Earnings Call Transcript - RITM Q2 2022

Operator, Operator

Good morning, and welcome to the Rithm Capital Second Quarter 2022 Earnings Call. Please note that this event is being recorded. I would now like to turn the conference over to Phil Simon. Please proceed.

Michael Nierenberg, Chairman, CEO and President

Thanks, Phil. Good morning, everyone, and thank you for joining us. The second quarter was marked by significant volatility. I'm very proud of our team's efforts as we navigated some of the toughest markets we've experienced in years. We observed a substantial rise in interest rates, widening credit spreads, and a challenging liquidity environment. We positioned our company to handle higher rates, and our portfolios increased in value. Consequently, our book value rose to 12.98 from 12.56 prior to the internalization payment to Fortress. Our company, formerly New Residential, has rebranded to Rithm Capital and has internalized its management contract. This transaction is expected to contribute an additional $0.12 to $0.15 in core earnings as we create synergies both within the investment management and our operational business lines. Alongside these synergies, we have diligently worked on reducing expenses and I'm pleased to share that our costs in our mortgage company have been cut in half. Our investment strategy focuses on quality rather than size; we aim to deploy capital when we see genuine returns. If a particular division or sector does not promise robust returns, we will redirect our capital. A prime example of this is our decision to reduce capital in our origination business from roughly $2 billion at the time of the Caliber transaction to $650 million today. We believe that the financial services sector over the next 6 to 12 months will offer opportunities to deploy capital with high returns, subsequently boosting earnings and enhancing shareholder value. We will also be bringing in exceptional talent in areas where our activity has been limited in the past. In terms of capital, we've been patient, as I mentioned earlier. We concluded the quarter with $1.8 billion in cash and liquidity, which currently stands at about $1.65 billion, following a $200 million payment to Fortress during the quarter. Moving forward, you can expect us to maintain the same disciplined approach to investing, led by our strong investment team, diversification in our income streams, and hopefully, increased earnings. I will now refer to the supplement posted online. I'll begin on Page 3 and work through it quickly before we move into Q&A. The key takeaway from this morning's presentation is about our future direction rather than past performance. As we discuss our company, our rebrand to Rithm Capital signifies our current state and our intent to diversify from the single-family residential focus. Our diverse portfolio of operating companies and assets sets us apart from many of our peers. Regarding capital, we are maintaining elevated levels of cash and liquidity intentionally, given market volatility and funding considerations with the Fed's influence and the accompanying uncertainties. We see opportunities to deploy capital for higher returns. In our single-family rental business, which we have discussed in previous calls, we currently own 3,700 properties. Given the housing market's cooling, due to increased mortgage rates, we anticipate deploying capital at significantly higher cap rates. We foresee increased opportunities not just in our traditional business lines, but also in areas such as commercial real estate. Since our inception in 2013, we have achieved a total economic return of 162%, averaging 18% annually. On Page 4, our business overview highlights include $4.1 billion in dividends since inception, a June 30 dividend yield of 10.7%, $7 billion in net equity, a $35 billion balance sheet, over $600 billion in MSRs, and recognition as a top 5 nonbank originator and servicer. With Genesis, we lead as a top business purpose lender, alongside growth in our single-family rental business. We possess complementary operating businesses listed on the right side of the page, and we are eager to explore new areas within financial services. On Page 5, financial highlights show a GAAP net loss of $3.3 million, reflecting a one-time fee of $325 million related to Fortress. Our earnings reached $145.8 million, with core earnings of $0.31 per diluted share and a dividend of $0.25. As mentioned earlier, cash and liquidity stand at $1.8 billion and net equity at $7 billion. Our book value is 12.28, which accounts for a $0.70 impact from the termination fee paid to Fortress. Page 6 addresses business highlights, including our announcement on June 17 regarding the internalization of our management function, which will enhance earnings by an estimated $0.12 to $0.15 per diluted share due to synergies across our ecosystem. The rebranding to Rithm, which trades as RITM on the New York Stock Exchange, is something we are excited about as it distinguishes us from our previous mortgage company, NewRez, and embodies the diversified nature of our business moving forward. Our emphasis on profitability remains strong, illustrated by the 50% reduction in our mortgage company’s run rate expenses. The integration of our operations is nearly complete, and we are continuously seeking further cost savings and revenue