Stonegate Mortgage (SGM) is a mortgage originator that has shown extremely rapid growth
Stonegate is the first pure-play mortgage originator we’ve seen since the housing bust. Most pure-play originators ended up going out of business or going bankrupt, as their warehouse lines were pulled during the financial crisis. Since then, investors have been able to take advantage of the recovery in origination only through buying bank stocks like Wells Fargo (WFC) or JP Morgan (JPM), or some mortgage REITs like PennyMac (PMT), Redwood Trust (RWT), or Impac (IMH). PennyMac and Impac both have legacy portfolios from the housing bust, and Redwood is a niche player in jumbos. If you wanted to invest in a plain vanilla originator, there just wasn’t a way to do that. Stonegate is not a REIT, but its business is closely related.
Stonegate went public on October 10. The deal was priced at $16 a share and the stock seems to have settled in here at the $18 level. The company originates mortgages through three different channels: retail, wholesale, and correspondent. The retail channel is based on having loan officers work with their network of realtors, lawyers, et cetera to drive business. It’s the most asset- and labor-intensive part, and also the highest margin. The second channel is wholesale, where the company originates loans through a network of mortgage brokers and mortgage companies. The broker will find the borrower and gather documents, and then Stonegate will determine the pricing and fund the loan. The broker will be paid a commission on the loan. Finally, it has the correspondent channel, which accounts for 71% of its volume. Here, it purchases funded loans from other originators and securitizes them. This is the lowest-margin part.
The trade is about the MSRs
Stonegate acquires and securitizes these loans and takes advantage of its scale to garner better pricing. One area where size matters is specified pools, which are mortgage-backed securities containing loans that exhibit lower expected prepayments. These loans are usually smaller (under $100K), and less likely to refinance because the fixed fee costs are a much greater percentage of the face amount. All mortgage originations have fixed and variable costs associated with them. The higher the fixed costs are as a percentage of face, the less likely the borrower is to refinance, all things being equal.
The wholesale and correspondent channels have much lower margins than the retail channel, but they have higher volume. A company like Stonegate may find itself doing the trade for the value of the mortgage servicing right (or MSR) and a minuscule cash spread. MSRs can be monetized, and as interest rates rise, they become more valuable. We’ve seen a brisk market in MSR trading lately as the banks sell them to comply with Basel III.
The risk with a stock like Stonegate is the decline of the refinance market. The refinance business was a highly lucrative one up until rates started rising. So while you have a “call” on the MSR portfolio, you will have to contend with lower volume. However, as the mortgage servicing right portfolio becomes larger and larger, the MSR effect will dominate the volume effect. The purchase business is still depressed, as credit is tight. But that will improve.