Description

Thesis

Mr. Cooper has only been written up once on this forum (excellently, I might add, by RSJ in November 2018). On the one hand, this surprises me - the stock has had a remarkable run over the past 5 years, with shares up ~392% (34.9% CAGR) since the previous post. On the other hand, I’m not shocked - a company like Mr. Cooper or its closest comps (e.g., PennyMac, Ocwen) can be confusing businesses to understand and intimidating financials to analyze. I hope to accomplish two things in this post - first and foremost, recommend Mr. Cooper (COOP) as a company to own and secondly, to provide a walk-through on how I analyze and understand the business.

Although COOP has performed exceptionally in recent years, I believe the market misinterprets the company as cyclical, volatile and highly rate-sensitive. In reality, COOP’s business model is “naturally hedged” by balancing the steady income that comes from its servicing business with the opportunistic and profitable originations/refinance operations. Mortgage originations are at a historical trough. While we can’t be sure how long this rate environment will last, we do know there is a structural undersupply of housing in the United States and millennials are beginning to purchase homes. When the rate environment does improve, COOP will be there to recapture the refinancing. In the meantime, they can continue to grow their servicing portfolio through MSR acquisitions and subservicing contracts, both clipping the servicing fees and growing the pool of customers they can recapture.

COOP has managed to compound Tangible Book Value (TBV) per share at 26% since 2018 and has posted a through-the-cycle median RoTE of 19.9%. While shares have recently rerated from ~0.8x P/TBV in October 2023 to ~1.2x P/TBV today, I believe 2023 saw the trough of RoTE. Over the next 3-5yrs, due to scale advantages and the opportunity for additional refi capture when we see lower rates, COOP can achieve an annual RoTE ~15% and warrant a P/TBV multiple of 1.5x. This, combined with the growth of TBV/share in the mid-teens over the next 3 years suggests an IRR of 23.5% and a MOIC of 1.76x.

Background

please refer to RSJ’s November 2018 post for additional background

The mortgage servicing industry of today was highly impacted by the definitive years of 2007-2008 following the mortgage bubble burst. The focus of both the industry and regulators became doing everything possible to keep a customer in their home and avoid foreclosure, a situation where nobody wins. Because of this, servicing became significantly more expensive, requiring more manual and intensive processes to work with homeowners. Moreover, additional regulatory oversight required more robust reporting requirements, which also came with significant costs and investments. According to the Mortgage Bankers Association, from 2008 to 2014, the costs of servicing performing loans increased 268% and the cost to service a non-performing loan grew 404%. The number of loans a single employee could service fell from 1,638 in 2008 to 706 in 2014. Consequently, scale became even more important for these businesses.

In February 2018, WMIH agreed to acquire Nationstar Mortgage Holdings (NSM) for ~$3.8bn in a deal arranged by the private equity owners of the predecessor companies (KKR and Fortress, respectively). WMIH was the former parent company of Washington Mutual Bank and operated as a shell with $6bn of net operating losses (”NOL”) that arose from Washington Mutual’s bankruptcy (as of 1Q24, Mr. Cooper still has $426m of deferred tax assets). Nationstar was an existing non-bank mortgage servicer and originator, operating under the Mr. Cooper brand. Upon the merger, the combined entity took on the Mr. Cooper brand. Jim Bray, previously CEO of Nationstar, has been Mr. Cooper's CEO since the creation of the new entity.

Today, Mr. Cooper operates three segments – Servicing, Origination & Corporate/Other:

Servicing - service loans on behalf of the owners of the underlying mortgages. Servicing consists of loan payments, remitting principal and interest payments to investors, managing escrow funds for the payment-of mortgage-related expenses (e.g., taxes, insurance), and performing loss mitigation activities on behalf of investors.

Origination - originate mortgages, both purchase and refinancings, to existing customers through DTC and purchase loans through other originators through correspondent channel. As of 3Q23, COOP was the 26th-largest mortgage originator in the US.

