New Residential Is Risky

Tuck Research profile picture
Tuck Research
1.03K Followers

Summary

  • New Residential Investment Corp has a business model built for rising rates, but will be more exposed in a recession.
  • Annaly Capital Management is holding on through rising rates by a thread, but its business model is more risk adverse.
  • Annaly Capital Management provides a safer option in times of economic uncertainty.

I recently wrote two articles. The first one is how I am long Annaly Capital Management (NYSE:NLY). The second one is how I sold my position in New Residential (NRZ). John Windelborn made a comment in my last article.

I'm going to explain more in depth why I hold this stance. This article is going to be a basic summary of each business model. Then I'm going to look at the risks of each model and what could be expected in different economic environments.

NRZ Business Model

New Residential mainly holds mortgage servicing rights or MSRs. The company also holds residential securities, call rights, and residential loans. There is also a very small amount of servicer advances and consumer loans, both of which New Residential has slowly been decreasing its holdings in.

Source: Annual 2018 Investor Presentation

Investors have been excited about the MSR portion of New Residential's portfolio. MSRs have negative duration, meaning the value of the security increases as rates rise. New Residential provides a helpful image of this process below.

Flow of MSRs

Source: New Residential Q1 2018 Earnings Slides

In a rising rate environment, refinancing goes down and prepayments drop. This means the MSRs have longer duration and NRZ collects more payments. One of the drivers of lower prepayments is lower refinancing rates. Recently refinancing has dropped really low.

Source: Annual 2018 Investor Presentation

Since refinancing is so low the price of MSRs have increased. Although refinancing rates can't drop much lower. This means New Residential shouldn't see more capital gains from this security and should see growth slow.

New Residential also holds a lot of residential mortgage backed securities or RMBS. Over 90% of these RMBSs are on a floating rate. New Residential also holds clean up calls, or the option to purchase the RMBS at a predetermined price. New Residential will exercise these call rights if they feel the underlying mortgages of the RMBS reduce to a certain threshold. They then exercise and purchase the RMBS. After that they then choose to retain the loan or sell the loan. They could also split it into pieces and retain and sell different parts. NRZ could also pass that loan to its servicing arm and attempt to get the loan to re-perform. NRZ has had success doing this in the past. If rates keep rising the RMBS portion of New Residential's business should see cash flows increase as long as defaults hold steady.

New Residential does better in a stable or rising rate environment. New Residential is a dynamic fund with an ability to originate and call on RMBS.

NLY Business Model

Although New Residential and Annaly are both mREITs, they have drastically different business models. 72% of Annaly's portfolio is agency MBS. This is primarily fixed rate securities. Annaly purchases its MBSs through repurchase agreements (repos). Repos are a type of securitized loan. Annaly sells its MBSs to a financial institution and uses that money to purchase other MBSs. Later, Annaly repurchases the original MBSs at the price it sold them for, plus extra interest. The extra interest associated with the repurchased MBSs is tied to LIBOR. Repos make up about 90% of Annaly's liabilities. The company uses this short-term debt financing to purchase long-term securities, mostly 30-year fixed MBSs. These long-term securities have a higher coupon payment than the interest that Annaly pays for the repos. Annaly uses this leverage-driven investment model to turn a greater profit. In this case, the use of significant leverage is safe because there is almost no default risk.

Recently Annaly has picked up a variety of different securities to combat rising rates.

Source: Q4 2018 Key Facts Sheet

This is the basic summary of the portfolio. The agency portion is 84% 30 year fixed MBS. This means about 60% of the entire portfolio 30 year fixed MBS. ACREG refers to commercial real estate lending. ARC refers to residential credit. AMML refers to middle market lending. ACREG, ARC, and AMML all perform better in a rising rate environment to balance the portfolio.

Side by Side Comparison

NRZ NLY
Dividend Yield 11.94% 11.9%
Payout Ratio 70.92% 100.00%
Market Cap 6.96 B 14.55 B
Price to Tangible Book 1.04 1.08
Interest Rev 1.66 B 3.33 B
Net Interest Income 0.95 B 1.96 B

Both mREITs are pretty equally priced relative to book and dividend. New Residential has an impressive payout ratio indicating a much safer dividend than Annaly. Annaly is paying their dividend on a razor thin margin. Annaly has paid a quarterly dividend of $0.3 since the end of 2013. New Residential's dividend was $0.175 at the end of 2013, it is now $0.5. Now that's what I call dividend growth. That dividend growth has since slowed and has been sitting at approximately $0.5 since 2016.

So why do I like Annaly over New Residential? To fully answer this question we need to take a look at the business model of each fund and the risks associated with each.

The Risks

Below is an image how I expect each fund to act under various market conditions. The arrows symbolize the general direction of how the fund will perform. This is based on my analysis.

Notice how Annaly performs slightly poorly if the economy continues to do well. This would assume rates continue to rise and would put pressure of the agency MBS portion. Annaly is much more protected against rising rates than it was, but it's not immune. I would expect Annaly to take a hit in a recession as defaults would rise, increasing prepayments. After that initial hit interest rates would most likely drop and increase the value of agency MBS on the books. Annaly would not do great in a recession, but it would perform much better than the rest of the market.

Chart

As can be seen in the chart above, Annaly took a hit in 2008 but quickly recovered.

New Residential will continue to do well in a good economic environment although growth should slow due to the refinancing rate approaching the minimum. New Residential would take a much bigger hit in an economic crisis. New Residential holds a lot of RMBS which is not backed by a governmental agency making default risk much worse. Also MSRs would see prepayments rise and the FV of the securities would fall.

Conclusion

I can understand why my argument is unpopular, but I still have a reason why I like Annaly better. New Residential has a risky model in my opinion. Annaly holds mainly government backed MBS which would allow it to take less losses in an unforeseen event. New Residential might seem like the safer bet right now because of its dividend coverage, but its model is subject to much more risk. As the economy becomes more uncertain I'll take the safer business model of the two regardless of Annaly's dividend coverage being thin.

Do you agree? Am I dead wrong? I always enjoy heated debate on Seeking Alpha. These funds are complex and it's always better to get additional input.

This article was written by

Tuck Research profile picture
1.03K Followers
What I Hold:GLD, SLV, PPLTI'm considering buying back into the Mortgage REIT space considering the extremely low prices. Please feel free to reach out with questions or to have a conversation.

Disclosure: I am/we are long NLY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Recommended For You

Comments (160)

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.