AAMC is the asset manager that controls the operations of RESI. Asset management is a business with potentially wonderful economics because the returns on capital can be absurdly high.
Suppose that AAMC generates returns on equity of 16%. After taking its fees, the owners of the ‘closed-end fund’ (RESI shareholders) would receive a 10% dividend yield on their REIT. In the current environment of low interest rates and yield hungry investors, it is likely that such a REIT will trade at a premium to book value. AAMC can then sell shares in secondary offerings to further grow their assets under management. High management fees combined with a rapidly growing AUM base can translate into very high returns for AAMC shareholders. The economics are somewhat similar to midstream GPs such as Kinder Morgan.
*Disclosure: No position.
The market cap is around $1.49B. The shares are quite illiquid.
What AAMC does
Historically, Bill Erbey was engaged in the business of owning and servicing MSRs (mortgage servicing rights). His companies Ocwen and Altisource have gotten very good at servicing mortgage pools that have very high levels of delinquencies. Erbey then saw an opportunity in buying up delinquent mortgages that other people do not want to service or own. Altisource spun off Altisource Asset Management Corporation (AAMC) and Altisource Residential (RESI) to handle this new adjacent business. Whereas Ocwen services mortgages and generally does not own mortgages, RESI will own mortgages and pay Ocwen to service them.
Why the opportunity exists
Traditionally, most mortgage servicers do a terrible job at servicing delinquent loans. There is a debt collection-esque aspect to the business where the company has to try to convince the borrower to stay current on their payments and to try to keep their house. If the mortgage would be unaffordable even with a loan modification, then the mortgage servicer should try to pay the borrower to give up the title/deed to their home (deed in lieu of foreclosure). By avoiding the formal foreclosure process, the owners of the mortgage save a lot of money on attorney fees, eviction costs, cleanup costs, intentional damage to the property by the ex-homeowner, etc. etc. Because the foreclosure process takes time, the delays push the cash flows from the mortgage further out into the future and reduce the net present value of the mortgage/future REO.
Mortgages that are securitized tend to be terribly managed. The servicing contracts on non-agency mortgages typically incentivize the servicer to:
- Spend as little money as possible on cleaning up REOs for resale. Money spent on the REO comes out of the servicers’ pocketbook temporarily. However, the servicer has to eat the cost of financing the advance.
- Get rid of the delinquent mortgages and REOs as soon as possible so that they can recoup their advances.
By owning the mortgage as well as servicing it, RESI does not suffer conflicts of interest between the servicer and the mortgage investors. RESI can properly renovate the home before resale. It can also choose between selling a REO and renting it out, depending on the relative risk/reward between the two options. In general, servicing delinquent loans is the most difficult part of mortgage servicing. There are many ways to create value.
See my post on “What Ocwen and Altisource do“.
AAMC is in multiple businesses
- It is the asset manager for RESI.
- It has a title insurance company, which is a three-way investment between Altisource, RESI, and AAMC.
- It is working on new insurance businesses.
In this post, I will stick to discussing #1 since it currently generates the bulk of AAMC’s cash flow and profits. Note that AAMC’s other businesses could be worth a lot in the future. Erbey may put his best ideas for new businesses into AAMC since he will own more AAMC than his other publicly-traded entities.
Illustrative economics
*Don’t take these numbers too seriously. Faulty assumptions may lead to garbage in garbage out.
Suppose that the underlying business has:
- 8% pre-tax return on assets.
- 4% interest rate on debt. (This is an arbitrary number.)
- 3X leverage. I have no idea how much leverage is safe.
- 16% return on equity, given the assumptions above.
In a normalized environment, the underlying business might earn 16% before AAMC’s incentive fees. This is slightly higher than what the business is currently earning with 2X leverage.
I presume that the delinquent loan flipping business is more profitable than renting out single-family residences (SFRs). There are a few publicly-traded REITs that are in the business of renting out SFRs. Their returns aren’t that great. In the future, RESI’s return on assets may decline as it accumulates SFRs and is forced into the business of renting them out.
Incentive fee structure
Page 11 of the 10-K describes the RESI/AAMC incentive fee structure. Here’s my simplification of it.
- The split between RESI and AAMC depends on how high the dividends are.
- If RESI shareholders receive exactly $1.028/year in dividends, then AAMC will receive
~$0.1652~$0.1210 in incentive fees for each RESI share. - Beyond this level, the split will be 50% / 50%.
- AAMC is currently in the ‘high splits’ because RESI’s annual dividends will exceed $1.028/year.
