This part provides an overview of the mortgage servicing industry and why Altisource will be a winner in it.
I am not an expert on the mortgage servicing industry but here is what I understand of it.
What mortgage servicers do
On a mortgage, the lender has to handle paperwork and mortgage payments. If the homeowner is late on payments or stops paying entirely, then the lender has a lot more work to do. The lender may try to negotiate with the homeowner to get back on track with paying their mortgage. It may try to get the homeowner to participate in government programs designed to keep people in their homes (in the wake of the subprime housing crisis there are a lot of these programs). It may try to work with the homeowner on a short sale to avoid the costs of a foreclosure.
Some mortgages will end up in foreclosure. There are many laws and regulations designed to protect homeowners during the foreclosure process. Lenders have compliance costs in making sure that they follow all laws and regulations. After the lenders initiate the foreclosure process, things get really messy. Ex-homeowners often completely trash the property. Some people squat in their home and may return to it even after they are kicked out (this can create dangerous situations). The property needs to be cleaned up and repaired… the lender may or may not elect to do this. Most lenders will sell foreclosed properties, often at large discounts. They may incur hefty sales commissions in doing so. As an alternative, the lender could hold onto the property and rent it out (this will be Altisource Residential’s business model).
Mortgage servicers may handle some or all aspects of the mortgage lifecycle. Some aspects of the mortgage lifecycle are very open-ended and create opportunities for adding value. A great WSJ article makes the following points about Ocwen/Altisource:
- It “has won praise from consumer advocates for its willingness to re-work mortgages and help struggling borrowers stay in their homes”
- The vast majority of its labour force is in India and offshore. While this lowers costs, there are some concerns about protection of personal data and regulatory compliance.
- It has many offshore incorporations to keep taxes down.
Ocwen/Altisource tries to automate as much as possible. For example, delinquent mortgagers are sent multiple letters and a DVD explaining the situation (e.g. how to apply to HARP). This saves time from having a call center employee repeat information to mortgagers. However, there is still a need for trained call center workers as not everything can be automated. On Ocwen’s website is a Morningstar “Operational Risk Assessment” report that contains a lot of detail on Ocwen’s operations.
As for foreclosures, Ocwen/Altisource tries to minimize its sales commissions by running its own real estate portal (Hubzu) and offering real estate agents lower commissions. Moving away from the traditional MLS models allows Ocwen/Altisource to lower their costs. Not surprisingly, real estate professionals complain about this (see complaints about Hubzu/gohoming.com/Ocwen/Altisource on pissedconsumer.com). For activities that require a human touch, Ocwen/Altisource is not perfect. The complaints page on pissedconsumer.com does suggest that its employees do make mistakes. The webpage also suggests that Hubzu has a problem with fake bids. I hope that Altisource/Hubzu is not directly responsible for this as it would be blatantly illegal. Considering that Altisource did not get fined in the robo-signing scandal, it would be unusual for Altisource to do something so ridiculous. My guess (hope?) is that third parties are putting in fake bids to try to increase their compensation (e.g. commissions based on the sale price).
The trend in the financial industry has been to outsource mortgage servicing to other companies. There may be a trend towards consolidation as larger servicers would benefit from fixed cost leverage and economies of scale from software costs, IT, regulatory compliance, etc. Altisource does a lot of in-house software development costs using low-cost offshore labour. It also develops intellectual property / business processes to get better at convincing delinquent mortgagers to restructure their mortgage. I believe that these factors give Altisource a significant cost advantage.
Does Altisource enjoy a durable competitive advantage?
The labour arbitrage advantage: I don’t know why but it seems that Altisource’s competitors have not set themselves up to use offshore labour. Publicly-traded competitors such as Walter Investment Management (WAC) and Nationstar (NSM) only employ Americans. Setting up foreign operations is a very difficult problem, e.g. Walmart’s Sam’s Club failed in Canada. I am sure you can find many more examples of failed international expansions. The problem is difficult enough that there are publicly-traded companies that specialize in outsourcing labour to India (G, CTSH).
Software: Starting a successful software company is very difficult. One of the hardest things to do is finding great programmers. Joel Spolsky (he runs his software company) has a blog post that explains why the process is difficult. Simply running a software company is very difficult by itself. It’s even more difficult if you add in the complications of running a foreign operation. My opinion is that the labour arbitrage is very difficult to pull off. I don’t know how well Altisource has pulled off its labour arbitrage. However, Altisource is highly profitable and has many job postings for Indian programmers/developers.
Business processes: Altisource is much better than its peers at working with delinquent mortgagers at restructuring loans. I don’t know how easy/hard it is to duplicate this.
Overall, I don’t think that Altisource’s ridiculous profitability is based on a single thing. It is a combination of many things that they do well. The Morningstar report referred to earlier “Operational Risk Assessment” (warning: it is boring) provides a lot of insight into the many things that Altisource is doing. Some of the things that they do seem to require a lot of hard-won experience. Altisource takes many steps to prevent payment processing employees from stealing (e.g. video surveillance, no drawers, etc.).
Scale: I believe that scale gives a minor cost advantage. Ocwen/Altisource is not the largest mortgage servicer however. This Reuters article states that big banks such as BAC, Wells, Ally, JPM, and C are the leading mortgage servicers. All five of these banks paid settlements over robo-signing… this suggests that they are not very good at mortgage servicing. All these banks let ex-homeowners squat in their own homes without paying their mortgages for years during the subprime housing madness (including Wells Fargo, a Warren Buffett favorite). I think that Altisource is well-positioned against these larger mortgage servicers.
Relationship with Ocwen: Altisource’s relationship with Ocwen has been hugely beneficial for Altisource since Ocwen is a captive customer. Better yet, Ocwen has been continually issuing equity and increasing its assets. Altisource has been growing without having to spend advertising/marketing money to get more business from Ocwen. However, Altisource would still do extremely well without Ocwen. Ocwen’s share of Altisource’s revenues has been declining as organic growth from non-Ocwen customers has exceeded Ocwen’s growth (the 10-K provides relevant figures).
The future of the mortgage servicing industry
My guess is:
- The trend towards outsourcing mortgage servicing will continue. I think that this financial innovation does create value.
- The major banks will get out of mortgage servicing. They don’t seem to be very good at it (e.g. robo-signing)… engaging in illegal activities suggests incompetent management. The industry will shift towards companies that specialize in mortgage servicing.
- The industry will consolidate into fewer players. The cost of regulatory compliance will limit the number of new competitors.
- My thinking is that Altisource will do very, very well given its competitive strengths. For example, Altisource compares extremely favorably to Wells Fargo. Altisource didn’t allow squatters to live rent-free for years. It didn’t engage in robo-signing. And it isn’t facing a litany of lawsuits for improper behaviour (just Google “Wells Fargo mortgage lawsuit“). In one instance Wells Fargo was slapped with a $3.1M fine for its reprehensible handling of one mortgage.
- Out of the publicly-traded mortgage servicing-related stocks, I think that Altisource (ASPS) will do better than Ocwen (OCN), Walter (WAC), and Nationstar (NSM). All of these companies should compound book value nicely as the overall trend is shifting towards specialist companies.
Basically, I think that Altisource will clearly be a winner.