Here are the excesses that I see in the lending markets:
- When investors put money into securitizations, they don’t pay attention to the underwriting quality of the loans that they own a piece of. They allow charlatans to unload low-quality loans into securitizations. Investors are ultimately buying into a pile of loans with inflated values. Unfortunately, yield-chasing investors gravitate towards assets that they don’t understand. This may be a desirable feature for the yield chasers- they will look smarter if others also don’t understand what the yield chasers own.
- Certain instruments such as Credit Risk Transfers (CRTs) and the lower tranches of CMBS have a significant chance of being completely wiped out. While the riskiest tranches of CRTs and CMBS have seen their prices drop 30%+, it doesn’t seem like investors are sufficiently scared about the senior CRT tranches in a COVID-19 environment.
- The system of yield-chasing mortgage REITs financing themselves almost entirely with short-term debt does not work. There are currently liquidity issues because lenders do not want to continue providing short-term debt (via repos / repurchase agreements) and the lenders also don’t want to sell the collateral. A key reason why problems exist is because the banks accepted highly leveraged investments as collateral.
I don’t think that the mortgage REIT stocks are very interesting because (A) none of them are good longs and (B) it’s not a good use of time to research them as shorts.
In this blog post, I’ll give my thoughts on industries that will almost certainly see many bankruptcies. In general, the stocks with the most bankruptcy risk have some combination of the following:
- A fall in revenues because consumers don’t want to go out in public and possibly die. Some industries will continue to be impacted even after a vaccine is developed (if it is developed).
- Fixed cost leverage. Some businesses such as restaurants are locked into leases that will cause them to burn a substantial amount of cash.
These situations may be very difficult to analyze. However, there may be opportunities in the mispricings such as going long restaurant franchises and shorting airlines, E&Ps, and the lowest quality lenders. If an industry such as airlines has high bankruptcy risk, I will also talk about related industries even if they do not have high bankruptcy risk.
I don’t think that Home Capital is a great short at the moment due to the expensive borrow (>60%). The expensive borrow and rising share price suggests a short squeeze.
However, I do think that there are serious issues with the company such as systemically poor underwriting.
This blog post is in reference to John Hempton’s post on Trex; the post points out that Trex’s operating margins are suspiciously high. I haven’t uncovered enough about Trex that would suggest to me that there is some form of egregious accounting fraud occurring. However, I can see how Trex’s margins can appear to be so high. This industry does not sell a commodity. Rather, the industry sells marketing hype and unproven technology.
Trex was one of the companies that pioneered the use of wood-plastic composites as decking material over 2 decades ago. Unfortunately, the composite materials did not live up to their fanfare and marketing hype (e.g. zero maintenance, lasts longer than wood, etc.). There have been issues with composite deck materials from virtually all manufacturers that have led to recalls, expensive warranty claims, and class action lawsuits. Some manufacturers have gone bankrupt and were not able to pay out all warranty claims, leaving homeowners holding the bag.
The current practice is for manufacturers to exclude known problems from their written warranties. These written warranties do not obligate them to stand behind their marketing hype.
(*Disclosure: No position.)
I previously described AAMC as a “royalty on yield chasing“. AAMC’s economics can potentially be extremely attractive because asset managers can generate extremely high returns on capital. Currently, the stock is trading at very depressed levels. Two explanations for the share price:
- Luxor capital and other major shareholders may be liquidating. Luxor suffered a lot of losses on the Bill Erbey family of stocks.
- AAMC generated close to no fees in the past quarter. Either you think that management screwed up or that there is a temporary hiccup in revenue recognition. Rental revenue, selling the home/mortgage, and marking the asset to BPO value all generate GAAP profits. There is a time period after a BPO (broker price opinion) and before a home is rented out (or sold) where the home will not generate any GAAP profits, which can result in less fees for AAMC.
On April 6, 2015 HLSS and NRZ announced that they have restructured the Feb 22 merger agreement between the two companies (press release). The new deal:
- Reduces the value received by HLSS shareholders.
- In the near term, HLSS has agreed not to transfer subservicing away from Ocwen. Ocwen has given up a little bit of value to reduce some of its unusual risks.
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).
I made a mistake. I did not figure out the game that Ocwen and Altisource are playing. Ocwen seems to receive fees from Altisource that could be (mis)construed as kickbacks under its “Data Access and Services Agreement”. These fees could be seen as a quid pro quo (“you scratch my back I’ll scratch yours”) for the big profits that Altisource formerly earned for lender placed insurance “brokerage”.
Today, Ocwen provided a company update for its shareholders. While the stock is up ~14% on the news, I am disappointed with how the current CEO is running the company.
- The update doesn’t seem to mention anything about buying back debt, which currently has fairly high yields (12-13%). To me, this seems like an obvious move to make. Where else might Ocwen get such high returns on capital with little risk?
- The company has halted its share repurchase program.
- The company intends “hire two financial advisors with significant experience in asset backed financing, capital markets, corporate and mortgage finance”. I’m not a fan of companies that piss away money on overpriced labour. Ocwen previously gave its CFO a raise in Dec 2014 but apparently he’s not good enough at his job that Ocwen now needs to hire outside talent.
So far, it seems that the new CEO is bad at capital allocation and bad at maintaining Ocwen’s status as a low-cost operator.
EDIT (2/6/2015): The update also indicated that the company may not be in full compliance with the CFPB metrics:
On the National Mortgage Settlement front, although we do not have the final results of the retesting of certain 2014 metrics by the National Monitor overseeing compliance, we do expect that, similar to many other Servicers in 2014, we will have metrics that will require remediation through corrective action plans as defined by the settlement.