Unusual risks at Ocwen

Unfortunately for me, the drama never seems to end at the Erbey complex (OCN/ASPS/HLSS/RESI/AAMC).  Ocwen’s regulatory problems has been cascading into other problems.  I suppose the lesson here is that some companies sit on very unusual risks.  When it rains it pours.

I believe Ocwen’s financing deal with HLSS exposes it to a very unusual risk.  Ocwen had (more or less) sold excess servicing rights on its MSRs to HLSS.  If Ocwen loses its MSRs, then it has to compensate HLSS for HLSS’ loss.  The payment will be for the purchase price of the excess servicing rights adjusted for run-off at rates pre-determined in the contract between Ocwen and HLSS (8-K filing).

Here’s what the Ocwen 10-K says [emphasis mine]:

A significant portion of our non-Agency servicing portfolio servicing agreements contain provisions whereby we could be terminated as servicer without compensation upon the failure of the serviced loans to meet certain portfolio delinquency or cumulative loss thresholds or in the event we fail to maintain required servicer ratings, among other provisions. As a result of the economic downturn of recent years, the portfolio delinquency and/or cumulative loss threshold provisions have been breached by many private-label securitizations in our non-Agency servicing portfolio. Terminations as servicer as a result of a breach of any of these provisions have been minimal. In the event we were terminated as servicer and the Rights to MSRs were sold to HLSS, we would be obligated to compensate HLSS.

Ocwen is currently at risk of losing a portion of its MSR portfolio because its servicer ratings have fallen too low.  Page 20 of the latest 10-Q shows how much Ocwen has had to pay so far in the 3 quarters ending September 2014:

In the event of a transfer of servicing to another party related to Rights to MSRs sold to HLSS, we are required to reimburse HLSS at predetermined contractual rates for the loss of servicing revenues. Settlements for Financing liability – MSRs pledged for the three and nine months ended September 30, 2014 includes $2.0 million of such reimbursements.

Note that these 3 quarters were before Ocwen’s current problems surfaced.

Future liability

One way in which Ocwen might face a huge liability is if it loses a lot of MSRs due to mortgage investors firing Ocwen as the servicer.  While mortgage investors are normally stuck with their servicer and cannot fire the servicer, they have an opportunity to fire the servicer if Ocwen breaches the minimum servicer rating requirements.  A small portion of Ocwen’s MSR portfolio have such clauses.

From Ocwen’s Feb 5 investor update:

  • We are currently a servicer on approximately 4,000 private label securities (PLS) agreements.
  • Of these, approximately 695 with about $44.8 billion of UPB have minimum Servicer Ratings criteria.
  • While rating agencies have taken actions largely based on public information regarding issues with regulators, they have not pointed to actual servicing performance deficiencies.  For example, the Fitch action of February 4th, 2015 starts by noting that “the company continues to perform servicing functions at a proficient level.” Objective data on PLS performance continues to show that Ocwen excels in managing loss mitigation timelines, bringing borrowers current on their payments and keeping them current.  For these reasons, we believe it is in the best interests of all stakeholders to continue to keep Ocwen on the job.
  • To date, including the recent announcement from Fitch, our servicer ratings have fallen below the minimum criteria set forth in 482 PLS agreements. This represents approximately $34.6 billion in UPB serviced by Ocwen, or 8.7% of our total servicing portfolio.
  • We have not been notified by any RMBS trustee of any intent to move Non-Agency RMBS servicing as a result of changes in servicer ratings or any other reason.

Since the Feb 5 investor update, one trustee concluded voting on 3 mortgage pools.  Ocwen was fired as the servicer for 2 of the 3.  See Ocwen’s March 2 update.

If Ocwen loses more MSRs, my theory is that Ocwen may have to make substantial payments to HLSS.

HLSS can pull subservicing from Ocwen

Under the contract between HLSS and Ocwen (8-K filing), HLSS can direct the sale of the underlying MSRs to other parties if Ocwen breaches any number of clauses in their contract.  This has happened because Ocwen’s servicer ratings are below a certain level.  If the MSRs are sold, Ocwen will not receive any compensation for its loss of subservicing.

