New Residential continues to pay attractive big dividends, but its share price is down more than 20% from its recent highs. After a brief review of how NRZ makes money, the big risks it faces, and why the business is attractive, we provide details on why the share price has fallen over 20%, and what might come next. We conclude with our views on investing in NRZ.
How NRZ Makes Money:
NRZ invests in higher yielding residential mortgage-related assets that offer steady longer-term yields (this is how NRZ supports its big dividend), as shown in the following graphic.
And NRZ uses lower cost debt to fund its investments (for example, the coupon rate NRZ pays on its outstanding debt generally ranges from 3.5% to 5.6%). We went into greater detail regarding these investments and NRZ’s cost of borrowing in our previous New Residential article. However, it's easy to see how NRZ has been generating all that cash to support its big dividend payments (i.e. it earns the spread between the yield on its investments (see table above) and the cost of its debts).
What are the Big Risks?
Despite NRZ’s powerful income generation, it is not without risks. As we described in detail in our previous NRZ article (see previous link), the business faces a variety of risks including growing competition (Wells Fargo, for example, is a deep-pocketed growing leader and competitor), illiquidity risk (NRZ’s assets are relatively illiquid, not publicly traded, and this could create problems right when the company needs liquidity the most), market cycle risk (we’ll have more to say about this later, when we discuss the MSR market), interest rate risk and credit spread risk (according to NRZ’s annual report “a 25 basis point increase in credit spreads would decrease our net book value by approximately $186.4 million”).
What Are NRZ’s Attractive Qualities?
Besides NRZ’s huge income generation and big dividend payments, our previous article also went into detail on New Residential’s other attractive qualities, including smart management (NRZ was an opportunistic pioneer in the post-housing crisis MSR space, and the company has continued to evolve based on market opportunities), economics that work (they’re getting paid a lot more on their investments than they’re paying on the debt), the market is big (although conditions are increasingly challenging in the MSR space, more on this later), low competition (even though it could grow, from big banks in particular), strong market conditions (although they have deteriorated somewhat in recent months), overwhelming buy recommendations from Wall Street analysts (they liked NRZ’s business last summer, and they continue to like it now—and believe the shares have big upside potential, see chart below), and of course the big dividend (as the share price has sold off, the dividend yield has gotten higher).
Why is the Share Price Down?
1. Everything is down: Before getting into the specifics on NRZ, keep in mind the overall marker has sold-off significantly in recent months. The point here is that NRZ’s sell off is not necessarily a wild outlier. However, NRZ has sold off more than the market, which is significant considering it pays a big dividend. Specifically, dividends are often a sign of safety, but in NRZ’s case—it’s considered a “risk asset” for a variety of reasons and the shares have sold off harder than the overall market recently.
2. Credit Spreads: As mentioned earlier, and according to NRZ, “a 25 basis point increase in credit spreads would decrease our net book value by approximately $186.4 million.” And here is a look at what’s happened to credit spreads recently (they’ve increased).
Curiously, NRZ used to include a metric in their quarterly earnings presentation on the more specific non-agency spread, but it was conspicuously removed from the last one, so for some perspective, here it is from the prior (Q2) presentation.
The point is that credit spreads have widened significantly, and this will have a big negative impact on NRZ’s book value when they next report. Also, this is one of the big reasons why the shares have sold-off—the market is anticipating a big decline in book value. This will create a variety of challenges ranging from less cushion on their debt ratios, the price-to-book-value valuation metric looking less attractive, and it makes it increasingly challenging for NRZ to raise capital in the capital markets. As a side note, NRZ did wisely raise capital by issuing new shares right before the share price fell significantly. Specifically, the company raised about $433M in gross proceeds after the sale of 25M shares, suggesting a price of $17.32. This was a well-timed move by management to issue shares when they could still issue them at the higher price.
3. MSR Growth is Slowing: Specifically, the MRS industry is not growing as fast as it was, and MSR valuations cannot rise forever. For example, CEO Michael Nierenberg said on the last call:
“MSRs can’t go up forever. So as rates continue to rise, they'll go up, but at some point, they'll stop going up.” To add a little perspective to that, when asked “how much room do you think is there for improved valuations on the MSR?” Nierenberg said the overall mark on the portfolio is a “3.8 multiple. I think that, could you see 6 and 7 turns or 6 and 7 multiples on the asset.”
And keep in mind, these comments were as of the end of the third quarter when the market (and future interest rate expectations) where significantly higher. This dynamic is important for several reasons. First, if rates don’t rise as fast as previously expected, then pre-payment speeds may not slow, and the value of the MSR book could decline. This is a big reason why the value of NRZ has sold off; simply put, the market perceives the MSR values to be lower, which could result in NRZ’s book value being marked down net quarter, which basically means they have less collateral against which to borrow money and grow the business.
