Risks to Ocwen and Altisource

I apologize for the high volume of Altisource posts.  Altisource is by far my biggest position so I need to make sure that I’m not goofing this one up (especially because I have been doubling down on Altisource).

As far as the risks go:

  •  Ocwen’s future earnings will likely be hurt as I do not see it taking kickbacks on force-placed insurance.
  • Regulation can theoretically be very ugly for Ocwen and Altisource.
  • Declining delinquencies could slow or reverse growth at either company.

Regulations will hurt Ocwen’s profitability

Ocwen currently faces scrutiny from these regulators:

  1. The CFPB.
  2. The NY DFS.
  3. The SEC.

Altisource recently announced that it will discontinue its lender-placed insurance “brokerage” business (see my previous posts here and here).  I think that this is bad news for Ocwen.  Presumably, it is Ocwen that directs the flow of lender placed insurance and it is Ocwen that is entitled to kickbacks (or “insurance commissions”).  My theory is that Ocwen took a lump-sum payment and in exchange gave all of the future kickbacks to Altisource when Altisource bought Beltline.  From what I can gather, this deal expires at the end of 2014.  In 2015, some new deal would be reached beforehand.

Note that Ocwen did not issue an 8-K in connection with Altisource’s cancellation of its brokerage business.  This could be because Altisource will be the bagholder and eat all of the costs.  Ocwen’s upfront lump-sum payment is unaffected.  From 2015 onwards I doubt that Ocwen will take any insurance kickbacks.  It will take a recurring hit to its earnings.  This might (or might not) translate to $45M to $60M a year.  However, the stock market disagrees with me because Altisource fell more on the news than Ocwen.

I don’t know which regulator caused Altisource to exit the business.  One of Lawsky’s letters to Ocwen suggested that Ocwen did not do any of this in New York State.  However, Lawsky theoretically could go after Ocwen to protect any New York-based mortgage investors (???).  The SEC might have minor problems with the conflicts of interests between Ocwen and Altisource shareholders due to the related party transactions.  However, I doubt that this would cause Altisource to exit the “brokerage” business and to harm its shareholders so badly in exiting the business.  It could be that the CFPB is now deciding that it will go after these kickbacks; I really don’t know.  Its prior consent order left the door open for small kickbacks (“Any force-placed insurance policy must be purchased for a commercially reasonable price”).

Consumer Financial Protection Bureau

Ocwen and Wells Fargo are currently fully compliant with the CFPB monitor’s metrics (while other big banks and GreenTree/Walter are not).  However, the CFPB has increased its regulatory burden on Ocwen since the consent order:

  1. As mentioned above, the CFPB may or may not have pressured Ocwen to stop taking kickbacks.
  2. Foreclosure timelines are longer.
  3. Ocwen can no longer force homeowners to agree to a gag order along with their home modification.

NY DFS

I have no idea what they will do to Ocwen.  In theory, they “ought” to do the right thing for society.  In practice, Benjamin Lawsky clearly is not doing the right thing.  This is extortion-style regulation… and it will likely be worse than typical regulation.

Ocwen has set aside $100M for a settlement.  The actual amount may exceed $100M.  This potential settlement with one state is greater than Ocwen’s settlement with 49 states under the CFPB consent order.  Ocwen’s 10-K states the loss under the CFPB settlement:

In addition, in 2013 we recorded a loss of $53.5 million in connection with our settlement with the CFPB and various state Attorneys General and other agencies that regulate the mortgage servicing industry regarding certain foreclosure related matters.

In addition, the New York settlement could impose additional restrictions on what Ocwen can and can’t do.  The most harmful restriction I can think of is hindering Ocwen’s ability to buy more MSRs.  I think that the rates of return on MSR transfers of highly-delinquent subprime portfolios will be very attractive for Ocwen.  Blocking such transfers would be awful for Ocwen.

The SEC

The division of profits between Ocwen and Altisource is a zero-sum game.  Because Bill Erbey owns a greater percentage of Altisource than Ocwen, one can reasonably expect that related party transactions will favour Altisource.  Robert D Stiles, former Altisource CFO and current Walter CFO, recognized this when he left Ocwen to join Altisource.  His Altisource options must have done quite well.

Whenever the SEC investigates Ocwen and/or Altisource, it will impose costs on both of those companies as they each have to hire their own set of securities lawyers.  The cost may “only” be a few million dollars, which would be fairly immaterial to both companies.  Ocwen disclosed a SEC subpoena in its 10-Q:

On June 12, 2014, we received a subpoena from the SEC requesting production of various documents relating to our business dealings with Altisource, HLSS, AAMC and Residential and the interests of our directors and executive officers in these companies. Following the above-described announcement on August 12, 2014 that we intend to amend our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 and our Quarterly Report on Form 10-Q for the quarter ended March 31, 2014, the Staff informed us that it plans to serve us with an additional subpoena in relation to such amendments.

