Mike Nierenberg has persisted in championing the investment potential for excess mortgage servicing rights (MSRs) over the past several years. As Board Chairman, President and CEO of New Residential Investment Corp., he has been an innovator and leader in the residential mortgage loan investment market — and MSRs are a prime example.
One of the critical roles for any successful investment manager is to search for and find undervalued assets on an ongoing basis. For MSRs, two key requirements for finalizing purchases of this specialized asset are adequate capital resources and strong long-term business relationships. During 2018 New Residential purchased $114 billion of MSRs based on the unpaid principal balance (UPB) of the underlying loans.
For an investment asset as complex as excess mortgage servicing rights, it is vital to have an in-depth understanding of both benefits and limitations — and the following section provides an overview.
Benefits and Limitations of Excess Mortgage Servicing Rights as Assets
An MSR is the contractual obligation to service designated pools of mortgages. This right is frequently sold for a fee that reflects the underlying value to the owner. If the fee exceeds a “normal” figure based on prevailing transactions, an Excess MSR is created — equal to the amount of the total MSR fee that exceeds the basic value. For example, if an MSR for one loan has a total monthly fee of $25 and the basic servicing fee is normally $5, then the Excess MSR is $20. MSR contracts are often expressed in terms of basis points (BPS) of the mortgage payment that are allocated to the MSR and basic servicing fees. One BPS is equal to .01 percent (1/100 percent). Here are six benefits of investing in mortgage servicing rights and excess MSRs:
- A New and Substantial Asset Opportunity — This represents a significant investment opportunity with the ability to “scale up” to larger transactions. During the past decade, banks have sold MSRs worth more than $3 trillion.
- High-Quality Cash Flow Opportunities — An Excess MSR is an asset that produces predictable and steady cash flow without increasing financial liabilities.
- Potential to Reduce Impacts of Interest Rate Fluctuations — MSRs should increase in value when rates increase. This is counter to many fixed-rate debt instruments that typically decrease in value as interest rates increase.
- Lack of Understanding Creates an Opportunity — One of the primary investment opportunities involving MSRs is due to the lack of understanding about mortgage servicing rights by many investors. This results in periodic pricing discrepancies that can represent buying opportunities for investment managers on the lookout for undervalued MSR assets.
- MSR Assets Cannot Be Easily Replicated — Mortgage servicing rights and excess MSRs are based on well-defined obligations that are tied to a pool of existing mortgage loans. While they can be readily bought and sold, creating “new” MSRs requires new loan pools and more mortgages. This creates a solid foundation for the asset’s value.
- The Current Supply of MSRs Is Strong — The availability of MSRs in 2019 is estimated to be around $350 billion of MSRs based on UPB of the underlying mortgages.
Two Important Limitations of MSRs — (1) As noted above, a key source of potential MSR value is derived from pricing discrepancies due to forced institutional sales and misunderstanding of asset values. Realizing this benefit of MSRs requires active portfolio management and expert knowledge of how MSRs should be valued — plus substantial capital resources to execute purchases with a quick turnaround. (2) A lack of critical business partnerships can hinder MSR transactions. Mortgage servicing rights investors should have working relationships with potential MSR sellers as well as established partnerships with co-investors in order to act quickly.
Overcoming MSR Investment Challenges — New Residential Investment Corp. is a residential real estate investment trust (REIT) that is well-positioned to invest in servicing-related assets that include MSRs and excess mortgage servicing rights. During 2018, New Residential acquired MSRs from 15 different sellers — and acquired 19 percent of the total MSRs sold. As noted by the company, “As banks continue to sell MSRs, there is an opportunity for entities such as New Residential to participate through co-investment in the corresponding Excess MSRs.”
Solutions for Residential Mortgage Investments
For much of the past decade, residential mortgages have often been viewed as a difficult financial problem rather than as an investment opportunity. Mike Nierenberg has proven to be a noteworthy exception by helping to create innovative solutions for the residential financing market. For example, he was a pioneer in developing a liquid market for excess mortgage servicing rights (MSRs). In his current role at New Residential Investment Corp., he was instrumental in the company’s decision to enhance capabilities for owning non-agency, Fannie Mae and Freddie Mac MSRs in all states.