growth opportunities. On the financial side, we maintain 99% of our portfolio in a non-daily mark-to-market status. Our business decisions are driven by a focus on ROE, IRR, and risk-adjusted returns. We've strategically reduced our equity in the mortgage origination side due to unappealing gain on sale opportunities. Page 7 outlines our strategic evolution from being merely an excess MSR owner in 2013 to our current state. Page 8 discusses our capability to manufacture assets. We won't manufacture assets aimlessly; it's only when we believe the capital returns for shareholders justify such actions. To that end, we've reduced capital in origination and will redeploy it to areas with greater anticipated returns. There's nothing unexpected regarding the macro environment. Inflation remains at a multi-year high, with signs of softening in certain economic indicators. With consecutive 75 basis point increases from the Fed, we anticipate another 50 basis points in September and likely further hikes thereafter. We are closely monitoring economic data and positioning ourselves for higher rates. If market conditions rally, we will add hedges to our portfolios. Our MSR portfolio reflects a gross WACC of 3.6%, currently about 175 basis points out of the money. Mortgage rates are currently between 5.25% and 5.75%. We expect to continue observing a downturn in the housing market. I personally have a more cautious outlook than some analysts, as I believe higher interest rates will put downward pressure on home prices. From a financing perspective, we are well-positioned. Overall, financing costs in the market have risen. The securitization market and the costs of funds from our bank counterparties have also increased. We maintain a patient approach to our investment strategy and are starting to deploy some capital at wider spreads. With $1.65 billion in cash today, if we deploy $1 billion at a 12% return, that could yield $120 million in net income over the year. We are committed to profitability and focusing on MSR valuations. We have significantly slowed our mortgage origination due to the lack of compelling gain on sale unless MSR multiples improve. We have over $600 billion in MSRs with a gross WACC around 3.6% to 3.7% and expect a 5-year season speed of about 11 CPR. We are evaluating whether to produce 6% coupon mortgages at roughly a 5 multiple or hold our position. The consensus is to maintain extra capital for deployment at more attractive levels while slowing origination until risk returns align with expectations, allowing gain on sale to become viable again. We are cautious regarding origination and anticipate that as we expand into other product areas, the diversification of earnings will become evident. Page 12 summarizes our business segments, including origination, servicing, and MSR-related investments, along with some real estate-related investments. Our single-family business is set for growth, but we will remain patient and focus on capital deployment at higher cap rates unless market conditions dictate otherwise. Page 13 showcases our MSR portfolio, and while I won't discuss the upcoming pages in depth, I will highlight our essential metrics: a 60-month season with a gross WACC of 3.6% to 3.7% and 11 CPR. Recapture rates are satisfactory, keeping in mind that in a lower refinancing market, recapture is limited due to decreased refinancing activity, though we believe we are positioned for success in the purchase market, particularly with our Caliber purchase franchise. Page 15 discusses our single-family rental business, emphasizing our strategic geographic considerations as we seek growth while adhering to our patient capital deployment strategy in response to higher cap rates. Page 16 indicates Genesis produced $1.3 billion in the first half, showcasing outstanding performance led by Robert Wassman and his team. We will continue to invest time in this business and explore additional growth opportunities. Page 18 covers the mortgage company's pre-tax income of $552 million and continued reduction in G&A expenses. Addressing origination going forward, we anticipate flat pre-tax income next quarter. In this quarter, we reported a pre-tax loss of $26 million, mainly due to prior clean-up costs related to Caliber and some exiting leases. However, absent these one-time expenses, the origination business is projected to break even. To provide overall company metrics following our Caliber acquisition, we slashed our workforce from approximately 13,500 to around 7,800, resulting in substantial cost savings to align with the current environment. The origination business is expected to stabilize, while the servicing portfolio continues to generate strong earnings. Finally, on Pages 19 and 20, we address the origination and servicing business. Baron will elaborate further, but we're starting to see openings for higher gain on sale margins, and we are actively working towards that goal while maintaining our disciplined approach to avoid originating loans that are not financially viable. With that, I'll turn it back to the operator for Q&A. The main takeaway is that we have a robust business, significant cash reserves, strong earnings, and we are enthusiastic about our direction under Rithm Capital as we aim to increase shareholder earnings and diversify beyond solely residential mortgage markets.