Corporate/Other - includes Xome, a real estate auction website (though deemphasized in recent years) and Roosevelt Management Company (a servicing platformed acquired in August 2023 for the purpose of building out an MSR fund management strategy).

Since the merger in 2018, COOP has grown its servicing portfolio from $533bn in unpaid principal balances (UPB) to $1.1tn today (1Q24), a 14% CAGR, making it the largest non-bank servicer in the United States. If you look back to NSM’s portfolio since 2008, UPB has grown at 30% CAGR (from $21bn). More significantly, TBV/share has grown at 26.2% CAGR since 2018 and 20.0% since 2013 (including NSM).

The discrepancy between RoTE and the CAGR of TBV/share is explained by COOP’s share repurchases, particularly in the past 2 years. These buybacks have been accretive to Mr. Cooper as shares were purchased at a discount to book value and COOP had limited needs to deploy capital for originations due to the slow mortgage market.

Mortgage Environment

Following the COVID refi boom subsequent rise in 10yr rates beginning in 2022, mortgage origination and refinancing in the United States has been subdued, at best. Industry expectations for total originations in FY24-25 have whipped around in lockstep with Fed rate cut expectations, as has consumer sentiment. Given that the effective 30yr mortgage rate in the United States is currently >7%, both originations and refinancings are at historical lows. Refi applications picked up slightly in 1Q24, but off a low base. Home purchase sentiment is also up slightly, in February and March 2024, but has probably come down in recent weeks amid revised rate cut expectations. 

As banks have increasingly retreated from the mortgage market due to Basel regulations, the largest U.S. non-bank mortgage lenders have continued to gain market share. The low origination volumes and pressured gain-on-sale margins of the last 2yrs have caused many subscale originators to leave the market. Fitch believes this continued consolidation will benefit the largest originators, who are better equipped to navigate rate hikes and exploit scale advantages. Those with large servicing books, like COOP, have benefited from the steady cash flow stream of the portfolio.

For the immediate future, particularly in a higher-for-longer environment, new originations are expected to remain muted. Redfin reported in January 2024 that 88.5% of homeowners with mortgages have an interest rate below 6%. Consequently, many homeowners are “locked-in” to their current home (i.e., by selling their home and incurring a new mortgage, the prevailing rate will be materially higher than their current mortgage, making them reluctant to move and lose their exceptionally low rate). The good news is that rate decreases – whenever they may come – will have an amplified effect on originations given the pent-up demand bottlenecked by the lock-in effect.

Due to years of underbuilding following the Great Financial Crisis, there remains a structural undersupply of housing in the United States. According to Moody’s, even if 2024 turns out to be a solid year for home construction (FY23 multifamily and single-family completions were +11.1% and +8.4%, respectively), the total domestic housing deficit will remain at 1.5m – 2m units.

Business Model

The goal of COOP’s business model is to keep growing the Unpaid Principal Balance (”UPB”) of its Servicing book. As of 1Q24, COOP’s servicing portfolio had a UPB of $1.1tn, of which $630bn was MSRs that COOP owned on its balance sheet and $505bn was sub-servicing for someone else who owns the MSR. Growing the portfolio provides more revenue and should be margin accretive given COOP’s operating leverage.

COOP grows its MSR portfolio in four ways 1) they grow their subservicing portfolio, 2) they originate/refinance mortgages, 3) they acquire bulk MSR portfolios and 4) they acquire mortgages through the correspondent channel.

Subservicing

While the margin for servicing an owned MSR is ~5x higher than a subserviced mortgage (FY23: 17.8bps vs. 3.5bps, as % of UPB), it also brings balance sheet risk (i.e., the need to finance its acquisition or origination), servicing advance (read: liquidity) risk and mark-to-market noise. Another advantage of subservicing is its ability to adjust pricing if a loan goes delinquent and COOP’s cost to service increases consequently. COOP’s management has stated they aim to be roughly balanced between Owned MSRs and Subservicing. Given the lower unit economics, the need for scale is even more important when it comes to subservicing.