What the future might look like
(*Edited 10/20/2014 to fix some math errors. I believe my numbers are still a little off from the “management incentive fee” figures given in the 10-Ks for some reason.)
Using last quarter’s numbers for share count + book value and assuming a 16% ROE:
- RESI shareholders will see annual dividends of
$2.1768$2.30 per share. RESI’s latest dividend was 45 cents, or $1.80 per share annualized. Basically, I’m projecting that future ROE will increase and therefore the dividends will increase once RESI achieves higher leverage. - AAMC will receive an incentive fee of
$1.3138$1.39 per RESI share.
Suppose that RESI doubles its share count and sells shares at $32.98 (the price it sold shares in the last secondary offering).
- RESI shareholders will receive annual dividends of
$2.5789$2.70. - AAMC will receive an incentive fee of
$1.7160$1.79 per RESI share.
Notice that the dividends jump if RESI can sell shares above book value. Also note that the incentive fees rise dramatically (2.6x). Selling shares above book value helps to put AAMC deeper into the 50/50 splits.
Given these assumptions, the incentive fees will total $203M/year. AAMC will have some expenses such as G&A, taxes (10% tax rate or lower), interest on its preferred shares, etc. etc. It might also see some profits from its insurance businesses. If we simply take that $196 and assign an arbitrary multiple of 15X to it, then a fair market capitalization for AAMC would be $3B. The current market cap is $1.49B or roughly half that. (I ignore share dilution from restricted stock and preferred shares, which will be quite substantial.)
Here is my Google spreadsheet: https://docs.google.com/spreadsheets/d/139PJG-O3Gw3VM-56Pps81rvIclvC1nZtBuIRF3kae1s/edit?usp=sharing If you want to play around with the numbers, you can make your own copy of the spreadsheet.
Drivers of growth
If RESI/AAMC can sustain high returns on equity, then it is likely that RESI will be able to sell more shares above book value. Is a 16% ROE reasonable? For comparison purposes (Google Finance data):
- HLSS has a ROE of 11.26%.
- OCN has a ROE of 17.43%.
- ASPS has a ROE of 82.48%.
- Combined, OCN and ASPS have a ROE of roughly 22.77%.
- Combined, OCN ASPS and HLSS have a ROE of roughly 12.75%.
A 16% ROE for AAMC+RESI seems plausible though I don’t know how realistic it is. If the underlying business exceeds a 16% ROE, then AAMC will benefit massively because the additional profits would be at a 50/50 split rather than a lower split. On the other hand, it is unlikely that RESI will be able to achieve high returns from renting out houses. RESI will need to find ways to keep most of its capital in the business of flipping delinquent loans.
I don’t have any insight on how to model or predict RESI’s capital raises. I have no idea how much capital it will raise.
The naysayers
I used to be one of these people. See my July 2013 writeup on Altisource (and my earlier January 2013 writeup) where I thought that AAMC was overvalued with the share price in the $300s. The share price is currently in the $600s.
Originally, AAMC was an asset manager that began trading at a huge premium to its assets under management ($100M). Currently, RESI’s book value as of the latest quarter is $1,310M so AUM is roughly $1,310M. Given the dramatic increase in AUM, suddenly AAMC does not look so overvalued. I think the lesson here is that one should never short businesses with potentially wonderful economics (e.g. AAMC, KMI, LNG, etc.).
- Here is a VIC writeup from Jan 2013 advocating shorting AAMC.
- Glaucus Research received some attention for their short thesis on AAMC (and long RESI). Their website presents their work. This was around March 19, 2014. So far the long RESI + short AAMC trade would be profitable.
What I’m doing
I am a miser and I do not like paying bid/ask spreads. The bid/ask spread on AAMC is in the ballpark of 4%. If you place an order for an odd lot (not divisible by 100), you will likely be forced to pay the bid/ask spread. Because 100 shares would be too large of a position for me, I would have to pay the bid/ask spread. And as I said earlier, I’m a miser and I don’t want to pay it.
To go long AAMC, I would really have to drink the Kool-Aid. I would need to have faith that Bill Erbey will be able to generate astonishing ROEs in its new adjacent business of flipping delinquent loans. Or, I’d have to believe that RESI will be able to continue to raise astonishing amounts of capital from yield-chasing investors. While such a future may be likely, I’m not completely confident in such a future.
EDIT: The largest position in my portfolio is Altisource. I also own Ocwen. These stocks do not require anywhere as much imagination or Kool-Aid drinking.