The Altisource thesis revisited

Originally, my thesis for Altisource was that regulation wouldn’t be so bad because they would create long-term barriers to entry.  I was wrong.  I did not forsee:

1. The NY DFS blocking Ocwen from buying MSRs.
2. Bill Erbey being forced out of all of his companies.
3. The California DBO threatening to suspend Ocwen’s mortgage license.

Normally, regulations reduce profitability in the short-term especially for industry players who lack scale.  An unintended effect of regulation is reduced competition.  In the long run, low competition will allow the remaining players to enjoy high profitability and high returns on capital.  Unfortunately, this is not how things played out for Ocwen as some of its regulators did not act like typical regulators.

The NY DFS prevented Ocwen from purchasing and onboarding new MSRs.  This only hurts Ocwen.  In the short term, Ocwen has been prevented from investing capital with high returns.  In the long term, regulations around servicing transfers will limit or perhaps even reverse Ocwen’s growth.  If Ocwen is prevented from boarding new loans (because it could not meet the NY DFS’ monitor’s benchmarks), then its existing MSR portfolio will naturally run off and the company will shrink.  I did not expect Ocwen to be regulated in a way that would stifle its growth.  I also did not realize that state regulators had so much leverage against mortgage servicers.  Many of the mortgage pools underlying Ocwen’s servicing rights were designed to be geographically diversified.  The inability to operate in any particular state will affect Ocwen’s ability to service most of its MSRs.

I could not find much information on why the California DBO is threatening Ocwen with a license suspension.  I could not figure out what documentation/information the DBO wanted from Ocwen and why the DBO was not satisfied with what Ocwen produced.

Unusual consequences of the current regulatory environment

One of Ocwen’s strengths is its ability to handle non-performing loans (NPLs).  Going forward, I see the number of NPLs dropping.  Firstly, the excesses from the US subprime lending bubble will slowly work their way through the system.  Secondly, there aren’t many originators making risky loans with a high chance of becoming a NPL.  Those making risky loans face a number of risks that are difficult to estimate:

1. Potential legal risks from representations and warranties clauses.
2. Regulatory risk if QM mortgages are deemed not to be QM.
3. Regulatory risk from servicing similar to the problems Ocwen is currently facing.
4. Simply being investigated by a regulatory agency will saddle the originator with a big legal bill.
5. The possibility of a public relations nightmare (which may be caused by a regulator).

Currently, agency lending is dominating the market.  Ocwen has stated that it makes higher returns on legacy non-agency MSRs than agency MSRs.  I believe (though I’m not 100% sure) that the agency lending today is more conservative/less risky than the days when Fannie Mae offered no-interest loans.  Going forward, the wonderful opportunities in non-agency MSRs with extremely high delinquency rates may go away.  Eventually the opportunities will decline faster than Ocwen’s ability to grow market share.  Ocwen and Altisource may need to find other lines of business that leverage their strengths.  Because Ocwen accounts for most of Altisource’s revenues, their fates are somewhat intertwined.

In the past, Ocwen would buy non-performing loans.  This is a capital-intensive activity compared to owning the servicing rights on loans.  Currently, the Erbey complex is pursuing this market via OCN, ASPS, AAMC, and RESI:

1. RESI puts up the capital.
2. AAMC acts as an asset manager.  It is also involved in title insurance (low cost and without kickbacks/commissions).
3. OCN handles the servicing.
4. ASPS handles the servicing technology and provides default-related services.  It also handles the operations of AAMC’s insurance business.

If this business line was as profitable as non-agency MSRs, Ocwen and Altisource would have put up their own capital for the business.  Because this business line has lower returns on capital, Erbey created RESI to put up the capital for this business.

Yield chasing

In today’s low interest rate environment, there has been strong demand for dividend-paying stocks.  If this trend continues, the yield-oriented vehicles in the Erbey complex (HLSS and RESI) may substantially grow their asset base.  Ocwen, Altisource, and AAMC are capital-light companies that will benefit from the growth of the yield-oriented vehicles.  They may be able to generate high returns on capital by leveraging other people’s money.

• HLSS is a play on mortgage servicing rights.
• RESI is a play on non-performing loans.  Over time, RESI may accumulate a large inventory of NPLs that turn into rental housing units.
• Ocwen’s OASIS notes are a play on interest rate risk.

Ocwen/Altisource has not explained its lender placed insurance “brokerage” business

Altisource shut down its highly profitable lender placed insurance brokerage business.  My theory is that Ocwen sold its kickbacks on lender placed insurance to Altisource.  Whether or not these are kickbacks, insurance commissions, or legitimate brokerage commissions is not that important.  Because the payments may be construed as kickbacks, they could attract unwanted attention from class action lawyers, mortgage investors, and regulators trying to protect borrowers.  There have been numerous class action lawsuits and large settlements over kickbacks on force-placed insurance.  As well, the NY DFS has been particularly aggressive in investigating these kickbacks.  It seems that Ocwen/Altisource obeyed the 2011 mortgage servicing practices (PDF) that prohibited kickbacks on force-placed insurance in New York.

