Last year was horrible for the mortgage space. The Federal Reserve hiked the fed funds rate in a series of aggressive steps from nearly 0% to 4.25%. This caused a collapse in mortgage origination and began a period of underperformance for mortgage-backed securities. In spite of that, Mr. Cooper Group (COOP -0.04%) has been one of the top performers in 2022 in the mortgage space. However, can that outperformance continue in 2023?
Last year was awful for mortgage banking
Mr. Cooper is a mortgage originator and mortgage servicer. Like most mortgage bankers, it was hit hard by rising interest rates, which eliminated the incentive for consumers to refinance their homes. If a borrower refinanced a home in 2020 with a 3.5% mortgage rate, there is no reason to refinance at 6.5%. It doesn't make financial sense. In addition, the home purchase market has taken a hit as rising rates and home prices have made housing much less affordable than a couple of years ago. The refinance market has virtually disappeared, and the purchase market is down some 35% compared with a year ago.
The bright spot for Mr. Cooper has been in mortgage servicing. Most mortgages are bundled into a mortgage-backed security and end up being held by a pension fund, by a mortgage real estate investment trust, or on the balance sheet of a bank. A mortgage servicer handles the administrative duties for a mortgage on behalf of the ultimate mortgage holder. The servicer sends out the monthly bill, collects and forwards the principal and interest payments, ensures property taxes are paid, and works with the borrower if he or she becomes delinquent. The mortgage servicer is paid 0.25% per year on the mortgage balance. So, if the mortgage is $400,000, the servicer gets paid $1,000 per year.
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Mortgage servicing rights are an unusual asset
The right to perform this service is worth something, and it's counted as an asset on the balance sheet. For the third quarter ending Sept. 30, 2022, mortgage servicing rights accounted for half of Mr. Cooper's assets. The mortgage servicing portfolio is revalued every quarter and can increase or fall based on numerous variables like interest rates or delinquency rates. Mortgage servicing is one of the few assets that increase in value as interest rates rise. This is because as interest rates rise, borrowers don't have any incentive to refinance, so the holder can expect to get that servicing fee longer. Conversely, when rates fall, the borrower has the incentive to refinance, and when that happens the mortgage servicing right disappears since the mortgage gets paid off. Mortgage servicing rights are extremely sensitive to interest rate movements.
Mortgage servicing acts as a hedge for the origination business
Mortgage originators like to hold mortgage servicing rights because it acts as a natural hedge to the mortgage origination business. This effect becomes obvious when you look at Mr. Cooper's third-quarter results. In the third quarter, mortgage servicing revenue accounted for 77% of Mr. Cooper's revenue. Gain on sale (or mortgage banking revenue) accounted for the remainder. A year ago, the mortgage market was very different. Low rates made the banking business highly profitable. In the quarter ending September 2021, gain on sale accounted for two-thirds of Mr. Cooper's revenue, while servicing accounted for a third. Note that servicing wasn't able to offset the entire decline in mortgage banking -- mortgage banking revenue fell by $457 million, while servicing revenue increased by $107 million.
If we look forward to 2023, servicing revenue will be negatively affected by two major factors. First, if the U.S. enters a recession, delinquencies will rise, which will increase the cost of servicing the portfolio. Second, Mr. Cooper won't get any further benefit from rising interest rates. We probably won't see enough of a drop in rates to see refinance activity, but this tailwind will be over.
Mr. Cooper is trading at 8.4 times expected 2023 earnings per share, which is on the high side for a mortgage banker. Mortgage companies rarely trade with big multiples because the industry is so cyclical. Next year will be better for the mortgage industry; however, the big earnings of 2021 aren't likely to recur.
