Description

Ocwen Financial Corp:

Current Situation:

Ocwen Financial Corporation (OCN) is a non-bank mortgage servicer that is undergoing significant changes to overcome obstacles such as stringent regulatory requirements, shifting industry dynamics, and reputational damage. At its peak in 2013, Ocwen serviced loans with $467B in unpaid principal balance (UPB), but after five years and numerous regulatory actions, UPB is down by 62%. Despite this, Ocwen still remains the 9th largest mortgage servicer in a $10T industry.

In April 2017, the CFPB (along with 30 states) sued Ocwen, which temporarily restricted it from acquiring mortgage servicing rights (MSRs), further decreasing UPB due to portfolio run-off. Although the mortgage servicing industry continues to face heavy regulation as well as deteriorating margins, Ocwen possesses the scale to return to profitability. Ocwen acquired PHH Corporation in October, and although PHH is a smaller servicer, it possesses the best mortgage servicing platform in the industry (Black Knight MSP). The CFPB action is ongoing, but Ocwen has since settled with all 30 states, allowing for MSR acquisitions once Ocwen successfully integrates the new servicing platform with the “legacy” platform. Additionally, White House statements indicate that the CFPB is no longer actively pursuing civil enforcements. Even in a pessimistic scenario that excludes near-term MSR acquisitions along with portfolio run-off persisting at current levels, the stock still trades at a steep discount to book. Near-term MSR acquisitions, synergies from the PHH acquisition, and positive trends in current UPB mix should put Ocwen back on track, while a decent CFPB outcome will force Mr. Market to realize that the 54% dip in stock price due to the CFPB action was unjustified.

Background:

Ocwen earns servicing revenue based on the UPB of its loans. OCN services conventional (agency), government-insured (guaranteed by FHA and VA), and non-agency (sub-prime) loans. Although Ocwen has traditionally serviced all three types, its core competency is sub-prime servicing, where the goal is to reduce delinquencies through “high-touch” servicing, generating ancillary fees in the process. Ocwen earns fees by collecting payments from borrowers, forwarding P&I to investors in securitized loans, remitting taxes and insurance premiums from escrow accounts, and performing collection, loss prevention, and foreclosure activities for delinquent loans. Additionally, Ocwen originates loans through its lending segment, where it can generate gain on sale revenue depending on the type of transaction. After origination, OCN can retain the servicing rights (servicing-retained basis) or sell the rights to other servicers (servicing-released basis), which either adds UPB through (servicing-retained) or generates gain on sale revenue once the serving rights are sold (servicing-released).

Non-bank servicers’ market share increased from 14% in 2009 to 31% in 2014 as banks increasingly categorized sub-prime operations as non-core, while some banks had to trim MSRs due to stringent capital requirements under U.S. banking rules, as well as Basel III. Although the trend toward non-bank servicing seems a bit overstated, an increase in MSR values will negatively impact capital adequacy ratios, causing a further transfer of MSRs to non-banks. In a rising interest rate environment with slower prepayment speeds, MSR values increase, requiring some bank servicers to adjust their balance sheets accordingly.

When banks offloaded MSRs to non-banks between 2009 and 2013 to meet newly introduced capital requirements and reduce the reputational risk associated with sub-prime, Ocwen’s UPB increased significantly. Since banks were effectively coerced sellers in the MSR market, Ocwen purchased a high volume of MSRs cheaply, but the delinquency rates on the underlying loans skyrocketed, which surpassed Ocwen’s servicing capabilities and created errors. These servicing platform errors caught the eye of the CFPB, which led to $127M in penalties for Ocwen back in 2013. In addition to penalties paid in the 2013 CFPB consent order, numerous states have sued Ocwen, which has created additional legal expenses related to compliance and third-party monitoring requirements.

Key Points to Investment Thesis:

Misunderstood Regulatory Situation: The market is overstating OCN’s legal and regulatory burden by using past penalties as a proxy for future expected penalties. Ocwen has overstepped some boundaries and failed to protect borrowers in some instances, but the current CFPB action has allegations that are less severe than past lawsuits, while White House statements indicate the CFPB is no longer actively pursuing civil enforcements.

