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round asked, "IO's and mortgage servicing rights tend to appreciate in a rising rate environment as the underlying mortgages from which these instruments derive value extend in duration. What do you know about
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round asked, "IO's and mortgage servicing rights tend to appreciate in a rising rate environment as the underlying mortgages from which these instruments derive value extend in duration. What do you know about how the company books these assets and the assumptions made in estimating their value?"<br>
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round, NovaStar is actually 2 businesses. They are a taxable mortgage banking operation...and a REIT, which holds the retained interests from their securitizations. The retained interests, (the value of which is almost all I/O's), produced 88% of their earnings last year. Historically, the mortgage bank has been a breakeven proposition, but they did make money last year. The mortgage operation lives to provide the "raw material (i.e., sub prime mortgages) for the securitizations. They also do prime mortgages, but NFI sells these off whole because there just isn't enough spread. I know everybody's skepticism about securitizations, but there is no question they are not playing games here and it could easily be proven. The really want to minimize the non-cash "gain on sale" because they have absolutely no interest in pumping it up. The non-cash "gain on sale" last year was $136M and it actually resulted in them paying $19M in cash taxes because it exceeded the expenses of the mortgage operations. GAAP forces them to take these gains, but they are as conservative as GAAP allows. GOS is also the nominal value of the retained securities, so regardless at what price they book these I/O's, they will still produce the same cash flows. These I/O's enjoy a gross excess spread of 500 basis points and produce returns exceeding 30% annually. To demonstrate that GOS is not overstated, NFI routinely re-securitizes these I/O's and institutional buyers value them higher than the value they are booked. <br>
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So getting back to your original question, because GOS is conservative, the price of the retained securities is also conservative. They have to back-solve the assumptions in order to get these securities to yield 30%+. So the combination of prepayment rates, default rates, and discount rates are higher than others in order to "create" a security that yields twice as much as comparable I/O securities (which are often created to yield 12%-15%). You will also see this by comparing "book value" of the retained securities to "fair value" in the 10K. <br>
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The "mortgage service rights" are tucked in the mortgage bank and it's safe to say they are also understated. By year's end, they will easily have a mortgage portfolio exceeding $10B and I doubt if they carry the MSR's at $30M. This is a scale business and they charge 50 basis point to service this portfolio, so it's easy to see they aren't capitalizing these streams of income aggressively. <br>
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"Also, how do "scratch and dent" type mortgages of less than pristine credit quality perform in varying interest rate environments? Do they perform like the higher credit quality stuff?"<br>
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It's hard to believe, but in a rising rate environment they'll probably perform better, unless we have a huge spike in rates that cause Depression-like defaults. I own prime mortgage banks whose refi businesses were down 50% in Q1 from the low rates of last year. And right now, I think prime refi's are just about over with current interest rates being where they are. NovaStar's refi's are still growing. About half their business is refi's and the other half purchases. Out of the refi business about 80% are cash outs. So these are the borrowers who are over-extended with 18% credit card debt and want to tap the equity in their homes to consolidate. Even if rates were to go up a few more points, it makes sense to take a tax deductible 9% loan and pay off the non-tax deductible 18% borrowings. <br>
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"I read the Greenberg article you referenced. Is there more to the short argument than what was presented in that piece?"<br>
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round, we both know to take Herb's articles with a grain of salt. I'm not a big believer in all the conspiracy theories, but I will say that he doesn't do his homework in all his "short" pieces. He'll win some and lose some. (Doggy feel free to jump in and list all the frauds he really did uncover). When you combine non-cash GOS, securitizations, sub-prime, derivatives, hedges, a high-yielding-dividend, a very difficult-to-comprehend-business-model, AND a huge short position...well, you can't blame someone for thinking it HAS to be crooked. So far, I have looked high and low, and I have not come up with anything that even resembles a good short candidate. I'm still digging though...<br>
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Jim
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"It would appear, as it should, that IO pricing in the capital markets drive the company's balance sheet amounts. But is the book of retained IO's and mortgage servicing rights market to market regularly such
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"It would appear, as it should, that IO pricing in the capital markets drive the company's balance sheet amounts. But is the book of retained IO's and mortgage servicing rights market to market regularly such that, should rates fall (prepayments rise) or IO buyers flee, the company would have to write down its portfolio?"<br>
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round, I doubt that would ever happen. I don't think they could go through a bigger drop-off in rates than the last several years. They are aware of what rates are doing when they price these deals, and in some securitizations they assumed whopping prepayments of between 40%-50% annually! The I/O securities are marked down very quickly -- usually have a GAAP lifespan of less than 3 years, even though they throw off cash flow much longer. I consider their book value a fiction. Amortizing the cost of their retained securities very quickly allows them to produce less current income. There are cash flow considerations in being a very fast growing REIT...and quickly amortizing their retained securities allows them to better match their capital outflows.<br>
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"Also, what's the general read on the company's servicing policies? Is this the kind of stuff where, should a borrower run into trouble, Novastar simply modifies the mortgage to keep the customer current, at least on interest?"<br>
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They figure about 12% of these loans will end up in default. The average loan is about $150K for a $190K home. While we may think of sub-prime borrowers as deadbeats, their average customer has a FICO score exceeding 630 and makes over $60K a year. So there is some protection in a default when the LTV is about 80%. Also, in much of their older portfolio, they have purchased deep mortgage insurance, which should protect them even further in a foreclosure. Their servicing group is very highly rated by Fitch and Moody's. It's interesting to compare their defaults with Countrywide's sub prime defaults. Countrywide's are much higher, which I think is a combination of the young age of NFI's portfolio and the fact that prime mortgage lenders just aren't as good as others who specialize in it. <br>
