Ocwen Revived: Where Do We Go From Here? by Oozing Alpha
On June 17, 2016, I had posted on Oozing Alpha Has Ocwen Stock Been Sufficiently De-Risked?
Since that post:
Baupost's investment process involves "never-ending" gleaning of facts to help support investment ideas Seth Klarman writes in his end-of-year letter to investors. In the letter, a copy of which ValueWalk has been able to review, the value investor describes the Baupost Group's process to identify ideas and answer the most critical questions about its potential Read More
- The company reported significantly improved Q2 results on July 27.
- During Q2 earnings call, it announced that it is negotiating with California regulator (CA DBO) and has set aside a $15 million reserve for a potential settlement, an insignificant amount when compared with $30 million that Ocwen spends on monitor fees on a quarterly basis.
- On August 4, Ocwen successfully priced a $500 million securitization.
- On August 9, Ocwen received an upgrade from S&P on its servicer ratings. This was critical since without an upgrade, Ocwen was at risk of losing ~ half its business next year. Thus, an existential threat was averted.
Due to these positive developments, the stock has appreciated 100% in a period of two months and now trades at $3.18.
My view is that there is tremendous upside potential in the stock. The risk-reward ratio is actually better now than it was back when it was trading at $1.60 but faced a grave threat to its business.
In my opinion, Ocwen stock is worth at least $7-$8 per share if the company were sold to a competitor. I say this based upon the fact:
- Ocwen had $5.27 per share in tangible book value on 6/30/2016.
- Owns another $4 per share of assets not reflected on its balance sheet (see slide #9 in Q2 earnings presentation.)
- Tangible book value does not reflect its lending business that generates around $30 million in pretax income and could be worth at least $1 per share.
That adds up to $10+ per share of intrinsic value. I am using $7 per share as the low end of the range to build a sizable cushion of $370 million for (1) MSR runoff until Ocwen is permitted to acquire servicing assets again and (2) future regulatory expenses and settlements – – a figure that many will argue is unrealistically large and unwarranted.
That said, at the moment, I have no reason to believe that a sale of the company is imminent so I value it as an independent, ongoing business entity. Over the long term, Ocwen stock could be worth much more than $8 but that higher valuation will take time to realize. Bear in mind that the stock is currently at $3.18.
Interested? Read on.
Servicing Biz: Ocwen has multiple lines of business but the one that matters and can “move the needle” is mortgage servicing. As of the end of Q2-2016, Ocwen serviced 1.5 million loans with an unpaid loan balance of $229.3 billion. Now in this business, a servicer is paid a fee based upon the unpaid principal balance (UPB) of mortgages that it services on behalf of lenders. To give you a historical perspective of Ocwen’s servicing segment’s size and profitability:
|Avg. UPB ($Bil)||33.8||35.3||37.9||47.8||55.3||46.2||41.1||59.6||81.3||118.8||415.7|
|# of Loans (Mil)||360||320||369||474||436||373||306||401||531||763||2,621|
|Pretax Inc ($Mil)||26||17||22||80||66||101||88||78||136||274||392|
So you can see in the table (above), up until the housing meltdown of 2007-2008, Ocwen was a niche player servicing $30-$40 billion in UPB.
But after the housing bubble burst, Ocwen grew by leaps and bounds as it acquired servicing assets (MSRs) that other financial institutions were unloading, reaching UPB of $415.7 billion in 2013.
In 2013, this segment generated pre-tax income of $392 million or 9 bips (calculated as pretax income divided by average UPB serviced). Due to the company’s extra-ordinary growth, the stock went from single digits to $60 per share during this time period and to paraphrase poet Browning, God was in His Heaven and All was Right with the World.
Now comes the ugly part of the story.
I am not going to get into the gory details about what ensued but to sum it up, after 2012, Ocwen grew too big too fast which impacted its service quality which got it in trouble with regulators. As a result, it was barred from acquiring any new servicing assets, had to pay hundreds of millions in penalties, and agree to have all sorts of regulators and monitors breathing down its neck, watching every move and trying to catch every mistake. That’s a tough way to live — Ocwen had no choice but to acquiesce.