Ocwen’s Importance to Mortgage Servicing: Ocwen has an important role in the industry. A severe fine could have far-reaching implications that could impact borrowers, smaller servicers, and even banks. For this reason alone, it is hard to picture a scenario where the company is forced into bankruptcy due to steep penalties.

Share Ownership: Incentives are properly aligned (~$10/share weighted-average strike price), while a large percentage of shareholders are mortgage-focused investors who have stuck with Ocwen as they realize Ocwen’s importance to the servicing industry. For example, John Devaney is a large shareholder (owns 9.7%). After the Financial Crisis, his firm purchased many sub-prime loans for pennies on the dollar, with high IRRs dependent on collection rates for the delinquent loans. His firm continues to trust Ocwen as a “high-touch” servicer, possessing the capability to service delinquent, sub-prime loans better than other industry players. Furthermore, Ocwen has very low institutional ownership, and is excluded from many financials ETFs/index funds (screens poorly). This problem could be solved once OCN lessens its regulatory burden and returns to profitability.

PHH Acquisition: Ocwen acquired PHH at 73% of net assets, which improved cash position by $94M, grew UPB by $129B, and replaced the error-prone “legacy” servicing platform with top-tier technology. Further, PHH possesses a clean compliance record and has an experienced management team that should smooth the integration process, making near-term MSR purchases likely.

Subservicing Focus: Ocwen acts as a master or primary servicer and as a subservicer, but has shifted toward subservicing through its partnership with New Residential (NRZ). Subservicing provides implicit optionality, giving Ocwen the chance to unload MSRs as needed in exchange for cash to cushion its liquidity, while also reducing leverage, improving ROE, and reducing the need for capital deployment.

Misunderstood Business Model: Ocwen is unfairly categorized as a cyclical company that rises and falls with the housing market, but Ocwen possesses a subscription-like business model completely overlooked by Wall Street. MSRs provide contractual servicing fees and there are very few industry players that possess Ocwen’s size and scope. MSRs are a source of negative duration for lenders and investors, displaying a negative correlation with housing prices, but a positive correlation with mortgage rates (and generally, interest rates). The business is hard to model, while very few institutions and sell-side firms have an incentive to properly understand the company due to its current legal issues and lack of potential fees.

Opportunistic Value Play: With PHH, the stock trades at 42% of steady-state BVPS (peers at 1.2x), providing a safe entrance point from a value standpoint. Alternatively, Ocwen trades at 18% of its MSRs (peers at 1.05x). Even in a portfolio run-off scenario where no MSR acquisitions are made within the next year, Ocwen trades at a 14% discount to its NTM book.

Servicing Segment:

Ocwen acts as a primary/master servicer (for conventional and government-insured loans), as well as a subservicer on behalf of other industry players. OCN receives a servicing fee as a % of the type UPB it services, along with ancillary fees such as late charges, loan modifications (10,000+ completed in Q2 2018), and float earnings (on escrow accounts).

After looking at sell-side research reports, most analysts take Ocwen’s total servicing fees as a % of UPB when forecasting financials, but this overlooks the fact that fees depend on the type of UPB. Agency loans with a larger UPB could earn less fees than sub-prime loans with smaller UPB due to the ancillary fees mentioned above. Similarly, costs are often forecasted in tandem with servicing fees (like COGS for a traditional company), but these costs are mostly fixed in nature. A $10M sub-prime loan could cost more to service than a $20M prime loan, but if taken as one, the different types of loans are all treated the same. Delinquent loans show the best example of this, as delinquent loans require more administrative work and resources in the servicing call center, regardless of the underlying principal balance on the loan.