Origination/Refinancing

Although the Servicing portfolio runs off at a faster rate in a falling/low-rate environment, this is precisely the time when COOP can turn on its origination engine. Originations benefit COOP in two ways - 1) it “manufactures” MSRs to replenish the servicing portfolio and 2) it generates an attractive gain on sale through the sale/securitization of the mortgage. COOP and other servicers have a unique advantage when it comes to refinancing insofar as they have a direct touchpoint with the homeowner since they’re the ones collecting the monthly payments for the mortgage. As a result, they have direct visibility into the rate the borrower is paying. The moment rates fall to when a mortgage is “in the money” (i.e., economically advantageous for refinancing), COOP can be the first one to tap the homeowner on the shoulder and offer them a refi. COOP then sells the mortgage to GSE (e.g., Fannie, Freddie, VA, FHA, etc.) or Ginnie Mae investors while maintaining the new MSR on its own balance sheet. Periods of high originations/refinancings are particularly beneficial for a business like COOP because they can both generate a gain on sale AND manufacture an MSR to grow its servicing portfolio.

The economics of the gain on sales are attractive and the margin has historically amounted to ~2.0-2.5% of the value of the origination on a blended basis (FY22: 2.24%, FY23: 2.15%), with directly sourced origination gains being significantly higher than those purchased from the correspondent network (FY23: 3.83% vs. 0.53%, respectively). Although the Servicing portfolio suffered high prepayments during COVID, COOP achieved its second highest year of top-line (only succeeded by 2021) after generating $2.1bn in gain on sales from its Originations channel, demonstrating the balance of the business model. The ability for COOP to “recapture” the refinance activity is therefore critical. COOP has shown its ability to maintain a high recapture rate. FY23 refinance recapture was 77% (1Q24: 70%), ~3x the industry average, as per Black Knight figures. 

Note: Data includes figures from NSM prior to the 2018 merger with WMIH

Bulk MSR Acquisitions

COOP also acquires bulk MSRs on the open market. Recently, there has been high levels of MSR portfolios coming to the market following the refi/origination boom during 2020-2021. The largest sellers of MSRs in 2023 were United Warehouse Mortgage and Rocket Mortgage, respectively. These non-bank lenders, the largest mortgage originators in America, have been selling the MSRs associated with their 2020-21 vintages to raise their liquidity and cash positions during the low-origination years from 2022-24. During FY23 alone, UWM raised over $1bn by selling MSRs and excess servicing cash flow on $90bn of UPB. Figures YTD in 2024 indicate UWM has sold servicing rights on an additional $70bn of UPB. BTIG estimates that UWM will likely sell another $60bn on MSRs during the remainder of the year. In addition to the benefit of generating capital, UWM is also incentivized to sell MSRs to not be seen as competing with its large brokerage channel, who want to maintain the customer relationship and the refi recapture. 

Due to Basel III regulations, banks have also been retreating from the mortgage servicing business and bringing their MSR portfolios to market. COOP’s management expects a multi-year trend of bulk MSR supply to present as opportunities for further market share gains on the part of nonbank operators, like itself, with scale and technology advantages. In 2023, Wells Fargo finalized the sale of a $50bn block of MSRs. New York Community Bancorp (NYCB), which became a large mortgage servicer after acquiring Flagstar Bank in December 2022, is also expected to bring its $78bn UPB portfolio to market during 1H24 to help boost its CET1 ratio. The volume of MSR trading from 2020-23 has been ~$1 trillion per annum, almost twice the average of $535 billion seen in the years 2015-20. Given the financial and operational requirements, there are a limited number of buyers for portfolios of this size. In 2023, Mr. Cooper was the largest purchaser of MSRs in the country. This should hopefully lead to better pricing, particularly for those with the lowest cost to service.