To recap how this works:

  • The underlying MSR is essentially split into subservicing and excess servicing.
  • Ocwen has the subservicing.
  • HLSS has the excess servicing.
  • HLSS can direct the sale of MSRs on which it owns excess servicing rights.  If we cancel out the excess servicing, HLSS can basically sell off subservicing rights that it can acquire for free.
  • I’m not sure but I believe that HLSS can cherry-pick the portfolio and selectively choose the MSRs with the most attractive subservicing.
  • The buyer of the MSR will be buying a complete MSR.

The probability of Ocwen losing subservicing

On the conference call for the merger of HLSS and NRZ, NRZ’s CEO commented that they have no intention of transferring servicing away from Ocwen.

Altisource’s CEO stated on the Q4 2014 conference call that he would like to see NRZ’s intentions memorialized in writing:

Ryan Zahara

And then just one last thing, can you just expand on your comments at the beginning of the call about memorializing in writing some of the commitments that were made on the NRZ-HLSS merger call?

Bill Shepro – Altisource CEO

Yes, sure. There’s not much more we want to say beyond what we said in the prepared remarks. But I think, look, NRZ and HLSS said all the right things, at least from Altisource’s perspective, in wanting to work with Ocwen, which obviously benefits Altisource. We would love to see that, those commitments made in writing, and we’ll leave it to HLSS and NRZ and Ocwen as to how they move forward.

If NRZ’s intentions are not memorialized in writing, then it will retain the option to essentially sell off Ocwen’s subservicing.  If market conditions change, this option could theoretically become a viable way for HLSS/NRZ to make money at Ocwen’s expense.

In hindsight, Ocwen could have prevented its current situation

If Ocwen had given HLSS fewer protections, it would have fewer problems today.

To avoid MSR transfers, the Ocwen/HLSS contract currently requires Ocwen to maintain all 3 of the following ratings:

(e) Seller fails to maintain residential primary servicer ratings for subprime loans of at least “Average” by Standard & Poor’s Rating Services, a division of Standards & Poor’s Financial Services LLC (or its successor in interest), “SQ3” by Moody’s Investors Service, Inc. (or its successor in interest) and “RPS4+” and “RSS4+” by Fitch Ratings (or its successor in interest);

In comparison, this NRZ contract requires Nationstar to maintain just one rating:

(e) Seller fails to maintain residential primary servicer ratings for subprime loans of at least “Average” by Standard & Poor’s Rating Services, a division of Standards & Poor’s Financial Services LLC (or its successor in interest);

I believe Ocwen’s current ratings are average for S&P (pass), SQ3- for Moody’s (fail), and RPS4 for Fitch (fail).  Mangrove’s letter to HLSS indicated that Ocwen had failed the latter two ratings thresholds and therefore HLSS should terminate its relationship with Ocwen.

The California DBO

The California DBO essentially threatened Ocwen with a death blow.  If it were to pull Ocwen’s license, Ocwen would be forced to hold a fire-sale of virtually its entire MSR portfolio because most mortgage pools contain mortgages in California.  I believe such a move would be quite harmful to borrowers because transferring a portfolio of that size would be extremely difficult (especially within a short timeframe).  Nonetheless, the DBO is crazy/angry enough to threaten Ocwen with such a move.  Not only that, its spokesman even suggested that they were more focused on suspending Ocwen’s license than on reaching a settlement:

“Ocwen’s behavior is egregious enough that we believe it warrants suspension of license”
“Like any enforcement action, settlement is always a possibility, but at this point we are focused on suspension,” he added. (Reuters)

The DBO seems very displeased that it did not receive the documentation it asked for from Ocwen.  Its spokesman has made other comments such as:

“We can’t just sit around and let them do that to us,” Dresslar said today in a telephone interview. “So we ultimately, after giving them plenty of opportunity to provide us the information, decided that we would go after their license.” (Bloomberg)

Because Ocwen ran into many problems with its servicer ratings, I believe it has an incentive to push it problems into the future with its settlement with the DBO.  This is why the settlement does not solve any of the underlying issues.  Under the settlement, Ocwen agreed to not purchase any MSRs (with mortgages in California) until the DBO is satisfied with Ocwen’s compliance.  Unlike the NY DFS settlement, there is no qualification to the injunction.  The NY DFS’s approval is “not to be unreasonably withheld”.  That language does not exist for the DBO settlement.

