For investors, low interest rates are a triple threat.

They reduce income, and increase the temptation to take on outsized risk for a bit of extra yield.

But their most underrated effect is the speed at which the flood of cheap and plentiful capital can turn a promising profit opportunity into a money pit.

We’ve just witnessed this disaster in shale drilling, a revolutionary technology producing painful losses now that its amply financed practitioners have caused a global oil glut. The high yields seen in shipping are similarly the result of a cyclical slump brought on by overinvestment.

But there exists a space where competition is diminishing rather than growing, and where the available capital is dwindling rather than pouring in. This is the business of transacting and managing America’s $11 trillion of residential mortgage debt.

When mortgage originators sell their loans, they typically have to retain a quarter-point (25 basis points) interest in the mortgage in exchange for making sure that the monthly payments are collected, and that investors in mortgage-backed securities are paid on time even if the homeowner’s payment arrives late.

Rights and Wrongs

This profit stream is known as a Mortgage Servicing Right (MSR). All of the associated servicing responsibilities, which become significantly more onerous when a mortgage becomes delinquent, can be subcontracted to a specialist servicer for a fee of just 6 basis points or so. What’s left is known as the “excess MSR” and it’s a claim on a sliver of a mortgage payments stream without any of the associated responsibilities. The excess MSR is the mortgage originator’s retained interest in the loan stripped of direct servicing obligations, and can be sold like any other asset.

A quarter-point of interest on $11 trillion in mortgages works out to an income stream of $27.5 billion a year, so it’s a decent-sized market. Nearly three quarters of the outstanding MSRs are owned by banks, but the big ones at least have been shedding them in spurts, mindful of the limits placed on their MSR holdings under the recently implemented capital requirements. (Credit unions have similar issues.)

The other problem with excess MSRs is that they evaporate if a mortgage defaults or refinances. No mortgage payments means no trickle-down for the MSR holder. There has, of course, been a whole lot of defaulting and refinancing of U.S. mortgages in the relatively recent past, two other reasons why the business of buying up MSRs isn’t especially crowded at the moment.

Another obstacle is that mortgage originators who wish to retain their excess MSRs must be authorized by the agency securitizing the mortgage as a servicer and often have to be approved by the states where the mortgages were issued as well, a lengthy and costly process.

But what’s bad for the originator, be they a mom-and-pop origination shop or a megabank, has been very good for New Residential Investment (NYSE: NRZ), a specialist Real Estate Investment Trust that’s accumulated excess MSRs on mortgages with an aggregate unpaid balance of $415 billion. This investment is valued at $1.7 billion and New Residential expects to earn an annual rate of return of  15% to 20% on its MSR portfolio.

The Upside of Impaired Credit

Importantly, the MSRs should appreciate as interest rates rise, because this makes refinancing less attractive. Furthermore, 85% of the portfolio is credit-impaired, meaning the borrowers of those balances (with an average FICO score of 659) are unlikely to qualify for refinancing.

Yet as long as they keep making the payments, New Residential will keep getting paid. With incomes rising, unemployment low, housing coming on and the excesses of the last boom wrung out of the system, chances look good that they mostly will. The weighted average loan age of New Residential’s MSR portfolio is almost 9 years, so most borrowers have seen boom and bust, high rates and low, yet have neither defaulted nor refinanced.

MSRs account for 56% of New Residential’s investment portfolio. Two other nooks of the mortgage system’s intricate plumbing make up much of the remainder.


Source: company presentation

The company has advanced $8.6 billion to specialized servicers Nationstar Mortgage Holdings (NYSE: NSM) and Ocwen Financial (NYSE: OCN), which must provide temporary liquidity to their mortgage pools for eventualities such as delinquencies and foreclosure. These low-risk loans have priority over returns to investors in the underlying mortgages, and New Residential finances them with relatively short-term debt at a current interest rate of 2.2%. It’s compensated via mortgage servicing rights. Because 90% of the money advanced is borrowed, New Residential expects an average rate of return of 20% to 25% on the servicer advances portfolio, which it values at $639 million.