For many investors, residential mortgage-backed securities (RMBS) have been problematic and therefore overlooked as potential assets for investment portfolios. Since RMBS have proven to be a key component in New Residential’s approach to opportunistic investing, this article will provide an overview of potential problems associated with securitized mortgages — and investment management solutions employed by Michael Nierenberg and his New Residential colleagues.
Residential Mortgage-Backed Securities: Problems and Solutions
Before describing investment solutions involving RMBS, it is important to describe the challenges that must be overcome in any successful approach to investing in these assets. Here are five of the major problems witnessed in recent years:
- RMBS Assets Are Complex — The recent credit and financial crisis provided numerous instances in which complex financial instruments such as derivatives were not as well understood as they should have been before being implemented. While residential mortgage-backed securities are substantially different from derivatives, an RMBS portfolio nevertheless entails ongoing complexities such as specialized terminology (for example, “tranches” of underlying debt to describe specific pieces of debt).
- Assets Are Sensitive to Interest Rate Fluctuations — A typical fixed-rate asset will decline in value when interest rates increase (and vice versa). Mortgages can include different underlying terms such as fixed rates and adjustable rates. Even when mortgage loan rates can be modified by the lender, there are limitations as to how much and how often these changes can be applied.
- Changes in Mortgage Servicing Rights Can Impact Security — The mortgage servicing industry is undergoing significant changes due to new regulatory requirements and capital resource needs. One result is that servicing relationships can periodically change, and RMBS investors have not always been properly notified when this occurs. Agency issuers like Ginnie Mae (Government National Mortgage Association) have recently taken steps to rectify this potential problem area by issuing new guidelines that are designed to provide more integrity and stability to the mortgage-backed securities market.
- Active Management Requirements — Because of numerous investment factors that can regularly fluctuate and impact the underlying value of RMBS assets, it is now realized that an active management style is one of the few ways to always be prepared to make necessary portfolio adjustments and take advantage of new investment opportunities. However, many RMBS portfolios over the years have been created and marketed without a management structure in place (tantamount to a “buy and hold” portfolio).
- Agency Versus Non-Agency Versions — The Agency version of RMBS involves a financial backing by agencies such as Ginnie Mae, Fannie Mae and Freddie Mac while the non-Agency version is not backed by such agencies. This has created a “dual market” for the two different variations, and periodic pricing volatility in non-Agency RMBS is one regular outcome. The biggest challenge for investors is to ascertain how much of a pricing differential is warranted when considering the investment opportunities involving either Agency RMBS or non-Agency residential mortgage-backed securities.
Multiple RMBS Investment Solutions — Solving the five RMBS investment challenges noted above is a multi-faceted process: There are no easy fixes. However, New Residential has developed several strategies to overcome the challenges just noted. One of the most important solutions is an active portfolio management style. This facilitates ongoing advantages such as monitoring for unexpected events, purchasing assets when forced selling by institutional investors occurs, repositioning portfolios and hedging investments when appropriate.
New Residential has periodically identified undervalued non-Agency RMBS investment opportunities. In addition to buying these vehicles when pricing is compelling, the company has also acquired call rights on some non-Agency securitizations. To enhance their position in the mortgage origination and mortgage servicing industries, subsidiaries now include companies in both areas. As one solution for addressing interest rate changes, New Residential has added portfolio assets such as MSRs that should increase in value as interest rates increase.
Opportunistic Residential Real Estate Investing
One of the less-publicized strategies for investing in residential real estate involves specialized financing vehicles such as mortgage servicing rights (MSRs) and residential mortgage-backed securities (RMBS). Because this niche investment area can be complex and misunderstood, very few investment managers have chosen to devote extensive time and capital to a comprehensive analysis of the underlying assets associated with residential real estate financing. However, as expressed in the wisdom of Albert Einstein, “In the middle of every difficulty lies opportunity.”