As well, Ocwen will have to pay for a monitor appointed by the DBO.  It is likely that the monitor will uncover problems at Ocwen because all servicers make errors (and also because California’s mortgage laws are more difficult than other States’).  In the future, Ocwen will likely be facing down an angry regulator with plenty of ammo.

*Disclosure: Long OCN and ASPS.  The pain continues.

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18 thoughts on “Unusual risks at Ocwen

      • I think it’s bad to engage in panic selling at the bottom. However, I need to recognize that the value of the company has gone down dramatically, the industry is no longer one where you can grow quickly and make a lot of money, and that the new CEOs won’t create as much value as Bill Erbey.

  1. Glenn, and others, you should be more focused on the long term than on short term issues. At this point either the whole thing goes bankrupt and you lose 100% of whats left of an already large loss. I think this is unlikely, because which regulator wants to bring a company to bankruptcy? Sure it can happen but then I would not lose much more.

    Or you hold for the turnaround (ocn, asps) and it turns around and you recoup all losses and make big profits.

    I chose my camp. There is no point in panicking over regulatory things that so far have not been predictable. This does not affect long term prospects that much, if you step back a bit from the news.

    • Regulators and politicians have already pushed many servicers into bankruptcy due to higher compliance costs and lengthy foreclosure timelines. My mistake with lawsky was assuming that he would behave vaguely reasonably. But he wanted to really punish Ocwen and that’s what he did.

      Going forward, I don’t think there can be much of a turnaround when Ocwen isn’t allowed to buy MSRs. If Ocwen is allowed to buy MSRs again, it is likely that its growth will be limited because servicing transfers harm borrowers. The NY DFS is anti-transfers it seems. The DBO thinks differently and doesn’t seem to understand the problems with transfers.

      2- The California DBO likely will be unpleasant in the future. Reading the settlement, it’s obviously that they did not solve the underlying issues. The DBO might take steps to prevent Ocwen from buying MSRs because it makes their job easier and enhances the regulators’ job security. In the past, the Office of Thrift Supervision did something similar for Ocwen (and then Ocwen debanked to avoid them).

  2. Thanks for the clarification about bankruptcies Glenn. I understand it could be led to bankruptcy since you have researched the sector and I haven’t.

    I will be careful and take your or any predictive statements of doom with some scepticism. They are all coming from strict analysis but so were all the predictions about everything going to dust in 2009 or Europe going to crash in 2011. This is negative headline indulged Bias.

    Why wouldn’t Ocwen be allowed to buy MSRs in the future? You think that in 3-5 years we will be in the same position in a “don’t buy MSRs and be investigated” situation ? No – in 3-5 years OCN will probably be buying MSRs again – or they would have shut the company down already. Why do you think they removed management? because they want new management in the ocwen of the future, so the regulator wants an ocwen in the future. If they don’t like what ocwen does after the investigation, even if they say “your company is terrible, shut down”, Ocwen will do everything to comply, even if they cannot, the shareholders will set up a new board that will again do everything to comply. Simple logic. It is an adjusting process.

    This is why I say take a step back from the day to day news.

    If my investment goes to Zero from now, which is very unlikely (I am only in ASPS which has debt but other lines of businesses), Id only have lost a few more dollars, and if I sold now I would already have a huge loss, so at this stage, a further loss will have a small impact on my portfolio while a rebound will have a big impact, I agree with holding.

    In my opinion yes there are problems, but weak hands sell, strong hands buy when there are problems. In 2009, weak hands sold, strong hands bought companies with sometimes huge problems of debt, no demand, impairments, and still it was the right time to buy, because it was priced in.

