Investing in an esoteric asset class is tricky

August 4, 2016

Written by

Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He also serves as  Vice President in Capital Markets at Silvergate Bankand holds the Chartered Financial Analyst (CFA) credential.

Mortgage Servicing Rights (MSRs) are an asset that represents the right to service a portfolio of mortgage loans. Servicing is the act of collecting and distributing payments. The value of an MSR is dependent on assumptions, such as prepayment speeds, loan delinquency and discount rates. And any increase in the assumptions will reduce the MSR value, notes Eric Nokken of Wilary Winn, a financial institution consultancy. 

Excess MSR and Basic Fees are key components. A $10 million pool of mortgages, with 100 loans and an average principal balance of $100,000, amortized over 30 years at a rate of 6 percent, pay a monthly payment of $60,000. The owner of the mortgage pool receives $57,500 after the servicing company collects 30 basis points, or $2,500 for the collection and distribution of the interest and principal payments. A basic fee of $500, or 6 basis points, is paid to the servicing company. The right to receive Excess MSR, at 24 basis points, or $2,000, can be sold. 

Buyers of Excess MSR include mortgage REITs such as New Residential Investment Corp (NYSE: NRZ). The company acquired Excess MSRs on residential mortgage loans with an aggregate unpaid principal balance of over $400 billion. This esoteric asset represents 58 percent of the company’s equity.

Supply-demand imbalance, attractive pricing and significant barriers to entry catalyzed New Residential Investment Corp interest in Excess MSR purchase. Banks need to sell MSRs due to regulatory guidelines. Because of the influx, attractive pricing is apparent. And the company boasted about its industry strong relationships. But it is one thing to purchase an asset; quite another thing to derive value from it.

The value in Excess MSR purchases is dependent on pricing correctly for prepayment and extension risk.  Prepayment risk is an uncertainty related to pass-through securities. Extension risk, a common concern in a rising interest rate environment, is the uncertainty that a pass-through security life will extend beyond expected maturity.

Whether acquiring Excess MSR is speculative in nature, or a sound investment practice for a Real Estate Investment Trust, is arguable. But there can be one consensus: former President Eisenhower, who signed the REIT Act in 1960, would be in awe of its evolution.