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"Sounds interesting so far, but this is an interest rate bet at its core. I guess you just got to get past that and it's a good bet generally that long term interest rates will rise."<br>
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They'll be an interesting dynamic if rates continue to rise. There's no question it will slow down mortgage originations, but the I/O securities will likely see their lives extended.<br>
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"Finally, I assume that most of the portfolio is fixed rate based. Given the recent past, characterized by falling interest rates and rapid prepayments, and assuming that the portfolio is marked to market (I have no clue here), could the high ROE be the result of hits the company must have taken to its portfolio as it faced a declining interest rate tsunami?"<br>
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The company has never taken a one time "hit" on its portfolio because they pre-empt that from ever happening. They themselves write down the securities faster than the market could force them to do it. That does result in sky-high ROE's because the book is really lower than it should be. In the Q's and K's, you can compare GAAP value of the securities to the company's estimate of true value. <br>
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The mortgage portfolio is predominantly variable in nature. They have a lot of hybrid 2-28's (2 years fixed, 28 years variable). The spreads on the sub prime mortgages (currently around 7.5%) allow them to hedge the interest rate for the first 2 years. They fund 95%-98% of these securitizations with bonds paying an all-in-cost of Libor plus 50 basis points. Their recent mortgage loans are yielding Libor + 625 bps once they hit the variable rate (some older loans are higher -- 9%-11%). It's obvious the longer they can keep these I/O's on the books collecting the excess spread of what the trustee pays the bondholders and what they collect from the borrowers, the better off they are. Their timing actually couldn't have been much better the last couple of years. The last thing you want is a portfolio loaded with I/O's at the start of a big decline in interest rates, but that was the period of time that they were really ramping up originations. They took advantage of rising real estate price, debt consolidation, and refi's to build a nice branch network to originate mortgages.
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At the risk of hijacking this thread -- max, I gave you more than a whole day to answer Bowd (lol).
"If you put those two marks together and figure that half of NFI's business is
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At the risk of hijacking this thread -- max, I gave you more than a whole day to answer Bowd (lol).<br>
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"If you put those two marks together and figure that half of NFI's business is re-fi, shouldn't we expect volume to decline by 50% at some point? And if that's going to happen over the next two years, then why worry too much about what happens to the NIM market in between, since the stock isn't much of a buy anyway? If you figure $13 in dividends over the next 2 years + a stock price of 10x $2.50 in dividends after that, the current price sounds in the ball-park. <br>
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To sum up:<br>
A: I don't know how large the pool of people eligible for sub-prime refi is.<br>
B: I don't know how quickly it's being depleted. <br>
C: I don't know how quickly it's being replenished."<br>
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Bowd, the entire subprime market is running at over a $300B, based on a run rate of the subprimer's Q1 production. If you look at the link max posted, you see it has grown tremendously over the last decade (from $25B). I suppose it's certainly possible to decline by 50% and go back to $150B annualized run rate, but I doubt this happens any time soon. NovaStar's Q1 production was $1.8B, which was 95% better than Q1 of last year, and was sequentially 12% higher than Q4....and the first quarter is usually seasonally slow. They give monthly reports and April's production was also much better this year than last. In April, production was $655M and paydown's were $233M, adding about 5% to the portfolio. So the mortgage portfolio grew from $8.4B to its current $8.8B. <br>
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Seeing the first 4 months of the year averaged over $600M in production, let's assume it gets cut in half. To be somewhat realistic, we know it's not happening in the next few months (it's actually growing every month), so we'll project $300M monthly production starting next year. In order to see production getting cut by 50%, an economic slowdown producing flat or lower housing prices will be the likely culprit. Even if we scale down production from its current monthly rate to $300M starting in January, we can see that the portfolio is still growing. In fact, even at next year's $300M monthly production run rate, the portfolio will be exceeding "current" paydowns. And interestingly, such a decline would not happen in a vacuum, so current NFI mortgage holders would have a much more difficult time refinancing if the economy was bad or housing hadn't appreciated. About 80% of prepayments are from customers refinancing their houses vs. purchases, so a slow refi market cuts both ways. Their I/O securities may extend well beyond the assumed 3 years. That portfolio is now over $400M and yielding over 30%, so extending their life another year or two is real money. <br>
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Assuming your scenario plays out, the portfolio will still easily produce $6 EPS this year and a dividend that exceeds that (they still have to pay a little more than a $1 from last year). Based on your 50% phased-in reduction in volume, the portfolio will still be at least $10B by year's end. A monthly production of $300M at that point will still grow the portfolio. The mortgage portfolio started the year at $7.2B and will have ended it at $10B, averaging $8.6B for the year. Next year, the average size portfolio will be at least $10B, producing even greater earnings, even with a sharp reduction in production. I know the company is planning on achieving a $30B-$50B portfolio, but even a steady state $10B, isn't so bad at current prices.<br>
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"A side note on NFI's securitization program: It's got to make the stock a magnet for shorts, and not because of GOS. Unlike a bond-based capital structure arb, the short isn't dependent on the ultimate EV of the company because the long side of the trade is with the SPV. At 3x book it's got to be real tempting to buy some of their CMOs and short the common. Do you agree that this arbitrage opportunity puts a bit of a cap on the price and diminishes the chances for a huge squeeze?"<br>
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Bowd, I'm afraid I don't follow you here. I can see why some would buy their ABS and why some would short their common stock, but I don't see what one has to do with the other. What kind of arb is this? I can see a capital structure arb here (buying the preferred and shorting the common), but I wouldn't do that one either, although at least I understand that one (g).<br>
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Jim<br>
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