrey-Hawkins mandate that matters at the end of the day.
Of course, if President Joe Biden continues to stumble politically and fails to reappoint Fed Chairman Jerome Powell for an additional term, then the interest rate calculous changes dramatically. With MD socialist and former bank regulator Lael Brainard as Chair designate, the 10-year Treasury yield would be at 3% before you can say “Goodnight Irene.”
The NRZ earning release has some points of interest. For example: “U.S. house prices have been growing at a 21% annualized growth rate over the last three months as a result of competition among buyers for a dwindling national housing supply.” Does this fact and the purchases of a non-QM originator by NRZ suggest a peak in asset prices?
To that point, the acquisition of Genesis Capital LLC from Goldman Sachs (GS) is another point of interest for investors. The market for non-QM loans, business purposes loans and fix and flip financing is a fringe market that exists in times of low interest rates and rising asset prices. As and when asset prices start to soften, however, the market for these loans likewise will start to evaporate as it did in April of 2020.
In our view, if Genesis was such a great business, GS would not be a seller. We think that the GS folks are too smart for that and realize that the fringe market in mortgage assets is a transient phenomenon. Once again, NRZ is buying at the top of the market in order to increase assets and drive nominal earnings. They have no choice. Stay big or go home.
In addition, while Caliber and Newrez Mortgage are being combined, there is still no hint of a spinoff of the lender from NRZ to finally separate the businesses from Fortress Investment Group and its parent company, Softbank. As we’ve noted before, the creation of an independent seller/servicer called Newrez a la PennyMac Financial Services (PFSI) to pair with the NRZ REIT a la PennyMac Mortgage Trust (PMT), would greatly enhance NRZ CEO Mike Nierenberg’s efforts. A spinoff could unlock shareholder value and hasten the rebuild of NRZ after the 2020 meltdown and subsequent prepayment blizzard c/o the Federal Open Market Committee.
Creating a good comp for the NRZ empire created by Michael Nierenberg and his team is just one reason for doing a Newrez spinoff, and sooner rather than later. The notorious Japanese investment firm that owns Fortress (and indirectly controls NRZ as the external manager of the REIT) has been involved in a number of dubious investment schemes, including Wirecard and WeWork, to name the short list. Softbank is now reported to be considering the sale of Fortress, which it acquired in 2017. That is great news for NRZ shareholders.
The Softbank purchase of Fortress never made sense to us. Of note, Bloomberg News reports that the Committee for Foreign Investment in the US (CFIUS) placed limits on Softbank’s corporate control of Fortress. Bloomberg reported:
“To win approval from the Committee on Foreign Investment in the U.S., SoftBank agreed to cede any control of day-to-day operations of Fortress. Since the transaction closed in December 2017, Fortress has been run independently.”
We think it speaks volumes as to the perception of Softbank by the US government that CFIUS would put such extraordinary limits on CEO Masayoshi Son’s control of a financial firm. CFIUS limits on direct foreign investments in the US usually are driven by national security concerns. Fortress founder Wes Eden is a leader in the world of finance, of course, but the CFIUS restriction on Softbank’s investment in Fortress is remarkable nonetheless. SoftBank shares have tumbled about 21% this year in Tokyo trading, compared with the 8% gain by the Nikkei 225 Index, Bloomberg reports.
The good news is that NRZ is growing and making strides in terms of asset creation and, especially, asset retention. The days when lenders could retain servicing for years and years are gone thanks to the FOMC. Duration is now zero. A blizzard of prepayments in both residential and small business loans has driven most of the hybrid REITS into the fringe markets of non-QM loans and fix & flip financing. NRZ today is the fourth largest originator in the US, but the asset mix is changing rapidly for all originators as they chase both yield and hopefully duration outside the world of agency loans.
Disclosures: NLY, CVX, NVDA, WMB, BACPRA, USBPRM, WFCPRZ, WFCPRQ, CPRN, WPLCF, UWMC (s), RKT (s)
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