Altisource and being greedy when others are fearful

Let me clarify how I feel about Altisource… I am extremely bullish on it.  It has everything I want in an investment:

1. Wonderful economics.  Historical growth over 30%/year with very high high returns on capital.
2. Low valuation.  P/E less than 10.  As a bonus, Altisource has gone crazy buying back shares after the share price fell.  It has bought back more than its free cash flow.
3. Talented management (see #1).
4. Ethical management.

In general, I always try to look at both sides of an argument.  To figure out if I am right about something, I try to prove myself wrong (e.g. to figure out the short thesis and to consider it).  That being said, I think that the fears over Altisource have been overdone.

Is now the time to be greedy when others are fearful?  I don’t like being promotional on this blog but I will say that I have been buying more Altisource.

Integrity

Overall, I think that Altisource and Ocwen combined have behaved with integrity.  They lead the industry in terms of loan modifications and avoiding foreclosures.  This has created a lot of value for society.  The pair also focus on creating efficiencies via technology, which also creates value for society.  Their record is blemished somewhat by allowing Cross Country Home Services to scam Ocwen borrowers (see “Are mortgage servicers evil?”).  Nonetheless, the big picture is that Ocwen has behaved ethically.  Compared to its peers, Ocwen is above average in terms of compliance with the CFPB.

I think that Ocwen is an honest business with an overzealous regulator (the NY DFS / Benjamin Lawsky).  Let’s look at somewhat similar situations.  Berkshire Hathaway was an honest business that was targeted by the SEC due to the potential conflicts of interest in its cross holdings between Blue Chip Stamps, Berkshire, Wesco, etc.  In the end, Berkshire settled with the SEC in 1976 admitting no wrongdoing, paid a $115,000 fine, and moved on (according to this website).  Berkshire stock has performed incredibly well since then.

Microsoft ran into anti-trust issues with regulators in the late 1990s and early 2000s over ridiculous concerns that bundling Internet Explorer with Windows was stifling competition.  With the benefit of 20/20 hindsight, we can see that the bundling did not stop Google Chrome from overtaking Internet Explorer in market share (Wikipedia summarizes some statistics).  In any case, Microsoft continued to compound book value per share since its antitrust issues.  Honest businesses tend to overcome their regulatory issues.

In rare cases, regulators have managed to deal a huge amount of damage to honest businesses.  There are numerous instances of regulators investigating hedge funds and saddling them with legal fees and other problems (e.g. Ed Thorp’s Princeton/Newport Partners was shut down despite not being guilty of racketeering or tax fraud charges).  This effect is likely unique to the hedge fund industry as clients can pull money out of controversial hedge funds.  It is the AUM outflow triggered by regulators that hurts the hedge fund’s business model.  Mortgage servicers do not have a similar dynamic that magnifies regulatory damage*.

(*When Ocwen wishes to purchase MSRs, the transfer of servicing rights must be approved by the securitization’s trustee.  The trustee is theoretically supposed to perform due diligence on the new servicer and to protect the mortgage investors from bad servicing.  If there are concerns about Ocwen’s servicing quality, then Ocwen may face difficulties in purchasing MSRs and difficulties in its relationship with HLSS.)

It is unlikely that regulators will devastate the mortgage servicing industry

If regulators were to put many mortgage servicers out of business, the consequences would be severe.  Somebody still has to service the mortgages.  If servicers exited the business, then the servicing will need to be transferred to another company.  The act of transferring mortgage servicing from one servicer to another is inherently harmful to consumers.  Some paperwork will likely be lost in the process.  Loan modifications approved by the old servicer may not be honored by the new servicer.  There will inevitably be unnecessary foreclosures.  Rapid servicing growth among the remaining servicers will also create problems with servicing quality.

Regulators want to be seen as being on the consumer’s side.  They are often motivated by their political goals.  They do not want to be seen as pushing borrowers into foreclosure unnecessarily.