So beginning in 2014, its servicing business began to shrink since it could not acquire any new MSRs which by the way have a natural attrition rate in low-to-mid teens. Additionally, Ocwen had a negligible origination business so it could not organically replace its diminishing MSRs and on top of that, had to sell a portion of its servicing business to improve liquidity. Hence, its top-line shrunk and elevated regulatory/monitoring costs, legal settlements, impairments etc. ate into profits.
|Avg. UPB ($Bil)||431.6||333.0||244.0||233.0|
|# of Loans (Mil)||2,669||1,625||1,551||1,506|
|Pretax Income ($Mil)||(174)||16||(68)||(15)|
As a result of these negatives, a business that was hugely profitable up until 2013 has been posting losses or near break even over the past 2.5 years. This is where things currently stand and the key questions investors are grappling with include:
- Once Ocwen gets past the remaining regulatory issues and distractions, can it generate a healthy profit in this segment and what level of profitability can it achieve?
- How long will it take to profitability because the servicing asset has a normal attrition rate in the low to mid teens and so the longer it takes, the less of a loan balance will be available for Ocwen to service?
- Can Ocwen stabilize its servicing asset (UPB) or even grow it again via acquisitions and get back on track?
I don’t believe that anyone, including Ocwen management, has definitive answers to these questions. What I can do, however, is sketch out a plausible scenario by making some assumptions. Feel free to dial up or down my assumptions and come up with your own conclusion.
In a fairly conservative scenario, I assume that it will take six more quarters (so year end 2017) for Ocwen to resolve its regulatory issues and be permitted to start acquiring MSRs. In the meantime, Ocwen will break-even or generate a small profit. I further assume that beginning in 2018, Ocwen will only be able to acquire just enough MSRs each year to stabilize its servicing asset (meaning zero growth).
Finally, I assume that it will never earn the high margins that it did in the past and that its pretax income in servicing will be down to 5 bips of UPB, which is what a close competitor, Nationstar (NSM) is currently generating in its servicing business.
So let’s do this:
MSR runoff at 13%, which is comparable to the current rate, gets me to UPB of $188 billion by the end of 2017. Five bips of pretax income on that UPB is $94 million. Ocwen has a lending business which I will not get into since it is small part of the story but still, it generated pretax income of $34 million in 2015 and $11 million in the first half of 2016. I assume this segment will generate $30 million of pretax income. Unallocated corporate costs are currently at a quarterly run rate of ~$13 million but the company is taking actions to cut this. I assume $40 million of annual corporate drag.
Servicing $94 + Lending $30 – Corporate $40 = $84 million pretax profit less 25% tax rate= $63 million net income divided by 124 million shares = EPS of $0.51.
Note that this is a fairly conservative scenario with regulatory resolution 18 months out, no growth in assets forever, servicing margins of 5 bips which it earned in 2004 when it was servicing a tiny fraction of loans than it does today and a tax rate of 25% compared to historical 15% rate – – Ocwen is a tax advantaged company under the laws of US Virgin Islands.
What multiple would you assign a business like that? 8x EPS would be a reasonably conservative valuation – that gets me to $4 in 18-24 months. Though you could argue that if there is no growth, perhaps Ocwen would choose to pay a very high dividend? Okay, a 40 cent dividend at 10% yield will get us to the same $4 share price.
But hold on. This does not account for some off balance sheet assets like call rights ($109 million), reverse mortgage future tail draws ($64 million) and deferred servicing fees ($23 million). These add up to another $1.57 of value giving a total stock valuation of around $5.50.
Hang on still. What if Ocwen could grow its business and earnings again? Also, interest rates are currently at historical lows and if they begin to rise, that MSR runoff rate could come down significantly and be additive to my base case scenario. Since Ocwen doesn’t have a meaningful lending/origination business, it wont get hurt in a rising rate environment.
In sum, a very conservative valuation gets me to share price of $5.50 in 18-24 months, an appreciation of 70%+ and in a straight liquidation, significantly higher value than that. And if Ocwen begins to grow again, then higher earnings and multiple on such earnings could easily fetch a $10 stock price, in my opinion.
Description of Ocwen’s business segments (source: 2015 Form 10-K)
Our Servicing business is primarily comprised of our core residential mortgage servicing business and currently accounts for the majority of our total revenues. Our servicing clients include some of the largest financial institutions in the U.S., including the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) (each, an Agency or, collectively, the GSEs), the Government National Mortgage Association (Ginnie Mae) and non-Agency residential mortgage-backed securities (RMBS) trusts. As of December 31, 2015, we were the seventh largest servicer in the U.S. based on the unpaid principal balance (UPB) of our residential servicing portfolio of $251.0 billion. We also service a small portfolio of commercial loans.