    This will be a lesson of panic selling on bad news in my opinion

  3. Future post recommendations:

    (1) sunk costs: how to think about them on their own and in terms of tax impacts
    (2) comparison of the Erbey complex with AIG. (Boyd’s “Fatal Risk” may be useful if more background is needed). Are there enough similarities to given an investor pause?

    • I borrowed Fatal Risk from the library but only read a few pages of it unfortunately. It seems to me that Ocwen’s problem are mostly unique??? The regulatory risk was highly unusual, because very few regulators behave like the NY DFS. As far as regulators go, I think it is so unusual for a (state) regulator to matter so much. Normally when regulators devastate an industry, it is because the industry has behaved egregiously (e.g. for-profit education). It is so unusual for a regulator to devastate an industry despite very little egregious behaviour. Borrowers entered into a legal contract with their lender. The borrower has no legal right to a loan modification. While making sensible loan modifications is the right thing to do, failing to help others should not be some sort of terrible crime in my opinion.

      And then on top of that, Ocwen has some weird and unique risks due to its contracts. I doubt that Erbey considered the present scenario (especially when he was buying back shares up to Oct 2014) and that Ocwen can potentially face unusual losses if it needs to reimburse HLSS.

      Perhaps part of the problem is that Erbey tried to do the right thing by giving HLSS shareholders a decent level of legal protection. Unfortunately, if Ocwen is fired as the servicer, Ocwen becomes the bagholder and faces its own losses *and* HLSS’ losses. Or you can look at it as poor risk management. Of course, this is a theoretical risk right now and it’s unclear if it will end horribly.

      Part of the problem is that Erbey didn’t think Ocwen’s servicer ratings would drop dramatically even though Ocwen’s servicing quality (from the mortgage investors’ perspective) hasn’t really changed that much.

      2- From what I understand about AIG.
      They took on risks in their securities lending program.
      They chased yield and they got punished for it.
      They got their faced ripped off because they bought a lot of RMBS and they lost a lot of money due to underwriting fraud and the drop in US home prices.

      3- My speculation on why Erbey was blindsided by what the NY DFS would do:
      A- He thought that regulators would be somewhat reasonable.
      B- He thought that by far the most important thing for servicers could do for consumers is to issue lots of loan mods. In the end, Ocwen did not get any credit for this. The NY DFS didn’t see things that way.
      C- Anchoring bias. The national mortgage settlement and Ocwen’s CFPB consent order seemed fairly onerous. It seemed that Ocwen was doing fine under the CFPB consent order. In hindsight, it turns out that the NY DFS would be far, far more punitive than the CFPB.

      • While I am not saying the Erbey complex is the same as AIG… there are enough similarities here to worry a bit.

        (Note, in a similar way to Howard Schultz at Starbucks, while Hank Greenberg technically wasn’t the founder of AIG, I consider him to be the pseudo founder of AIG. Calling him anything less, even just CEO, misses the point to how core he was to the company and its large scale development over a long time horizon.)

        Both the Erbey complex and AIG really fell apart because of a state regulator’s pushing. NY DFS for the former, NY State Attorney General Elliot Spitzer for AIG.

        I think you’ve laid out most all what’s known about bad behavior at the Erbey complex prior to Erbey being forced out. The thing about AIG is, under its pseudo founder Hank Greenberg… it was up to some accounting games (including with Gen Re which Buffett noticed after buying it from AIG) that they shouldn’t have been doing. But those weren’t really risk management issues in a direct sense. Further in and of themselves they hardly seem that much worse than Lehman’s repo 105 and mark to market issues, or Welch’s various earnings smoothing maneuvers at GE. (Let alone the games Citi was playing with SIVs which I still don’t totally have my head around.) I’m not endorsing them. When companies piss on my leg and tell me it’s raining, I am not pleased at all… but context for the games other large financial companies were playing in the 2000s is useful.

