The refinance drought caught up with Nationstar and shares dove

Nationstar is a mortgage originator and servicer

Nationstar (NSM) is one of the largest non-bank servicers in the United States. It’s also in the mortgage origination business. A mortgage servicer is the entity a borrower usually interfaces through with their mortgage. A servicer acts on behalf of the ultimate mortgage-backed security (MBS) holder and is charged with sending out the monthly bills and statements, remitting principal and interest to the MBS holders, remitting property taxes and insurance, maintaining escrow balances, dealing with the borrower if they become delinquent, and handling that delinquency all the way through modification or even foreclosure.

NationstarEnlarge Graph

Servicers are paid a fee that’s usually the difference between the underlying note rate on the mortgage and the interest rate on the mortgage-backed security. For example, a mortgage with a 4.5% note rate would fit in a 4% mortgage-backed security. So the amount the servicer collects every month is slightly more than what passes on to the security holder. That difference is compensation for the servicer. Servicing can be a tough business because one of the responsibilities of the servicer is to pay bondholders even if the borrower stops paying. These are called “advance payments,” and the servicer will get repaid in full once the property is foreclosed upon. But in the meantime, they have to use their own funds to advance principal and interest to the bondholders, and that’s a big use of capital. Pre-crisis, banks would offer advancement lines of credit that servicers could draw upon. Those are no longer available.

Highlights of the quarter

Nationstar reported earnings per share for the third quarter of 2013 of $1.08 per share, well below the Street estimate of $1.27 per share. Revenue increased 4.7% quarter-on-quarter to $631.8 million. Nationstar’s servicing portfolio increased to $375 billion. If you include servicing already under contract, that number increases to 415 billion. Mortgage gain on sale revenues fell 27% to $268.7 million on $8 billion in origination.

Nationstar announced a restructuring, through which it would sell its wholesale mortgage banking business and some retail branches to Stonegate Mortgage (SGM). It’s also cutting over 1,000 jobs. It guided down its 2013 and 2014 estimates, but it may not compare to the Street estimates given the sale of its wholesale arm. The stock was down as much as 20% intraday.

Take care with growth stocks

Nationstar had been an extremely fast-growing stock, as you can see from the chart of revenue growth above. One thing to keep in mind with fast growers is that when they disappoint, the stocks often sell off dramatically because a small change in current growth makes a huge difference when extrapolated, especially if the analyst is using a discounted cash flow model.

Read-across to other mortgage REITs

Nationstar isn’t a mortgage REIT exactly, like Annaly (NLY) or American Capital (AGNC), but it’s similar to some REITs, like PennyMac (PMT). On the servicing side, it’s most similar to Ocwen (OCN). One of the interesting things about the servicing business is that your portfolio increases in value as rates increase. This is a rarity in the fixed-income world, where bond prices usually fall as rates increase. Why is this the case? Prepayments. If you’re servicing a 3.5% mortgage and rates increase, what happens to that cash flow stream? It will lengthen in expected maturity because the odds that the mortgage will prepay has fallen. If the expected life of that mortgage was seven years when rates were 3.5%, that expected life may increase to ten years if rates go up to 4.5%. The use of mortgage servicers is one way the retail investor can hedge the interest rate risk in their portfolio without having to pay carry.