After experiencing one of the best years in over a decade, mortgage bankers are being treated as suspect by the market. Investors are fretting about rising mortgage rates choking off the refinance market, and increased competition among bankers suppressing margins. In this environment, a mortgage banker with several additional business lines like New Residential Investment (NYSE:NRZ) can be a good way to navigate the current environment. 

New Residential is officially a mortgage real estate investment trust (REIT) and holds a $15.9 billion portfolio of mortgage-backed securities and residential whole loans. The company also owns $5.4 billion of mortgage servicing rights (MSRs) and is the largest nonbank owner of mortgage servicing rights.

Abstract picture of interest rates

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Mortgage servicing rights are an unusual asset

Mortgage servicing rights are interesting in that they increase in value as interest rates rise; pretty much every other financial asset (stocks, bonds) decreases when this happens. Since mortgage originators are likely to see refinance activity fall when rates rise, the mortgage servicing asset can help offset this decline in volumes. 

Here is how a mortgage servicing right works: Mortgage servicers handle the administrative tasks of a mortgage loan. They collect the monthly payment, ensure that the owner of the loan gets the principal and interest due, and ensures that property taxes are paid and that homeowners' insurance is up-to-date. If the borrower gets behind on the payments, the servicer works with the borrower to get the loan current or modified. If the borrower defaults, the servicer handles the foreclosure process. For performing these tasks, the servicer gets 0.25% of the value of the loan per year. 

Mortgage servicing can offset the decline in origination volume

From an investor's point of view, the servicer is going to get 0.25% a year, but the question is for how long. If the borrower refinances the loan within a short period, the asset isn't worth much. On the other hand, if the borrower keeps the loan for a decade, then the asset is worth quite a bit.

Much of that value depends on what interest rates are doing. If rates are going up, then the borrower won't have any incentive to refinance, and the mortgage servicing right is worth a lot. This increase in servicing will help offset declining revenue from the origination business. 

On the first-quarter earnings conference call last week, CEO Michael Nierenberg explained it this way:

With refinancing volumes significantly lower and the purchase market for housing expected to remain robust, there is nobody that will be better positioned to take advantage of this scenario than us. As we look ahead, our investment business is well positioned to take advantage of higher rates with MSRs leading the way. It will go up as rates rise, leading to more cash flow and higher earnings. The addition of Caliber [Home Loans] and the great strides we have made around recapture at NewRez will offset the lower expected earnings we will see in the origination business as gain on sale margins continue to shrink.

Servicing income accounted for 44% of revenue in the first quarter, which was a function of servicing income and an increase in servicing values. As a percentage of the loan amount, they increased from 1.06% to 1.19%. Management said on the earnings call that it sees much more upside in the asset as rates rise. 

New Residential reported that book value rose 4.4% during the quarter to $11.35 per share. At current levels, the stock is trading at a 13% discount to book value, which is pretty large for the mortgage REIT sector these days. The stock also pays a quarterly per-share dividend of $0.20, which gives the company a 7.8% dividend yield. For income investors, New Residential provides a decent dividend yield, plus has an operating business that makes it less sensitive to the vagaries of the mortgage-backed securities market. 

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.