We are a leader in the servicing industry in foreclosure prevention and loss mitigation that helps families stay in their homes and improves financial outcomes for investors. Our leadership in the industry is evidenced by our high cure rate for delinquent loans and above average rate of continuing performance by homeowners whose loans we have modified. Ocwen has provided more loan modifications under the Federal Government’s Home Affordable Modification Program (HAMP) than any other mortgage servicer and 50% more than the next highest servicer, according to data published in the U.S. Treasury’s Making Home Affordable Third Quarter 2015 Program Performance Report. Overall, Ocwen has completed nearly 644,000 loan modifications from January 1, 2008 through December 31, 2015, including over54,000 modifications under Ocwen’s own Shared Appreciation Modification (SAM) program that incorporates the ability for our servicing clients to recoup a portion of the principal reductions granted if property values increase over time.
Servicing involves the collection and remittance of principal and interest payments received from borrowers, the administration of mortgage escrow accounts, the collection of insurance claims, the management of loans that are delinquent or in foreclosure or bankruptcy, including making servicing advances, evaluating loans for modification and other loss mitigation activities and, if necessary, foreclosure referrals and the sale of the underlying mortgaged property following foreclosure (real estate owned or REO) on behalf of investors or other servicers. Master servicing involves the collection of payments from servicers and the distribution of funds to investors in mortgage and asset-backed securities and whole loan packages. We earn contractual monthly servicing fees (which are typically payable as a percentage of UPB) pursuant to servicing agreements as well as other ancillary fees in connection with our servicing activities.
We also earn fees under both subservicing and special servicing arrangements with banks and other institutions that own the mortgage servicing rights (MSRs). The owners of MSRs may choose to hire Ocwen as a subservicer or special servicer instead of servicing the MSRs themselves for a variety of reasons, including not having a servicing platform or not having the necessary capacity or expertise to service some or all of their MSRs. In a subservicing context, where Ocwen does not own the MSRs, we may be engaged to perform all of the servicing functions previously described or it could be a limited engagement (e.g., subservicing only non-defaulted mortgage loans). As a subservicer, we may be obligated to make servicing advances, though most subservicing agreements provide for more rapid reimbursement of any advances from the owner of the servicing rights than if we were the servicer. Ocwen is also engaged as a special servicer. These engagements typically involve portfolios of defaulted mortgage loans, which require more work than performing mortgage loans and involve working out modifications or short sales with borrowers or taking properties through the foreclosure process. We typically earn subservicing and special servicing fees either as a percentage of UPB or on a per loan basis.
Servicing advances are amounts that we, as servicer, are required to advance to or on behalf of our servicing clients if we do not receive such amounts from borrowers. These amounts include principal and interest payments, property taxes and insurance premiums and amounts to maintain, repair and market real estate properties on behalf of our servicing clients. Most of our advances have the highest reimbursement priority and are “top of the waterfall” so that we are entitled to repayment from respective loan or REO liquidations proceeds before most other claims on these proceeds, and in the majority of cases, advances in excess of respective loan or REO liquidation proceeds may be recovered from pool level proceeds. The costs incurred in meeting these obligations consist principally of the interest expense incurred in financing the servicing advances and the costs of arranging such financing.
Reducing delinquencies is important to our business because it enables us to recover advances and recognize additional ancillary income, such as late fees, which we do not recognize on delinquent loans until they are brought current. Performing loans also require less work and are thus generally less costly to service. While increasing borrower participation in loan modification programs is a critical component of our ability to reduce delinquencies, the persistence of those modifications to remain current is also an important factor. As of December 31, 2015, only 22.4% of Ocwen modifications were 60 or more days delinquent as compared to non-Ocwen subprime servicer re-default rates of 27.0%, according to data from a leading independent third party mortgage industry data provider. According to the same data, Ocwen has modified a larger percentage of its subprime portfolio, 66.0% versus 59.3% for the non-Ocwen subprime servicers. The data also demonstrated an ability to generate greater cash flow to our servicing clients because it showed that 80.4% of Ocwen’s subprime borrowers have made 10 or more payments in the 12 months ending December 31, 2015 as compared to only 65.1% for other subprime servicers.
While our Servicing business grew rapidly via portfolio and business acquisitions from 2010 to 2013, we made no significant acquisitions during 2014 or 2015. Our growth ceased primarily as a result of significant regulatory scrutiny, which resulted in our settlements with the New York Department of Financial Services (NY DFS) in December 2014 and the California Department of Business Oversight (CA DBO) in January 2015, which are discussed in greater detail in the Regulation section below. These settlements have significantly impacted our ability to grow our servicing portfolio, which naturally decreases over time through portfolio runoff, because we have agreed to restrictions in our consent orders with the NY DFS and CA DBO that effectively prohibit future acquisitions of servicing until we have satisfied the respective conditions in those consent orders. If we are unable to satisfy these conditions, we will be unable to grow our servicing portfolio through acquisitions.