Since servicing fees depend on UPB, while costs depend on loan count, it is beneficial for Ocwen when the count of non-performing loans decreases, while the UPB/non-performing loan rises. Since 2016, non-performing loans have dropped from 12% to 5% of the total loan count, but the UPB per non-performing loan has increased from $160,000 to $200,000. If it takes the same amount of effort to service a delinquent loan regardless of the underlying UPB, higher principal balance generates more ancillary fees, and helps offset the fixed costs associated with the loan.

Due to legal expenses, rising industry-wide servicing costs, and high interest payments on its corporate and asset-backed debt, OCN has recently been shifting toward a capital-light, subservicing approach through agreements with other industry players. Since 2016, Ocwen’s subservicing portfolio has grown to 60% of its total UPB. In its latest strategic partnership with NRZ, Ocwen will subservice NRZ’s loans for five years. OCN will receive subservicing and ancillary fees, while NRZ will generate float earnings and deferred servicing fees. Subservicing is a lower margin channel than traditional servicing, but does not require MSR financings (match-funded liabilities) or funding for advances (payments to securitization trusts for delinquent borrowers). Advances are a large capital outflow for servicers, but NRZ will bear the funding liability for the MSR, leading to improved ROE for Ocwen. Since ancillary fees can be collected if delinquencies are kept in check, Ocwen’s core competency of high-touch servicing could help sweeten its end of the deal.

Lending Segment:

Less than 10% of OCN’s revenue comes from its lending segment, while sub-prime originations have been virtually nonexistent since the Financial Crisis. Ocwen currently possesses a small market share of less than 1% in the refinancing origination market for both forward and reverse mortgages (across three channels): retail (direct-to-consumer), wholesale (through brokers), and correspondent (secondary market). Due to low margins in forward lending, Ocwen has exited the wholesale and correspondent channels in this space, but still operates in all three channels for reverse mortgages. Further, Ocwen appears to be putting more emphasis on reverse lending, with reverse originations now accounting for 40% of total originations (up from 20% in 2016).

PHH’s platform will enhance Ocwen’s sub-prime origination capabilities, making re-entry into wholesale and correspondent forward lending a possibility. Sub-prime lending has been flat across the country, but underwriting standards are loosening, and banks no longer want the reputational risk associated with the business. The free optionality in this segment allows OCN to originate higher (lower) volume of refi. mortgages when rates are low (high), creating additional MSRs in the process (or generating gain on sale margin after origination).

PHH Corporation:

Aside from gaining a new loan servicing platform that will allow near-term UPB growth, PHH has a clean compliance record, an experienced management team, and better loan administration operations than competitors. Its strong technology infrastructure and loss mitigation practices have resulted in better performance on loans with modifications when compared to peers.

Aside from the PHH acquisition making UPB growth a strong possibility, management has been discussing cost synergies in the ballpark of $100-$145M. In December, Ocwen revised the estimated cost synergies upward to $145M from $100M, with a target of $200M in total cost savings. Within the next 12-18 months, Ocwen hopes to re-engineer the marginal cost structure on PHH’s loan book. With Ocwen’s scale and PHH’s servicing platform, Ocwen should have the ability to resume portfolio acquisition activities during this current quarter, which can offset some of the legal expenses Ocwen has been incurring in a time when it is operating at a loss.

A key timeline to follow will be the servicing system conversion from Ocwen’s legacy platform to Black Knight MSP. In Q3 2019, loan transfers are expected to be completed, and in Q4, the synergies will start to be realized. A key risk present in most sell-side reports raises concerns about OCN’s ability to properly integrate PHH in a timely fashion, but the new CEO from PHH should help smooth the transition.

Accounting Considerations:

MSRs at Fair Value:

OCN has traditionally held MSRs at amortized cost while competitors held MSRs at fair value. The key inputs into MSR valuations are interest rates, delinquency rates, and prepayment rates. OCN’s use of amortized cost has failed to capture the current market environment, using a higher CPR than actual.