There’s also the $338 million net investment in non-agency residential mortgage-backed securities with a face value of $1.1 billion, dating back to the last boom and purchased at 73 cents on the dollar. These come with cleanup call rights that allow New Residential to redeem the securities at par value, repackage and re-securitize the performing loans at a premium and recover what it can from the non-performers over time. One brokerage analyst has argued the cleanup calls alone are worth more than half of NRZ’s current share price.

New Residential also has an interest in a consumer loan portfolio with $3.9 billion in outstanding balances, purchased in 2013 for $241 million. That investment has already produced $492 million in cash flow. Although the loans have a weighted average coupon a shade above 18%, the chargeoff rate has halved to 6.2% since the purchase.

All this adds up to sufficient “core” earnings to pay a 45-cent quarterly dividend currently yielding 12.6%. The payout was increased 18% in May, soon after New Residential bought out the assets of ailing rival Home Loan Servicing Solutions, an Ocwen affiliate.

Let’s Remake a Deal

The deal, originally structured as a merger, was subsequently changed to an asset sale, and the negotiated price reduced by 6% to $1.2 billion. That was after Ocwen acknowledged HLSS was having trouble rolling over its debt, apparent fallout from regulatory probes and sanctions over Ocwen’s handling of delinquent mortgages.

Although New Residential is not involved in servicing mortgages, it is a key lender to both Ocwen and Nationstar, which do, and the direct mortgage servicers are still struggling to cope with the increased cost of handling delinquencies and regulatory pressure not to cut corners in the process.

And HLSS serves as a reminder that New Residential’s business also crucially depends on leverage accomplished by bulk, low-cost borrowing. This lifeline would cost more if interest rates rise, and relies on the continued good will of lenders.

The regulatory risk extends to the Federal Housing Finance Agency’s longstanding interest in alternatives to the quarter-point MSR. If the FHFA, the overseer of mortgage securitization giants Fannie Mae and Freddie Mac, were to mandate a fixed servicing fee instead of the MSR it would severely crimp New Residential’s profitability, growth and therefore valuation. This is a four-year-old suggestion that still hasn’t been implemented by the FHFA in the face of strong private-sector opposition, but could be at any time as an administrative matter.

Another issue is that all this leveraged coupon-clipping goodness doesn’t come without significant corporate strings attached.

The Price of Success

New Residential’s portfolios are managed by representatives of the alternative assets manager Fortress Investment Group (NYSE: FIG), in exchange for rich fees comparable to those charged by top hedge funds or some MLP general partners. As a “permanent capital vehicle” of Fortress, New Residential owes it annual management fees equal to 1.5% of its equity and, now that it’s cleared the initial 10% hurdle, incentives amounting to 25% of subsequent earnings. In addition, Fortress is entitled to free options on 10% of the stock sold by New Residential in any offering, with a 10-year term but exercisable within 30 months.

The compensation structure provides incentives for Fortress to ramp up New Residential’s equity value and shares outstanding quickly, whether or not that benefits NRZ shareholders in the long run. That’s a real risk, but not a fatal flaw. Similar conflicts of interest are commonplace between MLPs and their general partners, as I’ve documented at length.

Less commonly, funds managed by Fortress also own majority stakes in Nationstar, a key New Residential business partner, as well as another lending affiliate with which New Residential does business. At least one savvy former Fortress and New Residential investor suspects that Nationstar has in the past sold MSRs to New Residential below cost, improving New Residential’s returns and the flow of incentives to Fortress. The implication is that the bottom line received an artificial boost that may not repeat. The effect is unlikely to be major, but has to temper some our enthusiasm over the company’s recent string of strong results and advantageous investments.

Still, barring a regulatory upset, the dividend appears to be sustainable and that 12% yield should decline by means of capital appreciation over time as the economy and the housing market gather speed.

Source: company presentation

New Residential has been hurt of late by its association with other mortgage REITs, which are vulnerable to declines in book value  as interest rates rise. New Residential will  not be affected in the same way because rising rates will tend to benefit its MSR portfolio.

The fundamental backdrop is certainly much healthier than in the energy industry at the moment. In fact, New Residential’s prospects are bright enough to warrant adding it to the Aggressive Portfolio.

The company reports dividend distributions on form 1099 and the bulk of its payout is classified as ordinary dividends, not the return of capital as with many energy MLPs. Buy NRZ below $17.