During 2015, we implemented a strategy to sell a portion of our Agency MSRs with the intent of reducing our exposure to interest rate movements, monetizing significant unrealized value and generating significant liquidity. We also desired to refocus our business on non-Agency servicing, where we believe we have traditional cost advantages. In a series of performing and non-performing MSR sales, we sold approximately $87.6 billion of UPB of MSRs, generating cumulative gains of $83.9 million and cash proceeds of $1.2 billion, $686.8 million of which was from sales proceeds and $486.3 million of which was via the recovery of advances. These proceeds, as well as ongoing cash from operating activities, were used to reduce our overall indebtedness by $1.4 billion during 2015. At this time, we remain a servicer of Agency and government-insured loans. However, we may enter into additional asset sales from time to time, if we view sale prices to be attractive. Additionally, we continue to originate and service new Agency and government-insured loans.
Given the intense regulatory scrutiny and the subsequent investments Ocwen has made in its risk and compliance infrastructure, we believe the underlying economics of our Servicing business have likely been changed for the foreseeable future. We believe it is unlikely Ocwen will achieve meaningful profitability in its Servicing business in the near term unless there is a significant, structural change in the business model. While we believe such structural change is probably unlikely in the current regulatory environment, we are nonetheless intensely focused on improving our operations to enhance borrower experiences and improve efficiencies both of which we believe will drive stronger financial performance through lower overall costs. An additional way to improve our financial performance would be to significantly grow or re-scale our Servicing portfolio. Although we are currently constrained under our regulatory settlements, if we can successfully navigate the regulatory hurdles and demonstrate the progress we have achieved in the areas of risk management and compliance, we believe that any potential future sellers of non-Agency servicing rights would view Ocwen’s infrastructure in a favorable light and place significant consideration on our ability to provide not only strong servicing performance for both RMBS investors and borrowers, but also on our ability to service loans in a highly compliant manner. Despite this belief, we do not believe there is a large market for future bulk servicing transfers at this time, and therefore our ability to add additional servicing rights through purchase transactions may be limited in the near term.
As a result of uncertainty regarding our ability to achieve meaningful profitability in our Servicing business in its current state and our ability to grow our Servicing portfolio, for both regulatory and market-based reasons, we are seeking to become a much larger asset generator to provide Ocwen with not only future servicing rights but also other future income streams. We intend to transform Ocwen over time by reinvesting cash flows generated by the Servicing business to grow not only our residential mortgage lending business but also to grow other new business lines, which we believe can diversify our income profile and assist us in returning Ocwen to profitability. We believe asset generation, through our residential mortgage lending business and our new business lines, will be Ocwen’s primary driver of growth for the future. There can be no assurances that our efforts to transform Ocwen in this manner will be successful.
In our Lending business, we originate and purchase conventional (conforming to the underwriting standards of the GSEs, collectively Agency loans) and government-insured (insured by the Federal Housing Authority (FHA) or Department of Veterans Affairs (VA)) forward mortgage loans through the correspondent, wholesale and retail lending channels of our Homeward Residential, Inc. (Homeward) operations. Per-loan margins vary by channel, with correspondent typically being the lowest margin and retail the highest margin. After origination, we generally package and sell the loans in the secondary mortgage market, through GSE and Ginnie Mae guaranteed securitizations and whole loan transactions. In 2016, we will securitize and sell forward loans through our Ocwen Loan Servicing, LLC (OLS) operations. We typically retain the associated MSRs, providing the Servicing business with a source of new MSRs to replenish our servicing portfolio and partially offset the impact of amortization and prepayments. The only jurisdiction where we currently do not retain servicing rights on new originations, other than recapture (which is our ability to convert borrowers in our current servicing portfolio into newly originated loans), is California, where we sell the forward mortgage loans servicing-released to meet a requirement of our January 2015 settlement with the CA DBO. Lending revenues include interest income earned for the period the loans are held by us, gain on sale revenue, which represents the difference between the origination value and the sale value of the loan, and fee income earned at origination.
We are working to increase the scale and breadth of our Lending business. Although the slowing of the Home Affordable Refinance Program (HARP) and the sale of Agency MSRs (which decreases loans available to re-finance) present challenges, we are focused on increasing conversion rates (i.e., recapture) on our existing servicing portfolio and expanding our correspondent channel through growing our third party origination businesses. Additionally we are exploring offering different products we believe we can originate profitably and with acceptable levels of risk. We believe our experience in servicing difficult loans will allow us to also help borrowers obtain loans that are more challenging to originate. Building the sales and operations capacity to meet this need is a goal for the business, as well as investment in the development of our LOS (Loan Operating System) and the continued use of process improvements to drive productivity.