        All the other things you mention those are all essentially post Greenberg activities. The securities lending program’s ill-conceived cash “yield enhancement” is probably the least well publicized piece of disastrous risk management – kudos to Boyd for enlightening me—but it did not exist while Greenberg ran the place. And while the Financial Products group did exist, it was not a malignant cancer, but instead a small contained business unit. All of these disastrous risks really emerged after Spitzer used extra-judicial means to force Greenberg into retirement over one particularly bad weekend in 2005. (While I don’t care about the prostitution scandal, if you read about how many times Spitzer was cited over the years for prosecutorial misdeeds like failing to hand over exculpatory evidence, etc. you’ll see he towers above Lawsky in terms of NY state government bullying.)

        And that’s my real point. The problem, as best as I can tell, is that AIG in 2005, was a large company but it wasn’t an institution. It was really just Greenberg and a couple guys in his inner circle that had been running the company for several decades. Greenberg belatedly started succession planning in 2005, but that required several years to institutionalize the knowledge and controls that were in his head, into the company. Instead Spitzer arranged a shot-gun divorce one weekend and after March 2005, AIG had neither the man nor an institution.

        My concern is that that the Erbey complex, too, may now have neither the man nor an institution.

      • Yes the succeeding CEOs may not be as good as Erbey. (I really wished that they would buy back debt and don’t think they are as good as Erbey.)

        But I think it’s worse than the CEO being pushed out. I think the big issue here is that lawsky is saying that Ocwen needs to make significantly fewer errors and to deliver significantly better customer service. To some degree he is forcing them to become a charity. And until Ocwen does that, it is forced into run-off as it is not allowed to buy more MSRs. The other issue is that the rules are not written. Whereas the NY DFS laid out servicing practices when Ocwen bought Litton, it seems that the NY DFS wants to make a totally new set of rules. As well, the NY DFS has always been into ‘pre-crime’. It assumes that capitalists will commit wrongdoing in certain circumstances so the NY DFS will move to pre-emptively block them from committing wrongdoing (e.g. Bitcoin regulation). Ocwen’s competitors may continue to let themselves run off until there is more regulatory clarity once Ocwen’s monitor creates benchmarks. We’ll see their appetite for mortgage servicing given that they have to worry about a huge number of regulators who arbitrarily change the rules all the time.

    • See https://glennchan.wordpress.com/2015/01/31/the-mortgage-servicing-game/

      If you believe that Ocwen modified more mortgages with low re-default rates, then Ocwen created a lot of value for homeowners and mortgage investors. Ocwen did some innovative stuff like the Shared Appreciation Mortgage. The adjacent businesses create some efficiencies because they don’t have sales and marketing costs (though they raise conflict of interest issues).

      If you were to behave ethically in the mortgage servicing space, I think it would look a lot like Ocwen. The big picture is that you would do lots of sensible loan mods (low re-default rates are highly desirable). In hindsight maybe there are things you might do differently, such as expanding less quickly and spending more money on customer service. Perhaps Ocwen could have spent more money on compliance (e.g. the CFPB report says that the working environment was chaotic), but measuring your compliance better doesn’t do much for borrowers or investors.

      And that really burns me. Erbey mostly did the right thing and got burned.

  4. Thanks Glenn for your continuous efforts to clarify us Erbey complex.
    You think it’s bad to engage in panic selling at the bottom. However, what is your current valuation for the stock? Investor can’t hold a company without any close sense of the stock valuation. And what is your current valuation for ASPS stock?

  5. YairF, the valuation today is based on today’s news and anticipations, this is a stock with beaten down expectations, who knows what earnings they will make in 3 years. any valuation based on 2015 earnings will be proven wrong in the future. It might end up worse or better in 2016-2018, so really no point in valuing ASPS now without knowing ASPS future products, sales and contracts. Sometimes we got to admit that the future is uncertain

  6. Great blog Glen. Any idea when Ocwen’s earnings comes out? I emailed their investor relations department last week. No response.

  7. Pingback: The restructured HLSS/NRZ deal is good for OCN and ASPS | Glenn Chan's Random Notes on Investing

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