New Residential Investment Corp (NRZ) is a unique mortgage REIT (because of its Mortgage Services RIghts) that is loved by many investors because of its big steady growing dividend payments (it currently yields 12.9%). However, this big yield does not come without risks as we’ve seen the shares fall 11% in the last three months. This article provides a brief review of the high-level risks facing NRZ, and then shares our views on the right way to think about NRZ as an investment.
For starters, we currently own shares of NRZ within our Blue Harbinger Income Equity portfolio. We like the company for a variety of reasons. For example, it’s Mortgage Servicing Rights (MSRs) actually increase in value as interest rates rise because less people pay off their mortgages early and NRZ makes more money servicing those mortgages. We also like NRZ because it just increased its quarterly dividend again (the second time this year). But anytime a company pays a dividend that is so much larger than just about everyone else, you, as an investor, should be skeptical.
We believe the biggest risks facing NRZ are as follows: (1) The growth in MSRs slows, (2) the company gets over confident and makes a bad mortgage-backed securities trade, and (3) NRZ’s counterparties may default (or partially default). The third risk is the biggest risk, so let’s start with that one.
NRZ’s Counterparty Risk
New Residential faces significant risks related to the counterparties it does business with. For example, in May NRZ confirmed it was talking about a deal with one of its largest counterparties, Ocwen (OCN). Ocwen has been struggling financially (e.g. the price is way down in recent years, net income has been consistently negative, and debt is approaching 100% of assets). Because OCN is such a large part of NRZ’s business, NRZ is will likely give more support to OCN per the details of the potential deal:
- The new agreement relates to about $117B in MSRs, and would convert NRZ's existing rights to MSRs into fully-owned MSRs. This would be done as soon as possible following a definitive agreement.
- As the MSRs transfer to NRZ, they will move to a new subservicer agreement (for Ocwen) for five years. NRZ will pay Ocwen $425M as the MSRs transfer (about what Ocwen for some time has said they were worth).
- New Residential will also take a 4.9% equity stake in Ocwen (presumably throughly newly-issued stock, but this isn't specified).
To be clear, it is not a good situation for NRZ to be taking actions to support its counterparties (NRZ’s price was down on the news), especially considering loan originators and services like Ocwen have been under persistent pressure from regulators for perceived wrongdoing to homeowners and mortgage holders during and after the housing crisis.
Further, Ocwen is not the only big NRZ counterparty that is under pressure and struggling financially. For example, Nationstar (NSM) (another big counterparty) has similarly experienced a declined stock price, almost non-existent net income, and a precipitously growing debt load. And the same general theme (financial challenges) applies to other big NRZ counterparties including OneMain Holdings (OMF), and Walter Investment Management Corp (WAC) (the owner of Ditech).
In the months and years ahead, we may see NRZ take more actions to support (or even acquire) its counterparties because without support they may file for bankruptcy, and this could have a material negative impact on NRZ’s stock price. We will be digging in deeper to NRZ’s counterparty risks in the coming weeks, but for the time being, we continue to hold our shares of NRZ, and we continue to enjoy the big (and growing) dividend payments.
Slowing MSR Growth for NRZ
Another risk for NRZ is simply lower growth in its MSR business. This business usually includes lower quality mortgage loans (to people with lower FICO scores, for example). And a lot of this business was originated leading up to the financial/housing crisis when mortgage lending requirements were much more relaxed than they are now. In some sense, this means there will be less of these types loans in the future. Also, NRZ has expanded aggressively to be allowed to acquire MSRs in states across the US, but now that they’ve received these right, there is less room for growth.
NRZ has a variety of complex MBS securities, hedges, and trades in place, and if any of them go wrong, it could have a materially adverse impact on the company. For example, according to NRZ’s annual report:
Many of the RMBS in which we invest are collateralized by subprime mortgage loans, which are subject to increased risks
Our investments in real estate related securities are subject to changes in credit spreads as well as available market liquidity, which could adversely affect our ability to realize gains on the sale of such investments.
Our investments in RMBS may be subject to significant impairment charges, which would adversely affect our results of operations.
We’re not suggesting any of the trades are about to go wrong for NRZ, but the complexity and in some cases leverage, increase the chance of highly negative outcomes.
We continue to own NRZ (within our diversified Income Equity portfolio, so as to reduce the stock-specific risks of any one position), but we also continue to monitor the position closely. We don’t expect the price to imminently collapse, but we do believe the upside may be reduced relative to historical periods when the returns have been higher. You can view all of our current holdings HERE.