Fortress Revs Mortgage Machine as Its Buyout Funds StallKathleen M. Howley and David Carey
Wes Edens, a co-owner of the Milwaukee Bucks, has shot his share of air balls at his private-equity firm Fortress Investment Group. With mortgage assets, Edens has found his mark.
Shares of the mortgage real estate investment trust that Fortress manages soared 50 percent including dividends in the past year. The REIT, New Residential Investment Corp., alone accounts for more than a quarter of all of Fortress’s private-equity fees.
Edens saw an opening after the housing crash to take advantage of regulatory changes and drive into the mortgage servicing business. Fortress built Nationstar Mortgage Holdings Inc. into a firm that’s now poised to become the No. 1 nonbank servicer. He accomplished that with financing from the REIT and a private-equity fund that’s also earning robust returns.
“It’s a great strength of his: The application of creativity towards very large market opportunities,” said Bill Miller, who runs the $2.3 billion Legg Mason Opportunity Trust, which invests in Nationstar. “He’s looking for structural change that he can exploit.”
Fortress’s $3.3 billion in mortgage assets are a small piece of the firm’s $75 billion in managed capital. Lackluster returns of three big private-equity funds Edens raised in the mid-2000s have contributed to a 55 percent slump in Fortress shares since it went public in 2007. They have risen 12 percent in the past year.
The firm’s mortgage servicing fund raised in 2012 has performed much better. The $608 million MSR fund is two-thirds deployed, while a follow-on pool of $1.1 billion gathered the next year is just starting to put out money. The 2012 fund has produced yearly returns of about 16 percent after fees, according to Fortress.
Fortress moved into the mortgage business at the worst possible time, buying Nationstar’s predecessor, a subprime lender, for about $425 million in 2006. A year later, after the mortgage crisis struck, Fortress tripled its investment to buttress the company’s finances and rebuilt it into a servicer called Nationstar.
Edens anticipated that banks would be compelled by new regulations to sell their servicing rights to nonbanks. In the last four years, nonbanks have increased their share of the $10 trillion servicing market to 26 percent in 2014 from 11 percent. The expected rise in interest rates this year makes MSRs more appealing because it reduces the risk of refinancings, which pull mortgages and their monthly cash flow out of portfolios.
“I’ve been around the fixed-income market for 30 years, and I don’t know another asset that goes up in value as rates rise,” said Edens from Fortress’s New York headquarters. “It is a terrific time” to buy servicing rights.
Edens was the first to use a REIT to provide capital to purchase mortgage assets for a servicer. In 2011, the Internal Revenue Service approved his request for REITs to own servicing rights and not just mortgages and properties.
Fortress’s model, which rivals Ocwen Financial Corp. and PennyMac Financial Services Inc. have embraced, takes advantage of the tax-free status of REITs. They can raise money more cheaply than an operating company like Nationstar, which collects loan payments and handles foreclosures.
“We had the foresight to go to the IRS and get the ruling,” Edens said. “But this is a strategy that has been used in virtually every other asset class in real estate.”
In a typical deal, Nationstar buys the servicing rights jointly with New Residential and Fortress’s private-equity funds. In exchange for managing the loan payments, they receive about a 4 percent cut of the interest payments.
Nationstar, which does all the servicing, gets about a fifth of the fee to cover expenses. The rest of the income stream, called excess servicing rights, is shared equally among Nationstar, New Residential and the funds.
The arrangement has boosted Nationstar’s return on equity, or earnings as a percentage of stockholders’ capital. The ROE is “roughly double” what it would be if Nationstar did the deals alone, Edens said.
Fortress has bought 25 servicing-rights pools from 2011 to 2014, investing a total of $1.8 billion. Edens said Fortress is keenly aware of the conflicts inherent in divvying up deals among his different vehicles. To avoid the appearance of favoritism, Nationstar, New Residential and the funds split each MSR investment almost equally.
“We wanted to allocate these things on a pro-rata basis, so people don’t feel there’s any kind of cherry picking,” he said.
On April 6, New Residential’s $1.2 billion purchase of the assets of Home Loan Servicing Solutions departed from the practice of dividing investments. Because HLSS, like New Residential, owned hundreds of millions of dollars of mortgage loans as well as servicing rights, the deal didn’t lend itself to a three-way split, Edens said.
The acquisition more than doubled New Residential’s servicing portfolio to $381 billion. On top of an annual management fee of 1.5 percent of raised equity, the REIT pays Fortress 25 percent of gains it makes each year above a 10 percent return.
Many mortgage REITs pay no incentive fees while others provide their manager less than a 25 percent. All have minimum return thresholds below 10 percent, making it easier for managers to get a cut.
Fortress’s $74 million take from New Residential in 2014 amounted to a third of the dividends the REIT paid to stockholders. That compared with fee-to-dividend ratios of 19 percent for rival Blackstone Mortgage Trust Inc. and 22 percent for Starwood Property Trust Inc.
“The Fortress fees are pretty high,” said REIT analyst Jason Stewart of Compass Point Research & Trading. “But some of that is justified, because their strategy is more active and esoteric than other REITs.”
Edens defends the incentive charge, pointing to the REIT’s 29 percent average annual return before fees on its mortgage servicing.
“If we are taking more out, it’s because we are making more money for investors,” said Edens, the REIT’s chairman.
Edens, 53, is banking on New Residential and other publicly traded businesses to revive Fortress’s stock. Fortress has five permanent-capital vehicles that are public or that it plans to take to market. Unlike private-equity funds, they don’t have to return capital to investors on a certain date, relieving Fortress of the need to raise new funds.
The stocks of firms that oversee such vehicles typically command higher valuations than those of traditional private-equity managers, Edens said in October. If Fortress raises $3 billion in a traditional fund, that may produce $360 million of market value, he said. In a permanent capital vehicle, $3 billion could generate $1.2 billion of market value.
“The math is compelling,” Edens said.
Nationstar, a traditional Fortress investment and the engine of its mortgage machine, is struggling to boost its share price. The No. 2 nonbank servicer has quadrupled its mortgage assets to $353.1 billion in three years and is likely to surpass Ocwen by mid-2015.
While both companies face scrutiny from regulators to comply with new servicing rules, Ocwen’s mishandling of mortgages has derailed the firm. It agreed in December with New York authorities to improve its practices and halt its growth.
Henry Coffey, an analyst for Sterne Agee & Leach Inc., downgrade his rating for Nationstar to neutral from buy on Feb. 26. Its return on equity dropped to 20 percent in 2014 from 40 percent in 2012 as its growth accelerated.
“Nationstar has to rethink its pace of acquisitions in terms of its earnings,” Coffey said.
Shares of Nationstar, where Edens also serves as chairman, have tumbled about 19 percent in the last 12 months. Billionaire investor Kyle Bass, once Nationstar’s biggest investor after Fortress, has sold at least 1.4 million shares in the last year. Fortress’s $1 billion investment in the company has produced a gain of about 89 percent since 2006.
Edens’s own investment in the Milwaukee Bucks may be a better wager. Weeks after he and hedge fund titan Marc Lasry paid $550 million for the professional basketball team in 2014, Steve Ballmer’s $2 billion purchase of the Los Angeles Clippers sent franchise valuations soaring. The Bucks played in the first round of the playoffs this year, losing to the Chicago Bulls, following a dismal 15-67 win-loss record last season.
“I don’t think many of the players thought there was much of a chance of that happening, and look what happened,” Edens said. “A great year for the franchise.”
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