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Rising interest rates have caused what some are calling a housing market recession. Mortgage origination has collapsed from 2021’s rates, and housing starts and home sales are well below last year’s levels. How does this affect Rithm Capital (RITM -2.85%)?
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Rithm Capital is the new name for New Residential, which went through a reorganization recently. The company is a real estate investment trust (REIT) that invests in mortgages as well as a mortgage originator. It is also a major servicer of mortgage loans. In 2021, mortgage origination volume hit $4.4 trillion as originators feasted on easy refinance volume, which was powered by the Federal Reserve cutting rates to about zero while buying oodles of mortgage-backed securities to support the economy in the aftermath of COVID. This is now all reversing. The Mortgage Bankers Association forecasts origination volume falling to $2.4 trillion this year as refinance activity evaporates as rates rise.
Rithm Capital has relied on servicing income to offset declines in mortgage origination. As a mortgage servicer, Rithm collects the payments from the borrower, ensures that any taxes and insurance are paid, and deals with the borrower if he or she falls behind in the payments. The servicer is then paid a fee (typically 0.25% of the mortgage outstanding balance each year) for performing these services. The right to perform this service is worth something, and it is carried on the company’s balance sheet as a mortgage servicing right.
Mortgage servicing rights are one of the few financial assets out there that increase in value as rates rise. Mortgage servicing rights gain value because higher rates reduce the incentive for the borrower to pay off the mortgage early, which means the servicer can expect that income stream to last longer.
So far this year, servicing income has risen, which is helping to cushion declining origination income. That said, servicing income is a function of rising mortgage rates, not rising federal funds rates, and the yield curve (in other words, the difference between short-term rates and long-term rates) is in an unusual situation called an inversion. This means that the Fed is raising the short-term federal funds rate, but long-term rates which are determined by market forces are rising more slowly. This is a signal that mortgage rates may be topping out, which means that servicing income will start topping out as well.
If the U.S. does hit a recession, servicing costs should increase, especially because we probably will have an uptick in delinquencies. For a servicer, handling a loan that is paying is easy money, but that gets harder as delinquencies increase. Mortgage delinquencies are at historically low levels, which means that servicing costs will rise as the economy contracts. This will get even worse if real estate prices decline.
That said, Rithm Capital currently pays a quarterly dividend of $0.25, which gives the company a yield of 11.9%. Analysts expect the company to earn $1.30 this year, so the dividend is well covered, at least for now. The takeaway for investors is that rising servicing income might not be enough to offset the big slowdown in mortgage origination.
Brent Nyitray, CFA has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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