Mortgage originators are coming off their best year since 2003 after COVID-19 pushed the Federal Reserve to cut interest rates, which prompted a massive wave of refinancing activity. This year was expected to be almost as good, but rising interest rates have forced many in the industry to trim expectations.

Meanwhile, Fannie Mae just threw a curveball at the industry, announcing that it would limit the total number of investment property loans it will guarantee to 7%. This change is bad news for most originators -- however, that loan demand will get fulfilled somewhere else, and that is where New Residential (NYSE:NRZ) comes in. 

Picture of a mortgage loan application

Image source: Getty Images.

The government attempts to insulate the taxpayer from further risk

In the waning days of the Trump administration, Treasury Secretary Steve Mnuchin sent a letter to the Federal Housing Finance Agency (FHFA), which oversees Fannie Mae and Freddie Mac. The letter instructed Fannie and Freddie to limit their purchases of non-owner occupied properties to no more than 7% of their portfolio. The change is meant to limit the amount of credit risk the two government-sponsored enterprises take on. There was also further language limiting the amount they could buy from any one lender.

Here is what this means in practice. Government-guaranteed investment property loans are about to get much more expensive, and a lot harder to get. The demand for investment property loans will remain, however, and prospective lenders will turn to non-government guaranteed loans. According to the Urban Institute, Fannie Mae and Freddie Mac use investment property loans as a cash cow to subsidize affordable housing initiatives. These loans are highly profitable, and that means lenders will want to make them. 

New Residential is one of the best known non-QM lenders

Non-government-guaranteed mortgages have generally not been the purview of banks since the housing bubble burst in 2008. The volume has been sparse, and limited to a few lenders. Loans that don't fit into the Fannie or Freddie box are called non-qualified mortgages (non-QM). The most well-known lender is probably New Residential, which had to temporarily suspend its non-guaranteed lending during the COVID-19 crisis. New Residential has the infrastructure already in place for this sort of lending, so it has a head start. 

Part of the issue with non-QM issuance has been a reluctance on the part of investors (including pension funds) to purchase non-QM-mortgage-backed securities. My sense is that part of this is due to the lack of a track record on issues like prepayments and defaults. That makes the loans hard to model, and therefore investors are reluctant to get involved. This changes if plain vanilla investment property loans become the mainstay of non-QM lending. There are oodles of data showing how these loans perform, which should give investors more comfort. 

This change will help origination income, and New Residential's assets

New Residential is an interesting story to begin with. As a hybrid mortgage real estate investment trust (REIT) and mortgage originator, it earns income from investments and fees. In 2000, the decrease in interest rates caused the company to write down the value of its mortgage servicing assets, but that will reverse as rates increase. The change from Fannie Mae will also positively affect the current value of outstanding mortgage-backed securities, since it reduces the likelihood of early payments. 

New Residential is trading right around the book value of its asset portfolio, which assigns almost no value to mortgage origination operations. The company filed a confidential prospectus with the Securities and Exchange Commission last year that apparently contemplated spinning off the mortgage ops into a separate company in the hopes that the market would assign a value to it. While the dividend was on a roller coaster ride last year due to volatility in the bond market, the stock yields 7.4% at Monday morning's prices, much more than that of any other originator and up there with the big agency mortgage REITs like Annaly Capital Management and AGNC Investment Corp.

There are lots of ways to win with this stock, and it is one of my CAPS picks. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.