Ocwen will begin holding all newly-acquired MSRs at fair value (as of 2018). The effects of this accounting change have not been seen due to the temporary regulatory restrictions on acquiring MSRs, but once PHH’s platform is integrated, all subsequently acquired MSRs will be held at fair value. Delinquency rate is the most important variable for non-agency UPB, while prepayment speed is the most material valuation metric for agency and government-insured loans. Both of those metrics are trending in bullish directions, so Ocwen will finally be able to benefit from an uptick in MSR prices, aligning its valuation closer to peers.

Servicing Advances:

OCN’s largest deployment of capital comes from the financing of servicing advances, which stem from delinquencies. When a loan is 30+ days late, OCN must fund (through a SPV) principal, interest, taxes, and insurance payments to securitization trusts. Consequently, this has been a massive use of liquidity for OCN as the interest rates on these funding liabilities are variable and directly linked to delinquency rates for its loan book. A shift toward subservicing will reduce servicing advances as the servicer (e.g. NRZ) is responsible for bearing the funding liability. Additionally, an improved economy with declining delinquencies can help reduce leverage as more loans are brought current. Advances as a % of total assets has decreased to 2.1% from 4.3% in Q1 2016.

Late Fees:

Delinquent servicing fees are booked when collected, not accrued, so speeding up the collection process is a priority for mortgage servicers with a sub-prime focus. Loan modifications can bring loans current, and a result, a quicker modification or foreclosure process results in an earlier recognition of late fees. As delinquency rates continue to fall, late fees as a % of total servicing fees should rise (now 7% of total fees vs. 5% in Q3 2016). As the economy continues to improve and Ocwen further examines opportunity for replenishing its UPB, OCN can find proper opportunities to maximize value, while ensuring the underlying loans are of higher quality. This will be especially important moving forward as Ocwen must continue to show regulators that it can handle the volume of loans it services.

Catalysts:

Legal and Regulatory Tensions Dissipate:

Ocwen will have the ability to acquire new MSRs with the PHH acquisition, which should replenish portfolio run-off, increase servicing fees, and scrap redundancies in the servicing segment. Before any temporary restrictions were imposed on Ocwen, the stock dropped 54% on announcement of the CFPB enforcement action. The market is understating the benefits of the PHH acquisition because steep legal expenses are expected to be incurred as a result of pending legal actions the company is facing.

The CFPB introduced new rules for mortgage servicers in 2016, which has increased automation requirements for servicing platforms and created new loss mitigation timelines. Ocwen’s proprietary servicing platform, REALServicing, simply could not adhere to the new standards, which drew regulatory scrutiny. The current CFPB enforcement action alleges failures in OCN’s servicing system, foreclosure practices, management of escrow accounts, and handling of consumer complaints, with the bulk of the allegations centered around the servicing platform.

While the CFPB’s rules for servicers are viewed as a large burden to servicers like Ocwen, I think there are future benefits. Since automation requirements will be met when PHH is integrated, this should help protect borrowers, leading to less reputational and legal risk in the future. The quicker foreclosure timelines will also allow OCN to bring more loans current, generating late fees in the process. In short, it was easy for the government to place blame on Ocwen for past misconduct, but if OCN adheres to the new rules moving forward, the company should be able to better focus its efforts on the core business, spending less time on external legal issues.

Since 2013, there have been seven CFPB enforcement actions against mortgage servicing companies:

Taking each total payout as a % of UPB, it is evident that the penalties levied against banks have been more severe than non-bank servicers. Using an average total penalty of .03% of UPB for non-bank servicers, a severity multiple of 1.5x the non-bank peer average, and 133.9M shares outstanding for OCN, the implied expected damages for OCN come out to $.57/share.

On the day of the CFPB announcement and before any restrictions were placed on servicing new loans, the stock dropped $2.97 on the news, which would equate to damages of .2% of UPB. As shown above, the only other comparable CFPB action with that level of severity is Flagstar Bank in 2014, but since then, the CFPB has new leadership, and the White House has effectively diminished the CFPB’s importance in levying fines against financial companies.

