What Ocwen and Altisource do

Erbey’s empire of publicly traded companies (OCN, ASPS, HLSS, AAMC, RESI) is a little confusing.  Here’s my understanding of what his companies do.

*Disclaimer:  Some of the information in this article may be wrong.  I’m not an expert in this stuff.

Ocwen’s bread and butter- mortgage servicing

It all begins when hundreds of American mortgages are packaged into a mortgage-backed security.  The resulting MBS is sliced into various pieces, many of which are sold to various parties.  One of the pieces carved out of a typical MBS is the mortgage servicing rights (MSRs).  The servicer that owns the MSRs is entitled to various payments.  The main source of revenue is typically 25 to 65 basis points on the unpaid principal balance (UPB) of the loans underlying the MBS.  By design, the base fee is typically much higher than the actual cost of servicing the mortgage pool.  This is to avoid a situation where the servicer cannot profitably service the MBS and wants to walk away.

The revenue stream from a MSR is sensitive to prepayments on the underlying mortgages due to refinancings, borrowers selling their houses, borrowers paying off their mortgages early, etc.  These activities cause loans to be taken out of the mortgage pool and therefore the UPB to decline.  More refinancings can happen if interest rates fall and/or home prices appreciate.  The UPB can also decline due to foreclosures.  Various factors affect the likelihood of borrowers deciding to stop paying their mortgages (home prices, unemployment, underwriting quality of the mortgages, balloon payments on mortgages, option ARM resets, the end of teaser rates, etc.).  As you can see… the risks of a MSR are weird.

MSRs do well in an environment with a low number of foreclosures and a low number of refinancings.  The US housing bubble was not that favorable an environment for MSRs as a wave of refinancings was followed by a wave of foreclosures.

Other revenue

The mortgage servicer typically gets to keep:

  • Late payment fees.
  • Prepayment penalties.  (Many mortgages do not have these.)
  • Assumption fees.  Some mortgages can be transferred from the seller of a home to the buyer of the home.  Mortgage assumptions can happen in an environment with rising interest rates.
  • Any kickbacks or “commissions” on services bought by the servicer on behalf of the homeowner or MBS investor.  See my post on force-placed insurance.
  • Interest income on the float generated by borrowers’ payments.  These payments are received slightly before MBS investors are paid.  (The investment income from this float is extremely low right now due to very low interest rates.)

Mortgage servicers can also generate additional fees through:

  • Origination fees for refinancing a mortgage that it currently services.  (Ocwen does this.)
  • Converting a delinquent mortgage into a HAMP mortgage.  The servicer receives upfront fees and subsequent fees if the mortgage does not become delinquent again.

Cost of servicing

Handling the paperwork and collecting payments on a mortgage is pretty straightforward.  Mortgage servicers also have to comply with various state and federal regulations, which imposes a compliance burden on the mortgage servicer.  The fixed costs associated with compliance favours mortgage servicers with scale.

One major expense for mortgage servicers comes from the servicers’ contractual obligation to put up advances.  When a borrower misses mortgage payments, the servicer has to advance the money for regularly scheduled principal and interest payments.  If the borrower catches up on all of the missed payments, the money goes towards repaying the servicer on the advances.  However, the servicer has to pay for the financing of the capital used for the advances.  It does not get reimbursed for its cost of capital (though it is entitled to receive late payment fees).

Advances become problematic for the servicer if the mortgage requires foreclosure and selling the foreclosed property.  The servicer has to advance substantial costs associated with the process:

  • Legal costs to properly foreclose on the property.  Due to the robo-signing controversies in the past, legal costs and compliance costs have gone up.
  • If the tenant is still living in the home, the cost of eviction.
  • The cost of cleaning up the property and repairing it to a state where it can be sold.  Some homeowners leave the property in a state of disrepair or intentionally damage the property.
  • Other property preservation (see this explanation).
  • A title check on the property as any title problems will slow down the resale process.
  • A broker price opinion (BPO) to determine a reasonable resale value for the property.
  • Carrying costs of the property- property tax, hazard insurance, etc.

New regulations have lengthened the entire process somewhat, increasing the cost of financing the servicer’s advances.

Creating value

Ocwen will offer borrowers the opportunity to receive cash to give up the deed and keys to the home (“deed in lieu of foreclosure”), avoiding the costs of foreclosure (money and time).  This saves investors money and increases the present value of their investment.  The servicer saves money because the home can be sold sooner, reducing the cost of advances.

Ocwen will also try hard to modify mortgages within the constraints of the MBS servicing contract.  Modifications retain more of the UPB in the mortgage pool and avoids costly advances, benefiting the servicer.  It also benefits investors because unmodified mortgages will turn into foreclosures, resulting in substantial losses from the foreclosure process.

Altisource works on behavioural analytics and call center scripts to try to increase the percentage of borrowers who voluntarily give up their homes, modify their mortgage, become current on their mortgage, etc. etc.

Ocwen usually tries to buy non-GSE (non-agency) MSRs with very high delinquencies in the underlying mortgage pools because this is where Ocwen can generate a lot of value.

Financial structure

Bill Erbey’s publicly-traded empire started out as one company- Ocwen.  Eventually Ocwen spun-off Altisource.  Altisource generally owns the better businesses with more attractive economics.

The spinoff also removed conflicts of interests between Ocwen and customers of its mortgage servicing technology.  By putting those businesses into Altisource, customers of the mortgage servicing platform did not have to worry about their vendor competing against them directly.  Lastly, Altisource would be able to sell services to MBS investors whose mortgages were being serviced by Ocwen.  Without the spinoff, Ocwen would be buying services from itself with MBS investors’ money.  This is potentially problematic if the investors decided to sue their mortgage servicer.  (In practice, investors rarely sue the servicer.)  Spinning off the mortgage services companies into an “independent” company reduces these concerns.  However, the conflicts of interest between the mortgage servicer and MBS investors is not removed entirely because Ocwen and Altisource are related parties via Bill Erbey’s ownership of both Ocwen and Altisource.