Mike Nierenberg has fashioned his notable financial career by blending an opportunistic investing mentality with an in-depth understanding of residential mortgages. During his tenure as head of global mortgages and securitized products businesses at Bank of America Merrill Lynch, he was described as “among the most highly skilled and knowledgeable people in the mortgage business”. He has recently served as Chief Executive Officer and President of New Residential Investment Corp. since 2013 (also Board Chairman since 2016). This article will provide several illustrations of opportunistic investing as practiced by Mike Nierenberg.
Servicer Advances and Call Rights for RMBS
Opportunistic investing frequently requires a willingness to tackle difficult challenges. For example, one of Lee Iacocca’s perceptive insights focused on recognizing a special opportunity in the midst of problem-solving scenarios: “We are continually faced by great opportunities brilliantly disguised as insoluble problems.”
New Residential generates cash flow from new investment vehicles such as servicer advances. A servicer advance is “standard operating procedure” in the mortgage securitization process and is usually provided as a non-interest bearing loan from a mortgage servicing company — the advance covers financial events that include a missed homeowner payment when a loan is non-performing. These payments can enhance portfolio yields and cash flow until loans become re-performing, and they facilitate making the best use of an unexpected opportunity.
Some investors are probably familiar with put and call options for securities such as common stocks. New Residential portfolio managers periodically purchase mortgage call rights that give the owner a right to buy a securitization vehicle within a specified time period at a pre-determined price — without the contractual obligation to exercise the right. In order to make this investment opportunity a profitable one, the portfolio manager must coordinate several transactions such as purchase of certain underlying portions of the debt at a discount to par, re-securitization of assets, sale of performing loans for a profit and retention of selected mortgages (all after acquiring the call right at an opportunistic price in the first place). At the completion of fiscal year 2018, New Residential owned approximately $125 billion of call rights based on the unpaid principal balance (UPB) of the underlying mortgages.
Excess Mortgage Servicing Rights
Another investment opportunity that can be disguised as a difficult problem involves excess mortgage servicing rights. When co-investing in MSRs, New Residential often obtains an “Excess MSR” — compensation that exceeds the normal servicing fee. Please note that the basic mortgage servicing right typically involves a servicing fee. This provides the obligation to “service” a pool of mortgages by receiving and processing mortgage loan payments while also handling additional financial requirements such as negotiating loan modifications, supervising foreclosures and calculating periodic payment adjustments.
Banks now own approximately 70 percent of mortgage servicing rights. Financial institutions are increasingly dealing with challenges such as regulatory changes and the need to improve capital reserves. As a result, banks are more inclined to sell the MSR assets — for example, sales have exceeded $3 trillion since 2010.
Owning the excess MSR assets does not result in the accompanying liabilities or obligations of the basic MSR. But the asset does produce additional cash flow and value for the portfolio. Based on the UPB of underlying loans, New Residential acquired about $110 billion of MSRs during the most recent calendar year.
A unique advantage of MSRs when compared to other fixed-income assets is that mortgage servicing rights should appreciate in value as interest rates increase. One strategic way that Mike Nierenberg and New Residential have positioned the company to take advantage of mortgage servicing right opportunities is by becoming qualified to acquire MSRs throughout the United States. This action was finalized about three years ago.
More Information: Mike Nierenberg and New Residential Investment Corp.
Mike Nierenberg has served as President and Chief Executive Officer of New Residential since 2013 and Board Chairman since May 2016. He was a pioneer in creating a liquid market for excess mortgage servicing rights. His previous leadership roles include managing director and head of Global Mortgages and Securitized Products at Bank of America Merrill Lynch and head of interest rate and foreign exchange trading operations as well as co-head of mortgage-backed securities trading at Bear Stearns. He has been a leader in the residential mortgage loan market for more than 25 years.
New Residential is based in New York and operates as a public real estate investment trust. The company’s recent stock market valuation was $6.7 billion ($16.55 per share February 22, 2019). New Residential subsidiaries include NewRez (mortgage origination) and Shellpoint Mortgage Servicing (integrated mortgage platform).
New Residential was spun off from Newcastle Investment Corp. in 2013 and operates as a separate entity that is publicly traded (NYSE: NRZ). As of market closing February 22, 2019 the company’s total market valuation was $6.7 billion ($16.54 per share).