The latest company to catch my eye is American Capital Mortgage (MTGE), so I'm opening up coverage on the mREIT. After doing my first two introductory pieces covering the assets and hedges of the mREIT, it feels like time to start putting together some digging.
If you're looking for an introduction to the company, you will want to start with this introduction and this follow up introduction.
After my first "digging" piece into their use of interest rate swaps, I wanted to do some digging on their net servicing losses. In my book, this qualifies as about medium to heavy difficulty digging. If you're not familiar with my work, this may seem absurd.
The Expense
The expense I'm talking about is highlighted by the pink arrow and pink box in the slide below:
Going Back a Little Further
I grabbed some earlier presentations to see if this activity had ever created anything other than a loss:
The answer appears to be "no". From the fourth quarter of 2013 when this activity began (or was initially reported) it has produced nothing but losses.
The reason I'm so interested in this loss is because the cost is excluded from their non-GAAP metrics demonstrated below:
The purple box relates to the interest rate swaps which were investigated in the first "digging" piece (it was linked near the start of the article).
When I'm looking for the sustainable dividend values I would treat the green box as the relevant starting point. Management seems to prefer using the value directly below the green box. The difference in the two evens out over time and it simply a matter of preference. Either one is a decent place to start. The problem is that far too many investors (and analysts, unfortunately) think it is a good place to end rather than begin. That is equivalent to climbing the stairs to the gym and announcing that the workout is done and was successful. If you want to build the big mental muscles to tackle these mREITs, you need to grab the shovels and dig in day after day. We'll use the 10-Q for the second quarter to get more data.
Management's Explanation
I went looking for further discussion of the role this portion of the business had in their results and was able to find the following disclosure on page 35:
Our subsidiary, Residential Credit Solutions, Inc. ("RCS"), is a fully-licensed mortgage servicer based in Fort Worth, Texas that has approvals from Fannie Mae, Freddie Mac, and Ginnie Mae to hold and manage MSR [mortgage servicing rights] and residential mortgage loans. During the first half of 2015, we continued to integrate the servicing platform into the broader MTGE operations, implement cost savings opportunities and focus on servicing performing conforming loans. While net servicing losses incurred since our acquisition of RCS are due largely to sub-scale servicing volumes, we continue to be cautious in our acquisition of MSR, as the risk-adjusted returns for these assets remain unattractive in our judgment. As of June 30, 2015, we held MSR with a fair value of $91.7 million, down from $93.6 million as of December 31, 2014, due primarily to portfolio runoff, partially offset by unrealized gains.
Was That Simple Enough?
Management indicates that this portion of the business has been creating regular losses because it is too small to have economies of scale. However, they don't want to allocate further capital to buying more of the assets this subsidiary manages because they provide "unattractive" risk adjusted returns.
What the Hell?
While I'm regularly a cynic, but that justification is remarkable. These assets remain unattractive for their risk adjusted returns, but management continues to hold them and allow the segment to operate at a material loss quarter after quarter. Even when further allocations would result in superior economies of scale, they still think additional assets are unattractive. Due to economies of scale, any further allocations should provide superior returns to the current allocations. If further allocations are unattractive, then current allocations are downright awful. These MSR assets have a fair value in excess of $91 million and rather than jettison them for fair value and close down this terrible segment, they continue turning a quarterly loss of around $4 to $5 million.
A Silver Lining
Further research brings up management's discussion of RCS (page 51):
As of June 30, 2015, RCS managed a servicing portfolio of approximately 64,000 loans, representing approximately $13 billion in unpaid principal balances. RCS provides full end-to-end services for mortgage servicing solutions, including (I) loan acquisition and boarding, (ii) customer service, collections and loss mitigation, and (III) foreclosure and real-estate owned services. We have elected to treat our investment in RCS as a TRS, and RCS is therefore subject to corporate income tax on its earnings.
Perhaps losses can create some kind of tax shield for earnings?
RCS History
MTGE acquired 100% of RCS in on November 27th, 2013. It came with NOLs, which are "net operating losses", so RCS was capable of producing losses even before being acquired.
Let's Go Back in Time
Since this deal took place in November of 2013, I'm changing financial statements to use the 2013 10-K.