Macro risks

Ocwen would hold onto the MSRs and the macro risks associated with them.  Because of these macro risks, Ocwen cannot safely take on too much leverage on its MSR portfolio.  The next step in Ocwen’s evolution involved transferring these macro risks onto other parties.  Ocwen’s OASIS debt is designed to transfer prepayment risk away from Ocwen for GSE/agency MSRs.  For non-GSE MSRs, Ocwen has been transferring these risks to HLSS (Home Loan Servicing Solutions).  Ocwen has sliced up its MSRs and sold the parts containing macro risks to HLSS.  Ocwen shareholders retain the value created by Ocwen’s low cost of offshore labour, HAMP modifications, origination of home refinancings, etc.

HLSS is also a cheap way for Ocwen to finance its growth and to lower its cost of capital.  Sometimes HLSS has sold slightly overpriced stock to invest in more MSRs.  This is better than Ocwen selling shares as Ocwen shareholders do not experience dilution.  They retain the same percentage ownership of Ocwen’s wonderful servicing business.

Adjacent businesses

Bill Erbey has been constantly expanding his empire into adjacent businesses.

Altisource

Altisource will act as a hired gun for debt collection services- credit cards, auto loans, consumer credit, unpaid second mortgages, mortgages, etc.

Altisource is also working on a number of initiatives that it has lumped together as “mortgage marketplaces”.  It provides software platforms designed for mortgage lenders to run their business.  These platforms also allow its users to conveniently purchase services (e.g. appraisals) from Altisource or 3rd party providers.  Altisource is trying to get more mortgage originators buying services through their software / marketplace.

Altisource’s Hubzu real estate portal is an alternative to traditional MLS systems.  It is an online marketplace for foreclosed (REO) homes.

Ocwen

Ocwen has developed its mortgage origination business and is looking into new areas such as RMBS arbitrage.  Ocwen and Altisource have a partnership in Lenders Onea cooperative for independent mortgage bankers.  Lenders One is a part of Altisource’s marketplaces strategy.

Altisource Residential (RESI)

Altisource Residential will supposedly generate most of its revenue from renting out single-family homes.  So far, only a few percent of its portfolio consists of rental units.

RESI started off by buying delinquent mortgages and foreclosures.  Using Ocwen’s servicing capabilities, RESI is trying to maximize the value of these homes through loan modifications, short sales, etc. etc.  Because these homes are not bound by MBS contracts, RESI does not have to deal with the conflicts of interests between the servicer and mortgage investors.  It can spend more money on repairs to fix homes and has the flexibility to rent out homes that have attractive cap rates.  So far, it seems to me that RESI has mainly made its profits from flipping distressed mortgage loans and foreclosures.  Over time I believe that RESI will accumulate rental units.  Eventually RESI will look at securitizing the rental properties to free up capital to expand the business.

AAMC

AAMC provides asset management services for RESI.

It also has a stake in NewSource, a Bermuda subsidiary that provides insurance and reinsurance related to mortgages.  AAMC owns the equity in NewSource while RESI owns preferred shares in NewSource.

My guess is that the idea behind NewSource is to fulfill one of RESI’s needs.  Because RESI will be purchasing a large number of homes, it will be buying a lot of title insurance.  Currently, title insurance companies (e.g. Altisource’s Premium Title) generally sell title insurance to unsophisticated retail buyers.  Their fee structure incorporates high commissions that are paid to the party that directed business to the title insurance company.  Because RESI will be buying a very large number of homes, it will want to lower its cost of title insurance.  NewSource is designed to cater to volume customers that demand a minimal amount of sales commissions.

Altisource will handle the operations of NewSource for 90% of net income.  I believe that Altisource will also offer NewSource’s insurance via its marketplaces, on which Altisource will presumably take a very small commission.  NewSource will simply provide the capital to absorb some of the risk from this new venture.  This capital came from Altisource to begin with.  In some ways Altisource spun off a new business venture into AAMC.

Recap

If all of the entities were combined, the combination would be a company that mainly focuses on mortgage servicing.  Over time, that core business spread into various adjacent businesses.

Looking at the parts:

  • OCN helps ASPS grow without ASPS shareholders seeing their interest in high quality businesses get diluted.  However, this task has been replaced by HLSS.
  • HLSS helps OCN grow without OCN shareholders seeing their interest in high quality businesses get diluted.  OCN’s growth benefits ASPS shareholders.  HLSS is likely to issue shares while OCN and ASPS are likely to buy back shares.
  • Together, AAMC and RESI form a business that flips delinquent loans and foreclosed properties.  Perhaps one day they will mainly rent out single family homes.
  • AAMC is RESI’s asset manager so AAMC is clearly the higher quality business.  RESI will likely continue to issue shares.  One day, AAMC will likely buy back shares if they weren’t ridiculously overpriced.

Links

Residential Mortgage Servicing for the 21st Century – The document has a good primer on MSRs.  Part I, VIII, and the appendices are the most relevant.

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3 thoughts on “What Ocwen and Altisource do

  1. Pingback: AAMC: A wonderful asset management company | Glenn Chan's Random Notes on Investing

  2. Pingback: Portfolio update November 2014 | Glenn Chan's Random Notes on Investing

  3. Great job explaining a very complicated industry in layman terms. Very informative and I think you have great investment idea with ASPS.
    Oh..great blog!
    FH

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