“On a risk-adjusted basis, spreads today are second only to what we saw in the aftermath of the global financial crisis, and you can see this in option adjusted spreads for bulk MSR deals, which have more than doubled in the last three years. What’s driving these returns is a huge supply-demand imbalance.” Christopher Marshall (President of Mr. Cooper), 4Q23 Earnings Call

COOP has the excess capital capacity and financing sources to continue to acquire bulk MSRs as they come to market. COOP’s current TBV/Assets are 29% and management has indicated its target to maintain it closer to ~20-25%. As of 1Q24, COOP has liquidity of $3.3bn, of which $2.7bn are unused lines available for MSRs, advances and warehousing. Moreover, the Servicing portfolio generates >$1bn per annum, which provides additional liquidity over time.

During 1Q24, Mr. Cooper acquired $54bn of MSRs with “double-digit yields” and expects to onboard another ~$100bn during the remainder of 2024 (split between owned MSR and subservicing). While the company does not disclose the specific pricing of its deals, we can make some basic assumptions to illustrate the unit economics. Bulk MSR pricing has recently been trading at multiples of ~4-5x gross annual servicing fees, which implies ~10% unlevered yields. Industry standard 30yr conventional mortgage servicing fees are ~30bps of UPB:

Correspondent Channel

The Correspondent Channel provides COOP the opportunity to purchase closed mortgage loans directly from originators (usually, small and medium-sized banks, credit unions and brokers), only to then separate & retain the MSR and sell off the underlying mortgage. COOP generates revenue from the receipt of underwriting fees from correspondents earned on a per loan basis, as well as sale of loans onto secondary market. The Correspondent Channel represented 37% and 53% of COOP’s mortgage originations in 2022 and 2023, respectively. Like bulk MSR acquisitions, the Correspondent Lending Channel provides another outlet for COOP to better replenish the servicing portfolio run-off at a better purchase rate than traditional bulk or flow acquisitions. However, on the flip side, the gain on sale margin is also lower, at ~50bps for Correspondent vs. ~400bps on Consumer Direct in FY23. The correspondent and broker channels concentrate more on purchase origination volumes and are less fragmented compared to the retail channel, which has experienced a faster decline in volumes due to decreased refinancing activity.

Operating Leverage

As of 4Q23, Mr. Cooper is the largest non-bank servicer in the United States, with >$1tn of UPB under its portfolio. Banks used to dominate the mortgage industry and have close to 100% share in both originations and servicing; today, that share has fallen to ~40%. COOP’s cost to service an individual mortgage is 33% less than large banks and 50% below midsized banks.

Financing costs aside, COOP’s largest operating expense is its call center. Consequently, call volume is material in determining overhead. I don't usually get too excited about AI disrupting everything we're familiar with. However, when it comes to improving loan servicing and call center operations, technological advancements, including AI and LLMs, are clearly beneficial. Since 2019, COOP has worked with Google Cloud to develop mortgage-specific machine learning models to help solve manual document management at scale. During 1Q24 results, the company mentioned that the tool developed with Google, known as Pyro, can onboard hundreds of thousands of mortgage documents with no human involvement and accuracy rates of >97%. This technology gives COOP additional speed and insight when bidding on portfolios. According to management, COOP can onboard a $100bn+ servicing portfolio today with less than 50 new hires and we are still in the “middle-innings” of lowering cost-per-loan.