The most severe payout observed during my research was on the state level. In a 2014 consent order with the New York Department of Financial Services (NYDFS), Ocwen paid a fine to NY at .5% of its UPB in the state. Whether or not this is being used as a proxy is unclear, but it is undoubtedly more draconian than any CFPB penalty incurred by a mortgage servicer. A key difference between the NYDFS penalty and past CFPB penalties are the factual allegations. In the NYDFS 2014 consent order, conflicts of interest between subsidiaries of OCN and multiple executives were proven true, and the former CEO was effectively banned from the industry as a result. On the contrary, the current CFPB action alleges servicing technology flaws, not blatant fraud, which could be further mitigated through the Black Knight platform.

From a legal standpoint, OCN is far from perfect, but as a company, its importance will have to be considered when handing out a penalty. Ocwen services 1.7M loans (with PHH) and is a top non-bank servicer. If a large penalty were handed out, loans would have to be transferred from OCN to other servicers, which could put borrowers at risk during the onboarding process. Banks must meet capital requirements and smaller non-bank servicers just do not have the scale to take on that many mortgages, which could disrupt modification processes, collection efforts, and foreclosure timelines.

MSR Valuations:

With new MSRs at fair value and legacy under amortized cost, subsequent MSR acquisitions and favorable trends could amplify the post-acquisition benefits of PHH. Fair value adjustments allow Ocwen to assess various strategies for making MSR purchases, while providing ample time to integrate PHH. If rates fall, Ocwen can leverage PHH’s platform to enhance refinancing originations and add MSRs (an added bonus), but also capture the possible upward valuation adjustment when rates begin to tick increase.

Credit Ratings:

Moody’s recently changed its methodology for rating finance companies, giving higher importance to financial performance over qualitative factors. In addition, rating agencies have noted that their notching adjustments for Ocwen are mostly due to the ongoing CFPB action. For example, Moody’s downgraded the CFR by one notch to reflect the CFPB lawsuit but noted that an upgrade could occur if this gets resolved. Resolving regulatory matters will not only result in a positive notching adjustment, but will also reduce legal expenses, and amplify the impact of new MSRs through fair value adjustments once the PHH platform is integrated. Enhancing profitability is a key driver, so a favorable CFPB outcome would not only have a positive impact on qualitative adjustments (notching) but could also aid profitability as UPB increases and future legal expenses are more predictable. The stock price is clearly depressed, but a positive movement in credit rating could improve its price once more institutions are willing to consider Ocwen for investment.

Key Risks and Mitigates:

PHH Acquisition:

The cost synergies for the acquisition appear aggressive, while margin improvements may take longer than expected.

• 94% of PHH portfolio of subserviced, so limited capital deployment is required on OCN’s behalf.
• PHH adds $94M to cash, $129B to UPB.

There are mounting concerns over the timeline for successful transition to Black Knight MSP, with management guidance suggesting a 9-12-month timeframe. In addition to concerns on timing (since OCN needs the platform to board new loans), there will be compliance requirements as a result of the state settlements. These will undoubtedly be costly, but once it is shown that OCN has successfully merged the two platforms, these issues should fade.

• Key mitigate: OCN’s new CEO is from PHH and has extensive experience with Black Knight MSP, smoothing the transition.

NRZ Partnership:

A key concern often referenced is that NRZ can terminate its subservicing agreement at any point, despite the agreement calling for a subservicing period of five years. To offset some risk, the original agreement gave NRZ a 4.9% equity stake in OCN. It should also be noted that NRZ is a mortgage REIT with expertise in MSRs. This agreement is mutually beneficial; NRZ gets to invest in MSRs at a discounted rate, while OCN receives cash and reduces leverage. It could be argued that NRZ can leverage its expertise to get a better price on OCN’s MSRs than it would otherwise get in an open market purchase. Why would NRZ want to terminate this for any other reason than regulatory?

Strategy Execution to Replenish Portfolio Run-Off:

In conference calls, management has stated goals such as >10% ROE, but more details are needed on issues OCN can explicitly control. OCN will need to assess the MSR market for near-term acquisitions to grow its UPB to return to profitability.