The second issue here is that shareholders may have been treated unfairly.  Lawsky’s letter highlighted a deal between Ocwen and Altisource over lender placed insurance.  He also mentioned that Erbey participated in the approval of the deal between the two companies.  The SEC could find a problem with the deal as Erbey may have benefited one group of shareholders over the other group.  Erbey owns more of Altisource than Ocwen so presumably the original deal may have favored Altisource over Ocwen.  (Ultimately the deal was quite unfavourable for Altisource as Altisource became the bagholder.)

It is possible that Altisource has not repurchased shares since October 2014 because it holds material nonpublic information.  Management stated the following on its Jan 16, 2015 conference call:

[Bill Shepro] So we’re working with our SEC Counsel now to determine whether or not we’ve disclosed enough information with this call to start the buyback program if we can open a window following this call. I don’t know the answer yet. If it is not following this call, it would be after our 10-K is issued and following the window opening after our 10-K is issued.

My theory is that the loss of profit from the lender place insurance business is mostly non-recurring.  If I am right, then that’s bullish for Altisource.  It would arguably be unfair for Altisource to repurchase its shares when the market erroneously thinks that Altisource lost a source of recurring profits.  I can’t be entirely sure about my theory until more information comes out.

Ethically, I would have liked to see more transparency.  To Altisource’s credit, not taking kickbacks is the right thing to do.  I wonder if Nationstar and Walter follow suit in avoiding “insurance commissions” (Walter) and “other fees” (Nationstar) that can be construed as kickbacks.

Servicing quality

Servicing quality can be defined in different ways:

1. From the borrower’s perspective, servicing quality is mainly about helping borrowers stay in their homes.  The best thing that can happen to a borrower is to essentially receive a large sum of free money in the form of a loan modification.  Less important issues are the rate of servicing errors, the servicer’s responsiveness, aggressiveness in collecting escrow, customer service, whether the call center employees speak with an accent, the quality of online portals, etc. etc.
2. From the mortgage investor’s perspective, servicing quality largely depends on how well the servicer helps investors make money.  A good servicer will lower foreclosure timelines, facilitate sensible loan modifications, deny bad loan modifications, find cheap vendors for default-related services, etc. etc.  Where conflicts of interest exist, hopefully the servicer does not abuse the mortgage investors too much.

Measuring servicing quality turns out to be tricky and messy.  In general, I have found Ocwen to be average or above average.  Here are some ways of measuring servicing quality from the consumer’s perspective:

1. CFPB benchmarks.  Until recently, Ocwen was fully compliant.  Its compliance results are currently being re-reviewed as the monitor determined that the past results could not be relied upon.
2. CFPB complaints per loan.  While this data is publicly available on the CFPB’s website, the methodology determines the result.  The white paper “Nonbank Specialty Servicers: What’s the Big Deal?” (page 6) cites an analysis by Compass Point Research & Trading that finds Walter/Green Tree Servicing to generate dramatically fewer complaints than Nationstar and Ocwen.  A Valuewalk blog post cites a different analysis that finds Walter to be worse than its peers.
3. Consumeraffairs.com reviews divided by # of loans serviced.  Unfortunately, this site has become unreliable because Nationstar has basically bought itself good reviews on the site.  Before that happened, Ocwen had a lower rate of complaints per delinquent loan compared to its peers.  Ocwen currently has 1101 reviews (almost all negative) versus Green Tree with 2021 (almost all negative).

Simply looking at things from the consumer’s perspective, I do not believe there is data that suggests that Ocwen has abused consumers (any more than its peers).  I do not believe that there is much merit to the accusations that Bill Erbey ran some sort of shady evil empire.

And from mortgage investors’ perspective:

1. Ratings agencies.  In the past, Ocwen’s servicing quality ratings ranged from average to above average.  Currently it is mostly average.
2. Fannie Mae STAR system.  Ocwen has received some praise from Fannie Mae with 3 stars out of 5.  It did not receive the full 5 out of 5 stars.
3. HAMP compliance.  While this does not measure overall servicing quality directly, HAMP compliance is desirable.  Ocwen is currently fully compliant (Ocwen press release).

The bottom line

The NY DFS dealt a huge blow to Ocwen (and its major vendor Altisource) by preventing Ocwen from executing on its plan of buying more non-agency MSRs.  However, I don’t think that investors should overreact to short-term problems.  Sometimes wonderful businesses only trade at depressed prices when investors overreact to short-term problems.

I don’t know if Altisource will continue to be well-managed with Erbey gone; some reversion to the mean is likely.  However, I think that they will continue to create shareholder value as they have done so in the past.  They have been very savvy at lowering their taxes, lowering their cost of capital through financial engineering, and at investing capital at high returns.  They have done a good job at finding operating efficiencies via technology, behavioural psychology, and using offshore labour.  They have done a great job at operating their businesses (though to be fair they’ve had their failures too).  If they continue to do what they have done in the past, they will find ways to create shareholder value despite being in a constantly changing industry.

*Disclosure:  Long OCN and ASPS.