Operator, Operator

Our first question comes from Bose George with KBW.

Bose George, Analyst

Can I get an update on book value quarter-to-date? And also, I assume you haven't put on any hedges on the MSR yet?

Michael Nierenberg, Chairman, CEO and President

Sure, I'll address the second part. Nicola will provide some additional insights. It's still early in the quarter. Regarding MSR hedges for a 3.6% gross WACC, we haven't taken significant action. Just yesterday, we purchased just under $1 billion in mortgages, but overall, we haven't hedged the MSR because we believe our MSRs are different. While there is a gap before we anticipate an increase in prepays, we think we are still quite distant from that point. Nick, would you like to discuss book value?

Nicola Santoro, Chief Financial Officer

Book value given change in rates is approximately, call it, $11.75 to $12 a share.

Bose George, Analyst

And then actually, what are your thoughts on the bulk MSR market in terms of seeing opportunities there?

Michael Nierenberg, Chairman, CEO and President

We can produce our own MSRs, and I mentioned this when discussing our origination business. We have maintained the multiples assigned to MSRs regardless of rate changes because we want to avoid experiencing significant fluctuations in the market. For example, the high for the 10-year rate was around 3.45 this morning, and now it is at 2.55. If you generate a mortgage with a coupon of over 6%, the chances of that rate diminishing are real, and we need to be prepared to recapture that. We have preserved what I would call our multiples. In the mortgage industry, I expect to see companies consolidate and some go out of business, which we've already started to witness. This could potentially create opportunities for us to acquire MSRs. However, we are not quite there yet. We are interested if the multiples are favorable. A key point to remember is that the cost of capital for MSR financing is approximately a 10% leveraged return. Therefore, we plan to be patient unless the MSR market becomes more affordable. There are other areas where we can invest our capital, and right now, we have around $650 billion in assets or something similar.

Bose George, Analyst

Actually, one quick one on servicing technology. Any update there in terms of what you guys are going to do?

Michael Nierenberg, Chairman, CEO and President

Yes. I think that we continue to evaluate that. I think we're getting closer to making a decision. So stay tuned.

Operator, Operator

Our next question will come from Eric Hagen with BTIG.

Eric Hagen, Analyst

Congrats on the transition here. A couple here. So with respect to the capital in the origination segment, should we think of that being sort of a baseline amount the company would need to keep there at its current size or the current amount that you're originating? And what might change that? And then how should we think about the growth in Genesis in the SFR business against the backdrop of what you discussed as lower home prices and just a bumpier environment in general?

Michael Nierenberg, Chairman, CEO and President

First of all, capital in the mortgage company will increase if the gain on sale increases. It's pretty straightforward unless we can find a better way to generate additional net income, not just gross revenue for the business. When considering Genesis, those team members are highly experienced and have been in the industry for a long time. Charles Sorrentino and I were on the West Coast last week and spent a couple of days together. The opportunity to explore different avenues in the real estate industry greatly excites us about collaborating with Genesis. I believe we'll witness expansion. We want to be cautious about our position in the cycle regarding construction as we anticipate a slowdown. However, with our capital and the relationships that Genesis has, I believe we can achieve good growth, possibly through non-traditional methods compared to their current approach. Lastly, in the SFR sector, we've increased our cap rates. We're not acquiring many properties right now as we expect home prices to decrease slightly. We're currently in the market with a securitization, so we are keeping an eye on the return on equity in relation to our property acquisitions. Therefore, you can expect a more patient strategy from us compared to others and perhaps a different perspective on capital management. We would like to see cap rates increase somewhat based on current rates. If they do not, we may consider moving toward lower cap rates. For the time being, we plan to be patient because we believe there are other opportunities where we can achieve better returns by utilizing that capital.