Collusion between Ocwen and Altisource

Here’s my theory about why it makes sense for Ocwen and Altisource to work together in extracting fees from mortgage investors (and to a lesser extent borrowers).

Before a delinquent mortgage turns into a foreclosure, Ocwen has to direct the purchases of various default-related services.  If the borrower manages to rescue his/her home and avoid foreclosure, then the borrower may be on the hook for these fees.  In theory, the piling up of these fees may make it more difficult for borrowers to stave off foreclosure.  (But let’s be honest… these fees likely will not make a difference in whether or not the borrowers lose their homes.)  Otherwise, the mortgage investors will pay the fees.  Ocwen’s website has a schedule of various fees.

In theory, Ocwen could take kickbacks on the default-related services it buys on behalf of borrowers and mortgage investors.  I believe the CFPB consent order forbids them from doing this.  However, it’s possible that Ocwen and Altisource will continue to do it anyways.

Ocwen purchases technology and IT services from Altisource.  This money is paid by Ocwen shareholders.
Ocwen purchases default-related services from Altisource.  This money is paid by borrowers or mortgage investors.

Ocwen can underpay for technology and IT services.  This is a win for Ocwen shareholders because Ocwen’s out-of-pocket expenses go down.  Ocwen can overpay for default-related services from Altisource.  This is only a minor expense for Ocwen as it only has to finance the advances to pay for such services.  This can creates a win-win opportunity where money can be transferred from mortgage investors (and borrowers) to Ocwen/Altisource.  This may explain why the margins on default-related services are so high and why the margins on technology services is so low.

The parties that get hurt the most by this practice are the mortgage investors.  They are the ones who usually end up paying for default-related services.  So far, I don’t believe that any mortgage investors have sued over this.  This practice would be slightly harmful to borrowers.  This could potentially be a problem if regulators find fault with this.  So far it seems like they haven’t.  Benjamin Lawsky of the NY DFS largely hasn’t commented on this though he did have some questions about Ocwen’s relationship with Hubzu (owned by Altisource).  If a home is being sold on Hubzu, the borrower has already been foreclosed upon and would not be on the hook for inflated fees.  Theoretically, if the home were to sell for a very high price, then the ex-borrower may be entitled to the proceeds in excess of the unpaid loan amounts.  There may be extremely rare scenarios where inflated Hubzu fees would hurt the consumer.

In practice, Ocwen seems to have “most favored nations” pricing from Altisource (see this website).  It receives the best rate that Ocwen offers to any of its customers.  However, I think that there are small ways in which Ocwen/Altisource can game this a little.  For example, Altisource can simply choose not to provide volume discounts where volume discounts would be warranted.  Ocwen is always Altisource’s largest customer.  By not receiving volume discounts that it would normally be entitled to, Ocwen can mildly overpay for default-related services.

Historical perspective

Servicers have always “abused” mortgage investors to some degree via kickbacks on force-placed insurance.  Large mortgage investors such as Fannie Mae and Freddie Mac did not sue servicers over this.  However, they changed the rules and no longer allowed kickbacks.

Part of the reason why they didn’t sue is perhaps because they did not want to hurt their partners (the partners being the mortgage originators who end up with MSRs that the originators can sell).  In 2002, Fannie Mae decided not to exercise clean-up calls because it did not want to screw those invested in mortgage-backed securities.  Similarly, Fannie might be trying to avoid a situation where it is suing its partners.

Are mortgage servicers so evil?  (Round 2)

As far as kickbacks go, they are found in many places in the mortgage industry.  Mortgage originators like Ocwen, banks, most homebuilders, etc. etc. will all gladly take kickbacks on title insurance.

I would point out that investment banks have caused more problems for society than the mortgage servicers.  The reason why foreclosure rates are unusually high is because there was so much dumb lending during the subprime bubble.  Investment banks had a key role in the madness as they participated in the securitization of toxic mortgage-backed securities.  They hurt the people they sold the securitizations to.  They enabled the risky lending that caused a lot of problems for everyday Americans who did not understand what they were getting themselves into.  The underwriters are far worse than the mortgage servicers.

Declining delinquencies

Ocwen can generate the most value on highly-delinquent portfolios because Ocwen’s roots are in dealing with delinquencies.  There is more room for value creation with delinquent mortgages rather than current mortgages.  If Ocwen were to buy low-delinquency MSRs, their brilliance and returns on capital will be watered down.

Ocwen’s management wants to see originators underwrite risky non-QM mortgages because it would lead to a supply of MSRs with high delinquencies.  At the same time, Ocwen does not want to take any credit risk on risky mortgages.  (It also doesn’t want interest rate or prepayment risk.)  Ocwen smartly does not want exposure to potentially toxic mortgages.  Personally, I think that this is perverse.  The subprime housing crisis has clearly demonstrated the destructive effects of risky mortgages.  Ocwen wants America to return to socially-destructive lending because it would create an environment where they can make more money.  Currently, Ocwen is getting into the business of originating Ginnie Mae reverse mortgages, which they expect will have high delinquencies.  Ocwen will presumably securitize those mortgages and hold onto the MSRs.  If this plan fails or Ocwen fails to buy large amounts of high-delinquency MSRs, Ocwen could see reduced returns in the future.

