- Regulators are difficult to predict.
- Don’t underestimate the amount of damage that a regulator can do.
- Use small position sizes for companies with potentially nasty regulatory risk.
While I was always aware of #1, #2 is what really got me into trouble. Due to the actions of the NY DFS, I do not see the subprime mortgage servicing industry as an attractive one. Lawsky may succeed in regulating away the industry’s profitability and crippling the growth of subprime servicers.
Regulators are difficult to predict
In practice, many CEOs seem to be no good at predicting what regulators will do. For example, many CEOs attempt mergers/takeovers that are later blocked by regulators (e.g. BHP/Potash); if they had known the outcome they would not attempt these mergers in the first place.
I don’t think Bill Erbey anticipated what the NY DFS would do to his companies.
- OCN, ASPS, and AAMC repurchased shares at prices several times higher than current prices.
- It is unlikely that Ocwen would have attempted to buy MSRs from Wells Fargo if it had known that Lawsky would block the deal.
I think a large part of the problem is that the NY DFS established a set of rules in Ocwen’s 2011 NY DFS consent order (PDF). Later, the NY DFS decided to operate based on a completely different set of new rules. Furthermore, the NY DFS retroactively punished Ocwen based on the new rules. And the NY DFS still hasn’t established all the rules of the game. Once the NY DFS selects a monitor for Ocwen, the monitor will be tasked with developing a set of benchmarks for Ocwen to follow. In the meantime, the NY DFS has blocked Ocwen from boarding new loans until the company is compliant with the currently non-existent benchmarks.
Going forward, it will be a real problem for capitalists if they will be arbitrarily punished based on an unknown set of rules. When a mortgage servicer decides to purchase MSRs, the servicer has to estimate future regulatory-related costs (foreclosure timelines, direct expenses, fines, other revenue such as insurance commissions on force-placed insurance, etc.) when figuring out how much to bid on MSRs. The inability to predict these future costs makes it incredibly difficult to value MSRs. Also, mortgage servicing will become a tougher business if regulators decide to arbitrarily increase servicing costs. So far the trend of higher servicing costs has continued.
Don’t underestimate the amount of damage that a regulator can do
I’ve researched a number of companies that simply paid a small/large fine and moved on. DaVita (writeup) is the most unethical company that I have ever researched. My opinion (not to be confused with fact) is that they murdered dialysis patients to earn kickbacks. Davita paid a large fine and moved on. Its share price has done quite well. I erroneously thought that regulators’ punishment would have some weak relationship to the misdeeds. I was very wrong to think that.
The most pernicious aspect of Ocwen’s settlement with the NY DFS has to do with regulations over servicing transfers. The NY DFS has selectively gone after servicing transfers of MSRs with high delinquencies (I’ll simply refer to them as subprime MSRs). Subprime MSRs are Ocwen’s bread and butter. If Ocwen is not allowed to purchase subprime MSRs, then Ocwen will shrink as its existing MSRs naturally decline. If it is never allowed to purchase subprime MSRs then it will effectively be forced out of the business. Lawsky will have succeeded in regulating Ocwen out of a key business.
So far, it is unclear what will happen. We will have to wait and see what Ocwen’s benchmarks will be. The additional rules will impose additional costs on servicing transfers. This reduces the value arbitrage from banks selling MSRs to specialist servicers that do a better job at servicing the MSRs. This is bad for companies that want to specialize in servicing (e.g. all of the non-bank mortgage servicers).
There will also be additional scrutiny over whether the servicers are charging excessive fees for default-related services and REO sales commissions. This will increase compliance costs for Ocwen/Altisource and Nationstar/Solutionstar.
I believe each individual state has a huge amount of leverage over Ocwen and other servicers. Mortgage pools were designed to be highly diversified from a geographical perspective. Many mortgage pools have mortgages in most US states. An inability to operate in any given state will affect the servicer’s ability to service most (or virtually all) of its MSRs. However, I’m not a lawyer and I don’t understand the intricacies of all the different pooling and servicing agreements out there.
Out of Ocwen’s $150M fine under the NY DFS settlement, only $50M of that will go to borrowers. $100M will go towards the State of New York. It is possible that other states may go after Ocwen to extort money from the company. If that happens, I do not think that mortgage servicers will be able to generate high shareholder returns. I have no idea if the California DBO is headed down that path.
Forcing the CEO to leave
In my opinion, Erbey is an excellent CEO.
Unfortunately, the NY DFS forced him to exit all of his companies. I do not believe that this is a socially desirable outcome because I believe that shareholders benefit when management has a lot of skin in the game (Erbey is a major shareholder in all of his companies). Nonetheless, he has been pushed out. In the long run, this can be a bad outcome for shareholders because the skill of the CEO plays a very significant role in shareholder return. In my short portfolio, the quality of the insiders is the #1 factor I look at.