Eric Hagen, Analyst

When we think about a market yield applied to the existing MSR portfolio, where would you say that shakes out right now?

Michael Nierenberg, Chairman, CEO and President

Probably 10-ish would be my guess based on where speeds are and our gross WACC on a levered basis.

Eric Hagen, Analyst

On a levered basis, how about an unlevered basis before you apply the levered?

Michael Nierenberg, Chairman, CEO and President

Some of the seasonal factors could be slightly higher, but you're probably looking at around 10.

Eric Hagen, Analyst

Would you say there's a meaningful difference in ROE between the MSRs that you service yourself versus subservice from others?

Michael Nierenberg, Chairman, CEO and President

You mean our subservicing?

Eric Hagen, Analyst

The loans that you service in-house compared to those serviced by others.

Michael Nierenberg, Chairman, CEO and President

Yes. So I mean, listen, we made some early purchases appears back from United Wholesale and Quicken. Obviously, those guys are very good in refinancing anything and everything they possibly can. But they're already burned out. So I would say that our own servicing stuff is probably a little bit better here. We have subservicing with Ocwen, those portfolios continue to perform extremely well.

Operator, Operator

Our next question will come from Doug Harter with Credit Suisse.

Doug Harter, Analyst

Michael, as you look to deploy your capital, do you think the opportunities are going to come in kind of asset purchases or potentially acquisitions of other companies?

Michael Nierenberg, Chairman, CEO and President

It depends. I think on the asset side, we're waiting for the shoe to drop if the shoe does drop. So I think to one of the earlier questions around MSR values. If MSRs went down, obviously, we would sit there and bounce on them and buy more MSRs. I think for us, it's a total return play. At some point, you want to deploy a little bit more capital. I think even if you listen to some of the comments from Jamie Dimon around the stress test and you think about bank capital, that will have an impact on the entire system as people think about financing their business. You see the banks taking breakdowns on some of their leveraged loan positions. That will have an impact on how people finance. Maintaining higher levels of capital. But we do think there could be some opportunities that even down the road that may come out of the banks. I would love to see it more on the asset side, quite frankly, than we would see on the operating side. But to the extent that there are some great opportunities, we’ll look at either one. I think we’ll be a little bit agnostic, but buying distressed assets typically is the way that folks have made a lot of money in the past.

Doug Harter, Analyst

And then as you look at the commercial real estate opportunity, I guess where is Rithm today as far as kind of having the right people in place to be able to take advantage of that opportunity? Is that something you need to hire? Or I guess where are you in that opportunity?

Michael Nierenberg, Chairman, CEO and President

The most important thing I want to share is that after many years in this industry, we are focused on attracting great talent to our organization. I believe we are nearing that goal. We plan to make an announcement in the next couple of weeks to a month regarding a team or partnership in the commercial real estate sector. Both Charles and I, with our extensive experience in evaluating commercial real estate debt, have strong expertise in this area. We are almost ready to share something with the market. This isn’t about acquiring a company; it’s about bringing on a team or forming a partnership with high-quality professionals who can help enhance earnings for our shareholders.

Operator, Operator

Our next question will come from Giuliano Bologna with Compass Point.

Giuliano Bologna, Analyst

I was wondering about the MSR discussion. Does it make sense to hedge more of your new production, or are there specific parts of the portfolio that would benefit from hedging? The new production is coming in at a much higher WAC, but it might be wise to hedge some of that new production along with most of the overall portfolio.

