The first quarter was one of the toughest ever for mortgage real estate investment trusts (mREITs). As the coronavirus pandemic set in, creditors pulled back, liquidity vanished almost overnight, and new legislation introduced massive uncertainty. Mortgage-backed securities, even government-insured ones, fell like a tech stock after a bad earnings report. And the Fed stepped in to support the market, which introduced a whole slew of new headaches.

Every player in the sector took its lumps -- even the agency mREITs, which specialize in government-guaranteed loans. Many others had near-death experiences. The non-agency REITs suffered the worst. How did one of the leaders in that space handle it?

Hand preventing dominoes from falling

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A complete overhaul of the balance sheet

New Residential Investment Corp. (NYSE:NRZ) described Q1 as a "tale of two quarters" on its earnings call. From Jan. 1 through March 13, the company was on track to earn $0.65 per share. In the last two weeks of March, that fell by $0.17, and the company came in at $0.48. Book value per share declined by almost a third, from an estimate of roughly $15.80 to a final mark of $10.71.

New Residential also exited the non-qualified mortgage lending business to focus on government-backed lending. Burned by falling prices on non-agency mortgages, the mREIT has decided to focus on liquid securities, at least for the near term.

What does this mean for New Residential's earnings? It's a trade-off. Non-agency loans generally have much higher rates and profit margins. They are also much more susceptible to the movements of the credit markets in that they are the first programs halted when credit markets become illiquid. The agency lending market is much more competitive, which means profit margins are lower. But in tough credit markets, lenders can still sell loans. With non-agency loans, the market can go "no bid" at times.

Going into the first quarter, mortgage servicing represented about 18% of New Residential's investment portfolio. It is now 46%. Non-agency residential mortgage-backed securities and loans accounted for 79% of the portfolio at the end of last year. They now represent 47%. Leverage fell from 3.5 times to 1.7 times. This reduction in leverage gives the company more breathing room if asset prices continue to fall, and also some powder if some bargains present themselves. Finally, New Residential recently sold $600 million of senior debt with warrants at an eye-popping yield of 11%. This will allow the company to reduce its reliance on short-term funding vehicles, but that is incredibly expensive financing.  

Mortgage servicing is going to be tough for a while

The mortgage servicing business will certainly struggle with forbearance. New Residential has prepared for this environment by increasing its advancing facilities by $1.8 billion to $5.3 billion.

Advances are one of the negatives of mortgage servicing. A mortgage servicer handles the administrative tasks of the loan once it has been closed. The servicer sends out the monthly bills, collects the money, and distributes it to the ultimate holder of the loan. And the servicer ensures taxes and insurance are paid, handles IRS reporting, and deals with the borrowers if they default. The servicer is generally paid 0.25% of the loan balance every year as compensation.

One of the problems for servicers comes when a lot of borrowers default at once -- since the servicer is required to pay the bills on behalf of the borrower, the cash drain can become extraordinary. By taking down these advance lines of credit, New Residential can borrow the money to fund these advances, which will be paid back once the borrower gets current or the home is foreclosed. It has plenty of experience with this issue: During 2015, the company had $8 billion worth of advances outstanding.

Putting it all together

The risk profile for New Residential is much different now. It can be looked at as a mortgage originator that has a large servicing book and a portfolio of non-agency loans and bonds. Servicing can be a lucrative business with return on equity in the high teens. Mortgage origination is a feast-or-famine business that ebbs and flows with interest rates, but it can be a reasonable cash generator that doesn't take much investment risk. In many ways, New Residential is going to look much more like PennyMac Financial Services, which is one of the few non-bank pure-play mortgage originators. Servicing and origination react in different ways to changes in interest rates, which makes earnings more stable.

New Residential is trading at a 35% discount to book value, which means the market is heavily discounting the value of the servicing book. Servicing values in the market have collapsed since the CARES Act required servicers to grant forbearance requests to anyone who asked for it. The stock represents a bet on servicing values improving, particularly non-agency servicing values. When that will happen is anyone's guess.

Corrections (May 24, 2020): The original version of this report incorrectly stated the form of New Residential's future dividends. Also, the comparison between New Residential's mortgage servicing and non-agency mortgage-backed securities and loans from the fourth quarter of 2019 to the first quarter of 2020 was based on its investment portfolio.

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