Also MSR industry growth opportunities are slowing. For example, the entire Mortgage Banking Industry will be challenged going forward, as mortgage lender profit outlook has fallen for nine straight quarters. And according to Nierenberg, only 5% of the entire mortgage universe is refinanceable. Specifically, Nierenberg said:
“I think that the mortgage banking industry is going to continue to be challenged. With a lot of these smaller mortgage banks having to do something around either capital, partnership or just figuring out a different path. The one slide that we point out that I like that we put in, 5% of the entire mortgage universe is refinanceable today based on a 4.90 current coupon rate. So if you think about that, where is production going to come from, how do folks stay in business, how do folks manage their expenses, it's a very, very hard business. When it's good, it's very good. When it's hard, it's very, very hard.”
What Comes Next For NRZ?
Given the recent sell-off for NRZ, what comes next? We see a variety of paths including “being opportunistic,” continuing to evolve the business, and the potential for credit spreads and interest rate expectations to settle down.
1. NRZ Stays Opportunistic: Considering the recent market wide volatility, we suspect NRZ has likely been opportunistically purchasing non-agency RMBS at attractive prices. For example, on the last quarterly call (before the sell-off) when asked about the opportunity to grow the non-agency RMBS portfolio, CEO Michael Nierenberg explained:
“I've been pretty vocal the past couple of quarters, the investing environment is not great. However, to the extent that we see opportunities to acquire these assets, where we have a strategic purpose and that strategic purpose is related to our call strategy, we’ll do so… [and] to the extent market volatility creates a softening in pricing, that would be great for us. So investment opportunities, they are there. We’re starting to see them rear their head a little bit.
Keep in mind this call was to report Q3, but it took place a few weeks after Q3, and into Q4 when the market wide sell-off had already started, so Nierenberg probably knew the opportunities were growing, but he was keeping his cards close to his chest.
And being opportunistic pertains not only to buying non-agency RMBS, but also M&A. Because NRZ has scale and liquidity (especially relative to its peers), there could be opportunities to buy distressed smaller players at discounted prices. When asked about his appetite for M&A on the call, Nierenberg said:
“Our appetite for acquisition, assuming that it's accretive for shareholders is always there and we’re seeing a lot more opportunity today or a lot more incoming, I would say, today around the mortgage banking folks, as it’s just a very challenging time quite frankly for mortgage bankers.”
He went on to say:
“we love the way that we're set up. We love our portfolios. We think that they're very, very difficult to replicate and for us to stay due course and continue to add where we can, to continue to drive home core earnings and pay our $0.50.”
2. Evolving Business: NRZ has a track record of evolving their business, and they could continue to do so as market conditions dictate. For example, they’ve been active in the non-qualified-mortgage securitization business. Specifically, when asked about the magnitude of originations going forward, Nierenberg explained:
“What I would say around the non-QM business, we’d like to get to a place where we’re issuing a deal a quarter. We're in discussions with a number of other mortgage bankers about providing pricing to them to acquire loans, to be able to issue more volume. Our business, not the CNRG business, the mortgage business has been talking about non-QM for four years or so. We are starting to see a little bit more production and we’re seeing plenty more issuance of the overall mortgage market.”
3. Credit Spreads Settle Down: As we saw earlier, credit spreads have widened. This will likely have a negative impact on NRZ’s book value, and it’s one of the big reasons the share price has fallen. However, what happens when the market settles down and credit spreads narrow? We don’t know when this will happened, but according to NRZ’s annual report: “a 25 basis point decrease in credit spreads would increase our net book value by approximately $190.3 million.” If the market does settle down and credit spreads narrow (will which almost certainly happen at some point, we just don’t know when), then NRZ’s share price will likely move higher quickly. The recent sell-off has been induced by fear of a dire market situation that has not yet materialized (people are just afraid that it might). NRZ is still generating plenty of income based on its diversified mortgage-related investment portfolio, they’re still paying their big dividend, and the shares will likely revert significantly higher when credit spreads come back down.
What Does It All Mean for NRZ?
Despite the “risk off” market conditions in recent months, the economy remains strong (GDP, unemployment and consumer confidence are all relatively quite healthy). And for perspective, here is a look at what happens to NRZ’s various assets under current and expected market conditions:
From NRZ’s perspective, the recent volatility is creating more opportunities to invest. And for income-investors, NRZ’s share prices has become considerably less expensive.
Conclusion:
NRZ has built its business by being opportunistic and smart during times of distress. This is basically how they became a leader in the MSR space in the years following the housing crisis. Our latest bout of market volatility isn’t anywhere near as severe as the housing crisis, but it does provide opportunities. Specifically, we’ve ranked New Residential #8 in our recent report The More It Falls: Top 10 Big Yields Worth Considering because recent market volatility allows NRZ to continue making opportunistic investments, and it provides an opportunity for income-focused investors to pick up shares at a discounted price. We don’t know when credit spreads will narrow, or how much NRZ’s book value will be marked down, but we’re not trying to bottom tick. NRZ pays an attractive big dividend supported by an industry leading business, and the overall economy remains strong. We believe the risks are outweighed by the attractive qualities of the business, and we currently own shares of New Residential within our actively managed, prudently diversified, long-term, Income Equity portfolio.