Nationstar Mortgage Holdings Inc. (NSM) announced on Feb 7, 2013 the acquisition Of Equifax Settlement Services, a provider of appraisal, title insurance and settlement services in the United States. This is a solid move as NSM evolves its business toward a more diversified, higher ROE model. While the near-term prospects remain strong, a more cautious approach should be taken when evaluating the longer term prospects. I remain neutral in my outlook for NSM at this time and simply want to outline how this recent acquisition fits into the picture in the context of NSM's evolving model.
The Evolution of the NSM Business Model
First, let's talk about how NSM makes money and then we can look at how this recent acquisition fits in. The NSM traditional business model is a "non-bank" mortgage servicer. The big distinction here is "non-bank" - they do not take deposits and use those deposits to fund mortgages like banks.
NSM services mortgage loans as either a "MSR holder" - they own specific assets called "Mortgage Servicing Rights" which entitles the holder to collect a pre-defined revenue stream in return for servicing the mortgages or they operate as a "fee-based servicer" - someone else owns the MSR asset and contracts with NSM to service the mortgages for a fee. MSR-ownership is a very capital intensive model as MSR assets can be very expensive depending on the quality of the underlying mortgages. Many MSRs trade at 50-100bps of the unpaid principal balance (UPB) of the underlying loans, so a $10 billion MSR portfolio could require $50-100 million in capital. So in order to grow the MSR servicing portfolio, NSM must continue to purchase costly MSRs requiring an ever-growing capital base, thus making it challenging to achieve high ROEs.
Enter into the picture Newcastle Investment Corp (NYSE:NCT), a REIT owned by NSM parent company Fortress Investment Group (NYSE:FIG). Now NSM can leverage the NCT partnership to buy MSRs - one model that has been shared with investors includes a co-ownership of MSRs with NCT buying 65% with NSM receiving a servicing fee, plus the upside with the remaining 35% ownership. This NCT partnership allows NSM to grow its servicing portfolio without having to cough up capital to fund 100% of the MSR purchase price. This model is similar to the OCN and affiliate company HLSS model where MSR ownership is divided among the two firms. The basic idea is to use less capital to service more loans - a move that is aimed at producing higher ROEs.
Now that NSM has a big enough servicing portfolio, it is moving further into fee-based businesses, with this recent acquisition of Equifax Settlement Services just the latest example.
How Equifax Settlement Services Fits In
When mortgage companies originate and service loans, they often need to engage 3rd party companies for various services - appraisals, title searches, etc. These are fee-based businesses based on technology and data processing. In other words, highly scalable activities with margins that get higher as you grow.
So rather than NSM sending that business to 3rd party companies, they can acquire their own settlement services business, roll it into their newly branded "Solutionstar" division and have a captive service provider for its now 1+ million loan portfolio while marketing those fee-based services to other financial institutions.
This is a much more "capital light" line of business compared to the traditional model of owning MSRs so it gives NSM a more diversified revenue stream with higher ROE, thus driving the aggregate ROE higher.
The Long Term View on NSM
While NSM is making great moves to drive higher ROEs and grow the servicing portfolio, NSM growth is fundamentally based on its ability to replenish portfolio run-off. It needs to keep adding more loans to its servicing portfolio in order to make up for the loans that are lost when investors default (and the loan no longer generates serving income) or when loans are paid off (either by refinancing with someone other than NSM, selling the home and not originating a new loan with NSM or just paying off the mortgage).
This is a tricky business because the more NSM grows its servicing portfolio, the more it needs to replenish its run-off. Historically in the mortgage business, there were not many opportunities to acquire large MSR portfolios but in the recent years as banks rethink their mortgage strategy or other servicing companies get swallowed up, there have been plenty of opportunities to grow servicing portfolios in big chunks. At some point this period of significant transfers will come to an end and NSM will need to be more reliant on its own mortgage origination capabilities to get new loans in its servicing portfolio.
This evolution would make NSM look very similar to the pre-crisis mortgage banks (i.e., Countrywide). Once this happens, NSM is competing with the banks and companies like Quicken Loans for new originations, so how does NSM capture enough new originations to keep growing?
That will be the ultimate question... if it goes the way of the pre-crisis mortgage companies, that would suggest offering lower lending standards (i.e., going into sub-prime or Alt-A) or unique loan products - the same avenues that led to the run-up prior to the crisis. Not only would this be a complete repeat of the past, but this will be harder this time around with new regulations defining "qualified mortgages" which will make it more costly to originate and securitize those types of loans.
So at the end of the day, this story centers around a near-term rapid growth play combined with a questionable long-term sustainability play. I think the growth story will be quite compelling over the next 1-2 years but I would remain cautious over a longer term horizon.