In early 2022, COOP formed a partnership with Sagent, a fintech servicing platform backed by Warburg Pincus. This partnership aimed to merge Mr. Cooper's existing system with Sagent's modern, cloud-based core. The enhanced cloud-based servicing platform would then be licensed to Mr. Cooper and other service providers, reaching Sagent's extensive network of banks and independent mortgage companies. In exchange for selling a series of its technology IP to Sagent, COOP received $223m and a 20% ownership stake. Chris Marshall, COOP’s Vice Chairman and former President, who has served on Sagent’s Board since the partnership announcement in 2022, was named Sagent’s Executive Chairman in January 2024, further cementing the relationship. In February 2024, Sagent launched Dara, an end-to-end process management platform, that the company anticipates can reduce total operational costs by ~40% compared to the traditional call-center model. Mr. Cooper is the first client of the platform and expects its full implementation in early 2025. Although it’s still in its early days, the new platform shaves ~40 seconds off an average call, resulting in millions of dollars of savings across thousands of daily calls. The opportunity from Sagent has the potential to both materially improve operating leverage as well as benefit from a 20% equity stake in the platform, should it continue to expand.

Note: to be clear, I do not model the potential future value of Sagent as part of this analysis and consider it to be upside.

Accounting

Despite the steady growth of the servicing portfolio and TBV/share, financial results for businesses like COOP are volatile and can be misleading. GAAP accounting requires that the value of the MSRs held on COOP’s balance sheet be marked-to-market through the P&L, creating a significant amount of noise. The value of the MSR is determined by a discounted cash flow of the expected servicing fees. However, the value of that cash flow is dependent on assumptions of prepayment speeds, option-adjusted spread, and cost to service. Prepayment speeds are the most rate sensitive. As rates go down, there is a higher likelihood that homeowners will refinance or accelerate repayments on their mortgages, thereby shortening the servicing fees that COOP receives over the lifetime of the mortgage (in other words, if the mortgage is cut short, then so are the stream of fees). Consequently, the amortization of the servicing portfolio (which runs through the P&L) goes up, impacting profitability. On the flip side, as rates go up, the risk of prepayments go down and the P&L benefits. Given the current rate environment in the United States, industry prepayment rates are at historical lows, leading to a low outlook for amortization levels through at least 2024. If/when rates fall, we should expect to see amortization levels tick up, but offset by higher levels of originations & refinancing.

Servicing Advances:

When a borrower stops paying their mortgage and begins the delinquency process, servicers like COOP experience increased costs in two different areas. First, the general cost to service the loan increases, as it requires more manual intervention and hands-on operations to work with the borrower to make them currently. Secondly, servicers are generally required to continue to front principal & interest payments to the mortgage owner, as well as required tax and insurance payments. All of these expenses incurred by the servicer create a receivable on their balance sheet, which may be repaid through liquidation proceeds from the loan.

It is important to note that because the underlying serviced mortgages are conforming to GSEs (e.g., Fannie, Freddie) and Ginnie Mae who guarantee the loan, the servicing advances present a liquidity risk rather than a credit risk. During the early months of COVID, this was the market’s primary concern about the business. In response, the Federal Housing Finance Agency (FHFA), as the conservator of Fannie Mae and Freddie Mac capped servicer liability for advances at four months, after which time Fannie and Freddie would take over the servicers’ obligations to advance the principal and interest. Requirements for Ginnie Mae loans were more punitive than those of Fannie & Freddie, but it nevertheless introduced a last-resort lending program (Pass-Through Assistance Program or PTAP), where servicers with a shortfall of cash can borrow from Ginnie at a rate of 5-6%, though statistics for take-up were limited.

Note: Ginnie Mae issuers are distinct from GSE issuers. Unlike the GSEs (Fannie & Freddie), Ginnie Mae neither buys loans from lenders nor issues MBS, but instead serves as a cosigner. The issuer pays Ginnie Mae a guaranteed fee of 6bps to be the counterparty, and then assumes responsibility for the securitization, issuance and advances of principal and interest to investors. Ginnie Mae’s role is to provide an explicit backstop for the benefit of MBS investors.

According to the CFPB, overall delinquencies rates from May - December 2020 for federally backed loans ranged from 0-10% for most servicers, with little variation. One subprime servicer reported a 30% delinquency rate during May 2020, only to fall to 19% by December. For private loans, overall delinquency rates were also below 10% for most servicers. According to the Mortgage Bankers Association, the forbearance take-up rate peaked at around 9%. As of 1Q24, COOP’s 60 Day+ delinquency rate on its MSR portfolio was at a historic low of 1.1%.