I believe that the CFPB understands the importance of not bankrupting the mortgage servicing industry.  On one hand, the CFPB has forced the servicers to increase their servicing quality to benefit the consumer.  While this hurts the servicers’ profitability, it was not so costly that it would push servicers into exiting the business.  On the other hand, The CFPB has allowed the servicers to continue with their existing practice of kickbacks on force-placed insurance (so far at least; I don’t know if this may change in the future).  The fines to servicers were rather small.  It chose not to deal a heavy economic blow to the mortgage servicing industry relative to the NY DFS.

The NY DFS has been a far more aggressive regulator than the CFPB.  The NY DFS extorted very large settlements from investment banks.  It has been quite aggressive in extracting fines from companies that it can hold hostage.  The NY DFS will likely extort a settlement from Ocwen that is equal to or exceeds $100M.  Ocwen will pay more to one state than it did in its CFPB settlement for 49 states (somewhere around $53.5M).  While the settlement has not happened yet and its terms are unknown, I just don’t see the NY DFS putting Ocwen out of business.  Ocwen is one of the lowest-cost mortgage servicers.  If Ocwen were to exit the business, it would imply that every other mortgage servicer would be exiting the business.  I don’t know who would be left to service all of the legacy subprime mortgages.  Any remaining servicers can walk away from the mortgage servicing business entirely if they cannot make a profit.  This seems like a scenario that would not benefit the people who are using the NY DFS to further their political careers (e.g. Benjamin Lawsky).

Altisource versus Ocwen

The CFPB consent order with Ocwen and subsequent changes force Ocwen into increasing its servicing quality to benefit consumers.  For example, consumers benefit if they have a single point of contact rather than explaining their situation over and over again to several different employees.  Ocwen’s appointment system helps it achieve the CFPB’s single point of contact requirements.  The CFPB consent order also required Ocwen to build an online portal/website and to send lots of mail to inform the borrower about certain things (e.g. impending force-placement of hazard insurance).

While Ocwen’s expenses have gone up due to the new requirements, some of the changes increases Altisource’s revenues.  Altisource builds the web portals, automated mail systems, and the software to handle the appointment system.  Ocwen’s settlement with the NY DFS could saddle Ocwen with more expenses and may help drive higher revenue at Altisource.  While Altisource has been hurt by some of the changes in the regulatory environment (e.g. it exited the force-placed insurance business), regulation may not be that awful for Altisource.

My expectations

Next quarter, I expect Altisource to take a huge one-time impairment charge relating to Altisource exiting the force-placed insurance “brokerage” business (see “Kickbacks on force-placed insurance revisited“).  If this does not happen, then I really screwed up my analysis of the company.  I would need to reconsider what I’m doing.

Within the next 2-3 quarters, Ocwen should announce a settlement with the NY DFS.  With the CFPB, Ocwen announced a settlement 2 quarters after it recorded a charge for the impending settlement.  It is possible that a settlement takes longer.  If Benjamin Lawsky leaves the NY DFS as rumoured, then it is possible that there would be delays.  Maybe his successor has different political goals.  In any case, I expect Ocwen to settle and move on.  I don’t expect the end of the world.

Given low share prices, I see OCN, ASPS, and AAMC continuing to buy back shares at a high rate.  OCN may be more conservative on its buybacks depending on:

1. How harmful its NY DFS settlement is.
2. The rates of return on purchasing more MSRs.

I expect Altisource to buy back shares hand over first like it did in the previous quarter.  It spent $128.1M on share repurchases versus net income of $43.1M (I did not adjust net income for amortization of acquisition-related intangible assets).

In the long run, I expect Altisource to grow its earnings at very high rates (e.g. above 20%).  Its earnings growth will depend on Ocwen’s ability to buy high-delinquency MSRs.

*Disclosure:  Most of my portfolio is in ASPS and a much smaller portion of it in OCN.  I did not diversify my longs; my lack of diversification could be a mistake.