In that year management described the acquisition with the following statement:
On November 27, 2013, we acquired RCS, a fully-licensed mortgage servicer based in Fort Worth, Texas. RCS has approvals from Fannie Mae, Freddie Mac and Ginnie Mae and the requisite state licenses to hold and manage MSR as well as residential mortgage loans, or whole loans. As a result of the RCS acquisition, we are able to invest directly in MSR and whole loans and, therefore expand our ability to invest in our targeted investment classes. As of December 31, 2013, RCS managed a servicing portfolio of approximately 53,000 loans, representing almost $10 billion in unpaid principal balance. RCS provides full end-to-end services for mortgage servicing solutions, including loan acquisition and boarding, (ii) customer service, collections and loss mitigation, and foreclosure and real-estate owned services. As of December 31, 2013, RCS had approximately 250 employees. We have elected to treat our investment in RCS as a taxable REIT subsidiary ("TRS"), and therefore RCS is subject to corporate income tax on its earnings.
A Substantial Risk
While there were several risk disclosures in the filing, including several specifically related to RCS, one of the areas that stands out is a disclosure that the MSRs are highly illiquid and subject to numerous transfer restrictions. In short, these assets may be extremely difficult to liquidate for anything near fair value. That is problem because it appears MTGE would benefit substantially from transferring all of the assets out of RCS or selling the company to another mortgage servicer that could take the assets and terminate the employees to achieve dramatically better economies of scale.
Management's Assessment of RCS shortly after the Purchase
The following excerpt comes from the earning release in February 2014. Mr. Kain continued:
At the same time, we are continuing to broaden our investment capabilities with the successful closing of our purchase of Residential Credit Solutions in November 2013. The combined platform not only gives us the ability to invest in mortgage servicing rights, but also significantly enhances our capabilities with respect to whole loan investments and credit positions retained from future securitizations. While these opportunities may be somewhat limited in the near term given limited non-agency originations and significant competition for these assets, we remain convinced that they will be an important part of MTGE's long term success.
A Different Tone in the 2015 Q2 Earnings Release
The statements provided in the last earnings release were substantially less exciting:
As of June 30, 2015, Residential Credit Solutions, Inc. ("RCS") managed a servicing portfolio of approximately 64,000 residential mortgage loans, representing approximately $13 billion in unpaid principal balances. During the second quarter, the Company recorded $11.4 million in servicing income and $(15.5) million in servicing expense, which included $(2.8) million in realization of cash flows on MSR.
Gary Kain on the Earnings Call
Gary slipped in the following bit:
We continue to evaluate strategies to reduce the current operating losses at RCS. Fortunately the operating headwinds are relatively small in the context of our overall portfolio and this gives us some flexibility to focus on an optimal long-term outcome.
What it Means for Shareholders
MTGE has an asset with a book value over $91 million, but without a change in the macroeconomic environment investors shouldn't expect that book value to provide any positive earnings. The assets may be difficult to unload which creates a material problem since it prevents management from simply jettisoning the inefficient servicing department. That means shareholders are facing these kinds of impacts from consolidation for the foreseeable future:
Per Share
If losses continued at a rate of $4.111 million per quarter, the drag on earnings available to common shareholders would be running around $.0803 per share on a quarterly basis.
Conclusion
Shares of MTGE are trading substantially below book value which has encouraged management to begin an aggressive buyback campaign. That is a solid reaction when an mREIT trades under book value, but it is also going to concentrate ownership of this subsidiary. In the future it may be possible for this segment to begin turning profits, but when investors in the sector want to see double digit returns each year it would be difficult to turn large enough profits to compensate for the losses. In establishing a fair relative value for the mREIT, adjustments will need to be made to reflect that this $91.7 million in book value is dramatically less desirable than $91.7 million in cash that could be used to repurchase shares or provide a special dividend to shareholders.
Establishing the proper treatment will be an interesting challenge, so I'd love to hear suggestions from readers. In my opinion, valuing the $91.7 million as if it were cash would be far too generous and would substantially overestimate the value of the company. On the other hand, writing it off entirely would be fairly harsh even for an illiquid "asset". On the third hand (why not), the subsidiary provides nothing but losses as it functions significantly below the level necessary to create income for the parent. It seems fairly generous to assign a positive value to a negative stream of cash flows.
On a per share basis, this "asset" is increasing book value by about $1.79 based on the data from the end of the second quarter.
What do you think?
