The first quarter of 2022 was supposed to be particularly brutal for mortgage originators and mortgage real estate investment trusts (REITs). The Fed has begun a series of increases in the Fed Funds rate designed to put the brakes on rising inflation. At the same time, the Fed is preparing to let its holdings of mortgage-backed securities decrease.
Rising rates are bad news for mortgage originators, and reduced demand for mortgage-backed securities is bad news for mortgage REITs. New Residential (NRZ 0.35%) managed to report an increase in earnings and book value per share. So what are they doing differently?
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A highly diversified mortgage company
New Residential operates three basic businesses. First, it invests in mortgages and mortgage-backed securities and earns interest income from these investments. This is the typical mortgage REIT model. Second, New Residential operates a mortgage origination business where it purchases completed loans from independent mortgage originators and then sells them into the market via securitization transactions. Finally, New Residential is a mortgage servicer, and this business line accounted for much of the company's earnings in the first quarter.
NYSE: NRZ
Key Data Points
Mortgage servicing rights are an unusual asset because they increase in value as interest rates rise. Here is how they work. When a mortgage loan is completed, there are two assets that can be split off and sold separately. The first is the loan itself, which an investor would hold to collect the monthly payments. The second is the mortgage servicing right, which represents the right to handle the administrative tasks of the mortgage for a fee.
Mortgage servicing performed well in the first quarter
The mortgage servicer handles the mundane tasks on behalf of the ultimate investor in the mortgage loan. The servicer sends out the monthly bills and statements, collects the money and forwards it to the investor, ensures that property taxes are paid on time, and deals with the borrower if the loan becomes delinquent. If the borrower ends up defaulting, the servicer takes care of the foreclosure.
In exchange for performing these functions, the servicer earns a fee (usually about 0.25%) or one-quarter of one percent of the outstanding mortgage balance per year. If the borrower makes the monthly payments on-time servicing is a pretty easy job. A servicer handling a $400,000 mortgage will get paid about $1,000 per year.
When interest rates rise, the servicer can expect to get that servicing fee for a longer time. This is because it won't make sense for a borrower to refinance the loan because rates are higher. Nobody is going to refinance a 3% mortgage with a 5% one. This makes the servicing worth more.
For New Residential, servicing accounted for 60% of revenue in the first quarter, which was split between servicing fees and an increase in the value of its servicing portfolio. In the fourth quarter of 2021, servicing accounted for only 28% of revenue. Total servicing revenue increased from $310 million in the fourth quarter of 2021 to $1.03 billion in the first quarter of 2022.
The dividend is well covered
This increase in mortgage servicing also drove a 10% increase in book value per share to $12.56 per share. The $0.25 quarterly dividend was well covered with $0.37 per share in core earnings. At current levels, New Residential pays a dividend yield of 8.7%, which is pretty solid considering the earnings. The entire mortgage REIT and mortgage origination sector is suffering from a tough macroeconomic environment and dour investor sentiment, but New Residential managed to increase book value per share by 10% amid rising rates. New Residential is worth a look for income investors.
