"Don't fight the Fed" is an old market saw. When the Federal Reserve starts raising rates, markets are vulnerable -- especially right now, in the mortgage space. In the latest Federal Open Market Committee minutes, most participants anticipated the Fed would begin scaling back its purchases of Treasuries and mortgage backed securities at the end of the year. New Residential Investment (RITM -0.63%) believes that its current business model will allow it to prosper no matter what the Fed does. Thanks to a somewhat arcane asset, they might be correct. 

The Fed was a tailwind for the mortgage business last year

In the beginning of the COVID-19 pandemic, the Federal Reserve cut interest rates to the floor and began purchasing $80 billion a month in Treasuries and mortgage-backed securities, all to stimulate demand in the economy. This activity was a boon for mortgage originators, unleashing a wave of mortgage refinance activity. Numerous originators like Rocket and UWM Holdings took advantage of the environment to conduct initial public offerings.

Picture of the Federal Reserve Building

Image source: Getty Images.

But going forward, the Fed will become a headwind for the mortgage business.

As more Americans get vaccinated and the economy starts recovering, the Federal Reserve is looking to reduce its footprint in the mortgage market. Since the Fed is one of the biggest buyers of mortgage-backed securities, its exit will drive mortgage rates higher, while driving down mortgage-backed securities' prices relative to Treasuries. This is generally bad news for companies like mortgage real estate investment trust New Residential. 

Mortgage servicing rights like higher rates

New Residential's strategy to mitigate the effects of the Fed rests upon its holdings of mortgage servicing rights, or MSRs. These somewhat esoteric financial instruments have one unusual aspect that sets them apart from virtually every other financial security out there: Unlike stocks and bonds, they increase in price when interest rates rise.

Every newly created mortgage loan has two parts: the loan itself, and the servicing -- the right to handle the loan's administrative tasks, and get paid for it. When New Residential originates a mortgage, it will sell the loan itself into the market and keep the servicing -- aka the MSR -- for itself.

Mortgage servicers send the borrower their monthly bill, ensure that taxes and insurance get paid, report interest paid to the IRS, and deal with the borrower if they get into trouble and cannot make the monthly payment. In return, the servicer earns 0.25% of the loan amount per year. If the borrower is like the vast majority of borrowers out there, the servicer has a pretty easy job, collecting $1,000 a year on a $400,000 loan for sending bills and cashing checks. 

The right to service the loan (and collect that fee) is worth something. The owner can sell that mortgage servicing right for cash, or hold it and collect the fees. If interest rates rise, the chance of the borrower repaying the loan early decreases, since it won't make sense to take out a 4% mortgage to refinance a 3% one. With borrowers likely to need servicing for a longer period of time, the expected life of the MSR increase. That's why its value rises alongside rates.

New Residential is betting that when the Fed starts increasing rates, it may originate fewer mortgages, but its portfolio of mortgage servicing rights will pick up the slack. It is hard to tell whether that will come to pass, since there are a lot of moving pieces here, but the basic theory is correct. Keep in mind that mortgage servicing rights are generally not a big part of New Residential's balance sheet. It holds $4.2 billion in mortgage servicing rights, representing about 11% of assets. New Residential plans to hold these as an asset and collect the servicing income. When rates rise, the value of the portfolio will increase, and that will hopefully offset the decline in mortgage origination income. 

New Residential is cheap right now

New Residential is trading extremely cheaply right now. It just reported book value per share of $11.27 and the stock is trading at a hefty discount to that. The market is basically ignoring the value of the origination business and valuing New Rez like a garden-variety mortgage REIT. On the earnings conference call, CEO Michael Nierenberg reiterated the company's view that if you assigned an earnings multiple to the mortgage arm, book value per share should be around $13 to $15 per share. 

The problem with the entire sector is that investor sentiment is pretty negative given the posture of the Fed. New Rez is a value stock at this point, and given its $0.20 quarterly dividend, it has a yield topping 8%. Investors are getting paid pretty well to wait and see whether New Residential's bet is correct and mortgage servicing will offset the issues when rates rise. Income investors should take note.