Other possible mistakes
I could have done more research on the NY DFS
In hindsight, it’s easy to see that Lawsky marches to the beat of his own drum. One could argue that regulators are normally motivated by:
- Personal self-interest. Many SEC employees for example work for the private sector after leaving the SEC. I believe that this explains why SEC enforcement is extremely light on investment banks, high frequency trading firms, market makers, etc.
- Political self-interest. Some regulators try to get a high profile in the press to further their future political careers.
- Politics. Sometimes politicians will apply pressure on regulators to behave in a certain way to further the politicians’ goals.
- Fiscal deficits. Regulators may try to extract large fines to shore up a state’s budget.
- Doing the right thing and protecting consumers.
However, there are many instances where Lawsky does not seem to be motivated by any of those factors. The NY DFS has gone after:
- Lyft, a company that is trying to break the taxi cartel.
- RelayRides, a car sharing service.
- Bitcoin. The NY DFS’ proposed Bitcoin regulation has made Lawsky very unpopular among the Bitcoin community. The proposed regulation may stifle innovation as many Bitcoin companies intend on avoiding New York if the regulations are too onerous.
- Cybersecurity for banks. This does not seem like an area where consumers are crying out for help because they have been horribly abused.
It seems that Lawsky has his own ideas about what a regulator is supposed to do and has his own ideas about right and wrong.
As far as the punishments go, the NY DFS seems rather extreme. It extracted massive fines from foreign banks. It punished a monitor (PWC) for watering down its report submitted to regulators (press release). In the case of Standard Chartered, the NY DFS came back for a second round of blood in 2014 after it was unhappy that the bank did not fully clean up its act after its 2012 settlement.
Lawsky’s speeches on non-bank servicers do foreshadow what would later happen to Ocwen. His speeches on Feb 12, 2014 and May 20, 2014 made veiled references to Ocwen’s 70 percent cost advantage. To some degree his speech telegraphed what he was about to do (emphasis mine):
I think it is appropriate for regulators – where warranted – to halt the explosive growth in the non-bank mortgage servicing industry before more homeowners get hurt.
This is not to say that specialty servicers with expertise in dealing with distressed loans do not have a place in the financial markets. If they can dedicate the necessary time and attention to individual loans – they may be a very good thing.
But regulators should not just be rubber stamps. And if they have serious questions about a company’s ability to deal with those loans without hurting homeowners – they should act.
Note that Lawsky was prepared to halt the growth of the non-bank mortgage servicing industry before all of the evidence was in. In hindsight, I should have taken Lawsky more seriously and should have realized that he would do what he said he would do. I should not have been blindsided by the big share buybacks at Altisource and Ocwen.
At the same time, I think that the current environment would have been incredibly difficult to predict. If you had a time machine and explained current events to yourself 2 years ago, I think that the current situation would be hard to comprehend.
- Wells Fargo and Ocwen would be fully compliant with the CFPB’s fairly comprehensive set of compliance metrics. Despite being one of the few compliant servicers, Ocwen would go on to have terrible regulatory woes. (*It now turns out that Ocwen will not be fully compliant with the CFPB metrics.)
- Ocwen would receive no credit from regulators for its hard work at giving loan modifications to borrowers. In other words, Ocwen would get very little credit for doing the right thing.
- RMBS investors would threaten to sue Ocwen for giving too many loan modifications. Regulators and consumer protection advocates would accuse Ocwen of giving too few loan modifications.
- Ocwen, Altisource, and AAMC would repurchase shares at up to 10X their future price a year later.
The Erbey complex went down due to shadiness
When it comes to regulators, shadiness may not be that important.
- Sometimes regulators will go after people who are the most successful, rich, powerful, etc. They are targeted simply because they are successful/rich/powerful rather than their actual misdeeds (e.g. Microsoft). I believe that this is a trait that is wired into human beings.
- Sometimes regulators will go after the wrong people (e.g. short sellers who are right about a company being a fraud).
- For various reasons, some regulators will do their jobs poorly.
When it comes to stock performance, integrity of management is extremely important because some management teams cook the books or steal from shareholders.
Maybe I’m crazy, but I still think that Bill Erbey is above-average in terms of integrity.
In defence of Bill Erbey:
- I agree with Erbey that the #1 issue for consumers is loan modifications. I do think that Erbey was very innovative in that department with things like mailing DVDs on what homeowners can do to save their homes, their appointment system for single point of contact, consumer psychology, the Shared Appreciation Modification program, balloon payment modifications, etc. etc. Some independent sources support the view that Ocwen worked hard to give out a lot of loan modifications (here, here).
