With interest rates rising, the economic backdrop for mortgage real estate investment trusts (REITs) and mortgage originators is becoming more challenging. Rising rates mean less origination business as refinances dwindle, and mortgage-backed securities are under a cloud as the Federal Reserve reduces its buying.
That said, not all REITs and originators are the same, and some have set themselves up to take advantage of this environment. New Residential Investment (RITM 1.73%) has done exactly that via an unusual asset called mortgage servicing.
New Residential's portfolio is diversified
New Residential has several different businesses. First, the company is a mortgage REIT, which means it holds mortgages as an investment and collects interest. Second, New Residential originates mortgages and sells them, earning fees and a gain on sale profit when the loan is sold. Finally, New Residential holds mortgage servicing rights (MSRs), which are a highly unusual asset in that they increase in value as interest rates rise.
Mortgage servicing rights increase in value when rates rise
A mortgage servicing right is an asset that is created when a mortgage is originated. A mortgage servicer performs duties on behalf of the holder of the mortgage. The servicer sends out the monthly statements, collects payments and directs the principal and interest to the right investor, ensures that property taxes and insurance are paid, and handles defaults and delinquencies. In exchange for these services, the mortgage servicer collects an annual fee of 0.25% of the outstanding balance on the loan.
So why do mortgage servicing rights increase in value as rates rise? The answer lies in the expected life of that mortgage servicing right. While most mortgages are officially 30-year instruments, they almost never last that long. If the borrower refinances the loan or moves to another property, the mortgage gets paid off, and the mortgage servicing right ceases to exist. So, if rates fall, it becomes more likely that the mortgage will get refinanced, and the mortgage servicing right will cease to exist. This causes MSR valuations to fall.
However, if interest rates rise, then the chance of the mortgage getting refinanced falls, since no one will exchange a 3% mortgage rate for a 5% rate. When rates fall, the holder of the servicing right might only get that 0.25% fee for three years. But when rates rise, the holder of the servicing right might end up getting that fee for 10 years or longer. Put another way, when rates rise, the expected life of the mortgage servicing right increases and that makes it worth more money.
Mortgage servicing acts as a hedge for originators
For a mortgage originator, servicing acts as a natural hedge for the business. When rates fall, the mortgage originator can expect to see a big pickup in refinancing business. This increases volumes and earnings. On the other side of the coin, the value of its mortgage servicing rights will decline.
If interest rates rise, the originator will see a decline in refinancing activity, which will depress earnings. At the same time, the increase in rates will make the mortgage servicing worth more, which will offset the decline in its refinancing business. New Residential estimates that a 1% increase in mortgage rates will have a net positive $0.11-per-share effect on earnings.
The mortgage originators are out of favor due to the fears of rising rates and the Fed's exit from the mortgage market. While many have performed abysmally, New Residential has held up better than most, and investors who are looking to bottom-fish in the sector should pay attention to whether the originators are holding on to servicing. That can be an ace in the hole in a rising rate environment.