Last year was absolutely abysmal for the mortgage space. The Federal Reserve's aggressive response to rising inflation along with rapidly rising home prices caused a collapse in affordability. Loan origination dried up and has yet to show any signs of recovery. We saw many mortgage originators severely cut back the business, go bankrupt, or exit the business altogether.
The originators who had large mortgage servicing portfolios like Mr. Cooper Group (COOP 0.08%) ended up outperforming. Can we expect this to continue?
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Mortgage servicing is an unusual asset
Mr. Cooper Group is a mortgage banker that also retains servicing. When a mortgage is created, there are two components to the loan, which are often separated. The first is the loan itself -- the right to receive principal and interest payments. The second component is mortgage servicing. This second component is an unusual asset.
Mortgage servicers handle the administrative tasks of managing a mortgage on behalf of the person who holds the loan (or the right to receive principal and interest payments). The servicer sends out the monthly bills, collects the payments and forwards them to the investor. The servicer ensures that property taxes are paid and insurance is up-to-date. If the borrower cannot make the monthly payments, the servicer will work with the borrower or foreclose, and might have to make payments to the investor if the borrower cannot pay. The servicer is generally paid 0.25% of the mortgage's outstanding balance per year. In other words, if a mortgage is $400,000, the servicer will get $1,000 per year.
Mortgage servicing acts as a natural hedge for the origination business
Mortgage servicing is unusual in that it goes up in value when interest rates rise. Most assets, especially stocks and bonds, react negatively to rising rates. Mortgage servicing doesn't, and this is because rising rates make refinancing unattractive, which means the holder of the servicing can expect to receive that 0.25% fee for much longer. Conversely, if rates fall, then the borrower will probably want to refinance, and when that happens the servicer no longer gets that fee.
Mortgage originators tend to retain servicing because it acts as a natural hedge for the origination business. When rates rise, refinance volume disappears and revenues fall. Servicing assets increase in value, which can help offset this issue. Conversely, when rates fall origination picks up, but a lot of the servicing portfolio will get refinanced away.
Servicing saved the day in the fourth quarter, accounting for 84% of Mr. Cooper's revenues. Origination volumes collapsed from $17.2 billion in the fourth quarter of 2021 to $2.8 billion in the fourth quarter of 2022. Mr. Cooper valued its servicing portfolio at 1.62% of the underlying principal balance, or 5.1 times the servicing multiple. Servicing valuations are pretty elevated at the moment, but there are a lot of mortgage originators looking to sell servicing in order to keep the lights on.
Mortgage servicing is on sale
On the earnings conference call, Mr. Cooper Group CEO Jay Bray estimated that there was about $1.5 trillion in mortgage servicing rights primed to hit the market coming from about 500 lenders. This should create an environment for Mr. Cooper to build its mortgage servicing portfolio. That said, increased supply should hit servicing valuations, which means possible write-downs ahead. Mortgage servicing portfolios are all different, so finding a "market" price is extremely difficult, but increased supply should have an effect on future valuations. if rates fall and delinquencies rise, that will negatively affect servicing valuations as well. The worst-case scenario would be falling servicing valuations without an increase in mortgage origination volume.
Mr. Cooper Group is trading at 9.6 times expected 2023 earnings per share, which should represent trough earnings for this mortgage cycle. Mortgage origination is such a cyclical business that these companies rarely trade at big multiples. During boom times, they will generally trade for mid-single-digit price-to-earnings ratios. Mr. Cooper Group is probably fairly valued at these prices given its vulnerability to the worst-case scenario mentioned above.