- Erbey looked for opportunity to create value in a socially-responsible manner (e.g. consumer psychology, technology, offshore labour, business processes, etc.).
- He treated shareholders more than fairly. When an interest-only investment went bad, Erbey and Wish repurchased the investment for $14M above market value (see page 10 of this Ocwen 10-Q).
- Overall I think that Erbey is more ethical than Malone. Compared to John Malone, Erbey’s spinoffs are more ethical. John Malone spinoffs often do not create value. They exist so that Malone can trade against his own shareholders. When it comes to legal contracts and rules, John Malone is always very aggressive in pushing for what he wants. He has had various run-ins with the IRS where the IRS has gone after Malone’s tax avoidance schemes. Malone has no problem with screwing bondholders, leading bondholders to sue him. The Liberty B share structures are arguably poor corporate governance. Malone always tries to get a full premium for his B shares (shareholders foot the bill).
On the con side:
- Ocwen/Altisource both seem to have engaged in kickbacks on force-placed insurance.
- Ocwen allowed its borrowers to be scammed by Cross Country’s deceptive cheque scheme.
Other things Ocwen has been accused of:
- Making errors that are extremely aggravating for borrowers (e.g. erroneous placement of insurance, unpaid taxes/HOA/insurance, etc. etc.). From a consumer protection standpoint, I think that loan modifications are far more important than zero errors. That being said, a lower error rate would be good for consumers. However, there is a balance between shareholder return and doing what’s right for consumers. I don’t think that it would be appropriate for Ocwen to be run like a charity.
- Pushing for foreclosures because it would make more money. I believe the opposite is true. Despite the rise in foreclosures, servicers seem to be going bankrupt more frequently.
- Nefariously backdating letters to prevent homeowners from getting a loan modification. If Ocwen wanted to deny a loan modification, it can simply say no. There is no law that forces servicers to issue loan modifications. The right thing for Ocwen to do is to give out sensible loan modifications and to reject loan modifications that will fail.
The spinoff structure is problematic
I don’t think it is. The Ocwen/Altisource spinoff was slightly beneficial for consumers and mortgage investors.
Suppose that Ocwen had a structure like Nationstar where everything is within a single company. If the servicer purchases default-related services from itself, there is a very strong incentive to charge above-market rates. The Ocwen/Altisource spinoff was structured so that Ocwen was legally obligated to purchase services at market rates. There is less incentive to purchase services at above-market rates. Legally, Ocwen is not supposed to do it due to its contracts with Altisource and due to insiders’ fiduciary duty to shareholders. In practice, it seems that some of Altisource’s services are at the high end of the range of market rates out there.
Because Erbey owns more of Altisource than Ocwen, he has an incentive to transfer wealth from Ocwen to Altisource by doing things such as buying Altisource services at the high end of market prices. I don’t believe that the conflicts of interest between Ocwen and Altisource shareholders have been problematic in practice.
HLSS and RESI are attempts by Erbey to lower his cost of capital. The relationship between AAMC and RESI is very similar to that of a closed-end fund and a publicly-traded asset manager. I think that these are examples of how capital markets should work. I think that asset managers can create value for society when their fees are justified by the value that they create. “Bad” asset managers focus on marketing, game performance figures (e.g. run lots and lots of funds), invest in frauds, trade against their clients, and inflate financial bubbles when they encourage investors to invest in overvalued asset classes (e.g. dot-com stocks).
Implications of regulatory risk
I find it incredibly frustrating that a regulator can come in and do a great deal of harm to a CEO that has largely done the right thing and created value for society. It really bothers me when honest people get punished. That being said, I should set aside my own views of right and wrong because they are largely irrelevant. I should never assume that regulators will do the “right” thing.
Secondly, I need to do a better job at predicting the range of possible outcomes. I clearly misunderstood the downside from regulatory risk. It may or may not have been possible for me to forsee the high degree of regulatory risk in the servicing industry. If I had really done my homework, perhaps I could have figured out that Erbey was wrong to repurchase Ocwen and Altisource shares when he did. However, this may be a case of 20/20 hindsight.
Lastly, I think the right way to model regulatory risk is to see it as a nasty tail risk (low probability but very high impact). I made a huge error in sizing my position too big. Following the concepts behind the Kelly Criterion and Gambler’s Ruin, companies that are exposed to nasty tail risks deserve small position sizes. In general, businesses are a lot more random than I think they are.
*Disclosure: Long OCN and ASPS.