In short, servicers were able to withstand the COVID shock through a mix of their existing liquidity positions, additional liquidity accumulated from significant refi/origination income and the float of principal on newly originated loans, caused by the timing delay between principal payoff and advance remittance.

Hedging and the mark-to-market of MSRs:

The mark-to-market on the MSRs through the P&L is virtually impossible to model. Most other investors I have spoken with do not attempt to and assume it nets out to zero over the long run. COOP has hedged ~75% of the mark-to-market risk on the MSR portfolio as of 1Q23, so it should have a more muted impact on earnings. Given the current portfolio has a weighted avg. coupon of 4.1%, it has significantly less duration and convexity risk than an at-the-money MSR, making hedging relatively simple. Although it can move around a fair amount on a quarter-on-quarter or year-on-year basis, I believe looking at the core earnings potential of the business is the key to understanding the value of COOP’s model.

Interest Income & Float

Interest income from float primarily stems from two sources. The main component is derived from loans that have escrowed funds for property taxes and hazard insurance. In this arrangement, the servicer collects these escrow payments monthly, pays out insurance costs annually, and disburses property taxes either quarterly, semi-annually, or annually, depending on local regulations. COOP generates interest income on the cash held in the interim. A smaller portion of float income originates from principal and interest payments, which are typically received on or just before their due date at the beginning of each month. Under specific investor programs, the servicer may remit these payments at a later time.

Valuation & Scenarios

I am not, nor desire to be, in the business of predicting interest rates. There is no denying that COOP’s business is dynamic with rates. That said, COOP can still compound book value per share regardless of the direction of rates. Management has made a point of emphasizing that they run the company irrespective of the environment:

“We're completely agnostic about rates since they're not in our control. And instead, we focus on those things we can control, namely process improvement, cost leadership, and operating leverage.” - Christopher Marshall (President of Mr. Cooper), 3Q23 Earnings Call

Rates Stay Flat - “higher for longer” (base case): FY26 target price: $138.69

• Servicing portfolio run-off/amortization continues to be low, though delinquencies tick up slightly from current historical lows

• MSR portfolio continues to grow through bulk MSR transactions and the Correspondent channel

• Technological tailwinds continue to improve operational efficiency and cost to service

• Interest income remains high on “float” balances

Rates Rise – inflation shows dramatic increase: FY26 target price: $108.29

• Servicing portfolio run-off/amortization goes even lower as more homeowners stay put; COOP continues to clip its steady servicing fees; hedges prevent the bulk of MSR mark-to-market upside

• Bulk MSR transactions become even more common at even more attractive margins as large originators see their core business dry up and sell off MSRs as a source of additional equity and capital (already seeing this right now with UWM)

• Interest income goes even higher, but so does interest expense

Rates Go Down – we turn the corner on CPI and the Fed lowers rates aggressively: FY26 target price: $171.58

• Servicing portfolio run-off/amortization speeds up - this impacts Servicing profitability in the short-term. However, the run-off is soon replenished by 1) the increase in originations/refinancings and 2) the growth of the subservicing portfolio (as all the new mortgages issued in the market will need someone to service them, even if they want to hold onto the MSRs)

• Hedges prevent the bulk of MSR mark-to-market downside

• COOP’s refinance recapture rate (~70-80%) allows them to both keep the MSR as well as generate a gain on sale from the origination of the new loan

• Interest income declines, but so do COOP’s borrowing costs, making it easier for them to draw on lines of credit to fund more originations and MSR acquisitions

Catalyst

• Continued acquisition of bulk MSRs and expansion of UPB
• Change in interest rate environment causing more refinancings and originations
• Structural undersupply of housing and household formation of millenials continues to increase the demand for new homes (and therefore, mortgages)