We historically have originated and purchased Home Equity Conversion Mortgages (HECM or reverse mortgage loans) insured by FHA through our Liberty Home Equity Solutions, Inc. (Liberty) operations. Effective in January 2016, we will continue to originate and purchase reverse mortgage loans through Liberty but will securitize the reverse mortgage loans through our OLS operations. Loans originated under this program are guaranteed by the FHA, which provides investors with protection against risk of borrower default. The reverse channel provides both current period and future period gain on sale revenue from new originations as a result of subsequent tail draws taken by the borrower. While we are focused on current period reported earnings, we also utilize our market experience to invest in future asset value when returns are at an attractive level. These future cash flows are not guaranteed but viewed as probable given our historic asset quality and slow prepayment speeds.
Correspondent Lending. Our forward and reverse correspondent lending channels purchase mortgage loans that have been originated by a network of approved third party lenders.
All of the lenders participating in our correspondent lending program are approved by senior lending and credit management executives. We also employ an ongoing monitoring and renewal process for participating lenders that includes an evaluation of the performance of the loans they have sold to us. We perform a variety of pre- and post-funding review procedures to ensure that the loans we purchase conform to our requirements and to the requirements of the investors to whom we sell loans.
Wholesale Lending. We originate loans through a network of approved brokers. Brokers are subject to a formal approval and monitoring process. We underwrite all loans originated through this channel consistent with the underwriting standards required by the ultimate investor prior to funding.
Retail Lending. We originate forward and reverse mortgage loans directly with borrowers through our retail lending business. Our retail lending business utilizes our significant portfolio of borrowers being serviced to originate refinanced loans. Depending on borrower eligibility, we will refinance into conventional, government or non-Agency products. We also are increasing our ability to originate in the external retail market. Through lead campaigns and direct marketing, the Retail channel seeks to convert leads into higher margin loans in a cost efficient manner.
We provide customary origination representations and warranties to investors in connection with our loan sales and securitization activities. We receive customary origination representations and warranties from our network of approved originators in connection with loans we purchase through our correspondent lending channel. We recognize the fair value of the liability for our representations and warranties at the time of sale. In the event we cannot remedy a breach of a representation or warranty, we may be required to repurchase the loan or provide an indemnification payment to the investor. To the extent that we have recourse against a third-party originator, we may recover part or all of any loss we incur.
In 2015, we originated or purchased forward and reverse mortgage loans with a UPB of $3.9 billion and $809.7 million, respectively. Our Lending business provides us the opportunity to expand into new markets and offer new products, for example prime loans that exceed the GSE limits (jumbo loans) or non-Agency loans, as market and investor demand develops in that product segment. We do not currently expect to originate loans not considered qualified mortgages (Qualified Mortgages) by the Consumer Financial Protection Bureau (CFPB).
New Lines of Business
Automotive Capital Services (ACS)
In August 2015, we launched our ACS business on a pilot basis in two markets in Florida. ACS makes short-term inventory-secured loans to independent used car dealers to finance their inventory. Loans are typically outstanding for 30 to 60 days and structured as lines of credit on which the dealerships can draw to finance inventory purchases. We anticipate that ACS could provide meaningful growth and income diversification in future periods. After a successful four-month pilot period, we began expanding across select markets in the U.S. In 2015, ACS approved twenty-one credit applications. We issued outstanding credit lines for $10.9 million and had drawn $2.8 million as of the end of the year. For the time being, ACS will fund new originations with available corporate cash. When the business grows to sufficient size, we anticipate obtaining warehouse line financing to fund new volumes, and eventually anticipate launching securitizations when loan volume and market conditions permit.
Liberty Rental Finance
Through Homeward, Liberty Rental Finance has entered the rental property finance market. The business will provide mortgage loans to investors interested in purchasing foreclosed properties or refinancing existing rental properties for the purpose of improving financing terms. We expect to sell the mortgage loans to aggregators including both private investors and the GSEs. Liberty Rental Finance is currently licensed to lend in 38 states and plans to expand to all states in the future. We believe that our substantial experience in small balance commercial servicing and single- and multi-family REO management along with our large customer base of REO buyers provide competitive opportunities.
Given the early launch status of the ACS and Liberty Rental Finance businesses and their present contribution to Ocwen, each is currently reported as a component of the Corporate Items and Other segment.