On the Altisource side of things, Altisource’s most profitable business is in default-related services.  Their biggest customer is Ocwen.  Clearly, delinquencies are coming down as option-ARM mortgages reset and the subprime excesses get worked off.  Altisource will need to find some way to fill their capacity.  The ideal scenario is if Ocwen is able to buy lots and lots of high-delinquency MSRs.  Currently, the NY DFS has blocked Ocwen from purchasing MSRs from Wells Fargo.  The deal has since been cancelled (8-K filing).

A slide from an old investor presentation provides projections on Altisource’s revenues under different scenarios:

service-revenue-scenarios

Altisource expects that its default-related services will decline over time unless Ocwen buys servicing rights to more delinquent mortgages.  Altisource seems to have taken down presentations link from their website.

asps-revisionism

The revisionism to their website could be a red flag.

*Disclosure:  Long ASPS and OCN.  I think that ASPS has better risk/reward.

Advertisements

7 thoughts on “Risks to Ocwen and Altisource

  1. sounds like you’re too emotionally involved with ASPS. it’s painful to read this post…too many wishful thinking and inconsistencies to make any logical sense.

  2. I think it could be a mistake to make this position really large. There is always some black box element around it. In hindsight, I wish I would have stayed away from this one alltogether. I think it belongs in the too hard pile. Why bother with such a complex stock if there are potentially more simple investments out there? In order to make it a large one, it has to be simple to understand, and very obviously badly mispriced with no black swan potential horror scenario’s surrounding it.

    Still im in this one, and let’s see how it goes :). But it certainly seems that having to spend a large amount of time like this on a stock and still be somewhat insecure about it is not a good thing. It seems to be a better idea to focus on small caps that are easier to understand with no regulatory bullshit around them. Even if upside is not 4 or 5x like with this one.

    Did you email IR about the removal of those presentations?

    • I think too many people are losing their cool over this one. Are Altisource’s problems similar to Amex’s salad oil scandal? Or are they similar to the government coming down on the for-profit industry?

      I think that it is more like the salad oil scandal. All mortgage servicers make mistakes but that’s the nature of it. The servicers are incentivized to be low-cost and the consumers sign a legal contract that doesn’t do much to ensure high servicing quality. The worst problems are the missed opportunities for loan modifications. In that area, Ocwen is a leader. Because Ocwen is average or above average in servicing quality, they shouldn’t be at risk. It will be the most abusive players that will go away first.

      It would be a terrible outcome if some level of government regulated away part of the industry. If servicers start going bankrupt or walking away from their MSRs, then somebody still needs to service these mortgages. They will be transferred to stronger servicers like low-cost Ocwen. And if nobody services the subprime MSRs, then the industry would grind to a halt and many people will be unable to buy a home when they can’t get a mortgage. What regulator would be dumb enough to create that scenario?

  3. It seems they remove all but their last Q’s presentation and earnings call. So next quarter they will remove Q3’s transcript and presentation. I don’t think this is a red flag.

  4. A lot of uncertainty around this one. From what I’ve gathered so far, the positives simply trump the negatives.

    As opposed to wishful turn-around cases (cough, SHLD), ASPS still gushing cash, they are (hopefully) still buying stock with rage and they’ve got skilled owner-operator at helm.

    It’s reasonable to assume that Ocwen can buy more MSRs in the future than not, in which case both stocks will without a doubt take off. As far as I understand, Altisources business isn’t necessarily completely obliterated if that’s the case.

    I’m happy with the worst-case scenario happening because it looks like a slim probability. If it’s something completely unforeseaable, can it be considered as a mistake? If it’s, for example, the scenario above, the risks were known and this time it happened to materialize. Whatever happens, this will prove to be a valuable lesson looking forward.

  5. Good on understanding
    I think the rate of buyback alone makes the investment good. When the problem is solved, then the investment is going to be more than good. ASPS is buying back stock at 100$. So at 50 … unless the guys at ASPS don’t know what they are doing when deciding to buy shares. Which I doubt.

  6. I think on the whole this is a very attractive opportunity. The biggest negative I see is their heavy reliance on Ocwen, which is a shame or else I think this could be a very large position at the current price. Sure their platform and technology is extremely valuable to other market participants and in the long-term they should be able to diversify their customer base.

    If they weren’t so heavily tied to Ocwen this may automatically be a very large position for me. Unfortunately they aren’t serving like hundreds or thousands of customers. But of course, if it wasn’t for their customer concentration in the first place, this opportunity would probably not exist today.

    Customer concentration is always a considerable risk.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s