March was a hideous month for the mortgage real estate investment trust (REIT) sector. COVID-19 has created a financial crisis for the mortgage sector that rivals 2008 in its severity. Even agency REITs, which invest in mortgages guaranteed by the government, have suffered.

New Residential (NYSE:NRZ) is a mortgage REIT that originates a lot of mortgages that are not guaranteed by the government. The market for these loans has nearly completely frozen, and that forced the company to take drastic action to protect itself -- including cutting its dividend. 

How REITs, like New Residential, finance their positions

Like most mortgage REITs, New Residential finances its mortgage portfolio via the repurchase market. Essentially, the REIT sells a security to a counterparty and agrees to buy it back on a certain date at a specified price. The difference between the up front sales price and the repurchase price represents the interest paid on the loan.

If New Residential defaults on its agreement to buy back the mortgages, the bank keeps the collateral. The problem starts when these securities begin to decline in value. When that happens, the counterparty issues a margin call, requiring New Residential to deposit extra cash as collateral for the loan. 

Picture of a keyboard with a red margin call key.

Image source: Getty Images.

Margin calls drive a distressed RMBS sale

Over the past several weeks, non-agency mortgage-backed securities have been crushed, and the banks have been demanding additional margin. New Residential sold a large portion of its non-agency portfolio in order to meet margin calls and reduce risk in the portfolio. The company sold $6.1 billion face amount of its $24.9 billion non-agency portfolio. About $7.3 billion of non-agency residential mortgage-backed securities (RMBS) were financed with repurchase agreements at the end of 2019.

A writedown and a dividend cut

On March 31, New Residential put out an update on the portfolio and COVID-19. Book value had declined by about 25%-30% from its level of $16.29 per share at the end of 2019. The company cut the dividend by 90%, from $0.50 to $0.05 per share.

On April 1, New Residential announced that it had reached an agreement to sell some of its non-agency assets. According to Michael Nierenberg, chairman, chief executive officer, and president of New Residential: 

While mortgage assets have stabilized relative to recent weeks, our focus in this environment continues to be de-risking, increasing our liquidity and protecting our book value. In line with those goals, we sold a portfolio of non-agency securities and reduced our short-term financing exposure. We believe this measure, as well as others we have taken during the recent volatility, are crucial to preserving long-term shareholder value.

Servicing -- the next headache

While margin calls have been the first shoe to drop, the second one is servicing. New Residential owns a lot of mortgage-servicing assets, and right now, mortgage servicers of any government-backed mortgage are required to grant borrowers forbearance on their mortgage for up to a year.

This is a major problem for servicers as they are required to advance (in other words, pay) the borrower's missed payments to the ultimate holder of the loan. Non-bank servicers generally don't have the ability to do that if borrowers request forbearance en masse. They simply don't have the money. The government is aware of the problem and will almost certainly do something to address it, but in the meantime, the uncertainty makes mortgage servicing a highly risky asset.

At New Residential, the servicing book is carried at $4.5 billion on the balance sheet. Given that the mortgage-servicing market is frozen right now, it is impossible to come up with a market value for the book. For the time being, the servicing book will be based on a theoretical model, and the huge drop in interest rates will cause it to take a hit. A good portion of the book will run off, once the mortgage markets start thawing out. The servicing book represents about $10.94 per share of book value.

So, while New Residential may appear to be trading at a big discount-to-book value, it is hard to tell whether any servicing writedown was included in the 25%-30% estimate. Luckily, it appears that New Residential values its servicing book on the conservative side. That said, until the government comes up with some sort of solution to the advance issue, the stock is basically a binary bet on survival, which is a function of the good will of the government.