Michael Nierenberg, Chairman, CEO and President

Yes, that's a great question. We've reduced our production in the mortgage company, which means we have less to hedge overall given the higher WACC compared to our existing portfolio. I mention this because we manage around $600 billion in these assets. It's a valid concern, and we are analyzing whether this is merely a bear market rally at 2.55 on 10-year yields. The market fluctuations are quite significant. One thing to note about the MSR business is that the MSRs currently have much less negative duration than they did a year or two ago. Moving forward, we will be adding more hedges against some of the higher coupon loans, which I believe is the focus of your question. We are cautiously optimistic; we have been consulting with our economists and believe the Fed will reach a 3.5% to 4% funds rate. However, I don't expect the 10-year yields to adjust in tandem. We want to avoid being in a difficult position. That said, I think the MSR asset will not increase significantly in value. Therefore, we need to stay aware of market moves and interest rates. Despite this, with the current mortgage spreads on higher coupon loans, we are beginning to hedge those, having started yesterday.

Giuliano Bologna, Analyst

That makes sense. Then just a little bit of a different question around the MSRs. You guys have roughly $2 billion of deposits. I'm curious roughly what kind of yield you're generating on those deposits? And then just a general sense of like what were the best index bee historically the closest to tracking roughly around where the yield you're able to generate on those custodial deposits?

Michael Nierenberg, Chairman, CEO and President

So I think the number is something like $12 billion on average during the month, depending on the time of the month. Those are generating rates close to the funds rate. We are actively working with our bank counterparties to ensure we are receiving appropriate rates on our deposits, which is a crucial part of our business. It's one of the key inputs into our operations right now. It's significant.

Giuliano Bologna, Analyst

It can be a big driver in MSR earnings power, but I'll jump back in the queue.

Operator, Operator

Our next question will come from Trevor Cranston with JMP Securities.

Trevor Cranston, Analyst

Okay. A question on the gain on sale margin. They bumped up pretty nicely in the second quarter. I guess, as you guys have moved through July so far, would you say that margins are kind of holding steady at the level you had for the second quarter? How should we think about how that's trending heading into Q3?

Baron Silverstein, President of NewRez

Yes. At least in July, we have seen margins maintain or increase, and that includes July. So we've continued to do that in the strategy that Michael talks about.

Trevor Cranston, Analyst

Okay. Got it. Regarding the MSR portfolio, it appears that the prepaid speed was around 11 in the quarter. Can you provide an outlook on where you think the speed will stabilize in terms of turnover speeds, assuming that the portfolio remains significantly out of the money?

Michael Nierenberg, Chairman, CEO and President

Your guess is as good as mine. I think it's roughly 10.67%. However, it really depends on one's perspective on the housing market. I believe our outlook on housing is likely a bit more pessimistic than the general market. Turnover will significantly affect your speeds. We typically have MSRs with a 5- to 6-year season. So, I think we should remain around this level. It's important to note that our DTC business is quite sizeable when it comes to recapturing clients. If we can attract some of these individuals who might sell their homes and seek to buy new ones, that will benefit us. We have the Caliber side, which encompasses both DTC and retail operations. This should provide support as well. We hope to maintain these levels. Additionally, it depends on where interest rates settle. Previously, we discussed a terminal funds rate of 3.5% to 4%, with the 2-year note sitting at 2.85 to 2.90. We do believe that rates will trend higher. I’m not sure if this rally reflects a fair market status; it seems that the market may be getting ahead of itself or that people are simply beginning to adjust to the slowdown.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Michael Nierenberg for any closing remarks.

Michael Nierenberg, Chairman, CEO and President

So thanks, everybody, for joining. Again, super excited about the next chapter in our lives. The ticker is our RITM that goes live today. Again, I think the most important thing to take away is that we had a great quarter. We're sitting on a lot of cash. The most important thing to get out of this call is, as we pivot to Rithm, I think you'll see more of an investment manager style than just being all in on the residential side. We look for great opportunities. It doesn't mean we won't get bigger in residential, but we look for great opportunities to deploy capital. Appreciate your support. Have a great rest of the summer. Any questions, you know how to reach us. Thank you very much.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.