In the most recent conference call, management has indicated that they will need $35B in UPB to replenish current run-off. Using a weighted-average prepayment rate of 14.2% (most recent 4Q average), a base MSR price of 60bps of underlying UPB, and $35B in UPB to replenish the run-off, it is expected that purchasing new MSRs for portfolio replenishment will cost $210M.

At current run-off rate (14.2%), Ocwen can expect replenishment to cost between $175M and $245M depending on the purchase price:

Liquidity:

OCN had ~255M in cash (pre-PHH), UPB will cost $210M to replenish, and the company continues to lose money. However, the PHH deal adds $94M in cash, while the NRZ deal can cushion liquidity as needed through lump-sum cash payments. Additionally, advance liabilities are a large capital outflow which reduce interest coverage, but delinquencies are falling, and more funds are being collected, which means the funding of advances should slow. Match-funded liabilities are now at 10% of total liabilities--down from 23% in 2016--due to the shift toward subservicing. Ocwen’s shift toward a capital-light approach should allow for adequate liquidity in the near term, while subsequent UPB growth can offset the rigid cost structure observed in the servicing industry.

Valuation:

Ocwen is mainly viewed as a book value financial despite a shift toward subservicing. The problem with viewing Ocwen as a BV financial is that subservicing reduces MSRs, but also reduces leverage. Sales to NRZ as part of the subservicing agreement are considered financings, not sales, which distorts cash flows and balance sheet values. However, I believe the biggest upside for this stock will be the market eventually realizing that litigation is priced in too highly, while also failing to consider the benefits of PHH. Still, looking at OCN’s value through the lens of the majority is reasonable, as the book value appears to be the bear or base scenario for most sell-side reports.

After including the PHH acquisition, I primarily valued Ocwen based on a blend of its current, steady-state NAV, as well the recovery value of its assets if it were to face bankruptcy.

Ocwen has funding liabilities that are secured by corresponding assets on its balance sheet. HMBS facilities are secured by loans held for investment, other secured liabilities are secured by loans held for sale, other financing liabilities are secured by mortgage servicing rights, and match-funded liabilities (non-recourse trust liabilities) are secured by match-funded assets. Assuming a 100% recovery value for loans held for sale (guaranteed by GNMA) and using Ditech’s recently disclosed asset recovery assumptions (provided by its management), recovery values indicate Ocwen’s stock is worth $2.24 per share. There is 100% coverage for its corporate debt, with the residual going toward other liabilities, then equity. In steady-state NAV, Ocwen is worth $4.81 (assuming no liquidation). Although it is difficult to put an exact figure on the stock, I believe these are reasonable ranges to show what the company is worth. Due to its unique situation, protecting the downside is important, and it appears that something must eventually give here.

There are numerous ways to look at cash flow for a mortgage servicer, so it is tough to slap a value on the company based solely on this. One way to value Ocwen on a FCF basis is to take its historical relationship between FCF and UPB, but due to current regulatory restrictions on acquiring MSRs, massive assumptions would have to be made on future UPB additions, run-off, transfers, and sales.

Comps can also be used, but accounting differences must be adjusted for. OCN has used amortized cost for MSRs, while others have used fair value. Ocwen trades at 18% of MSRs on its books, while peers average 1.05x. Even when OCN uses FV for future purchases, this still seems like an undervalued stock. Using a steady-state P/B ratio for Ocwen along with a Price/MSRs ratio that is adjusted for MSRs pledged as collateral and amounts due in connection with NRZ sales, Ocwen appears undervalued on a comparables basis, as well.

Conclusion:

Ocwen, despite its tainted reputation, unmatched legal scrutiny, and current restrictions on acquiring its lifeblood asset, is still undervalued. Ocwen is far from perfect, but changes could occur that will force investors to realize its true value. A favorable CFPB outcome will result in lower legal expenses than what the market is pricing in, while a return to profitability could boost institutional ownership. The stock screens poorly (due to net losses and deteriorating book value), has minimal sell-side coverage, and is unfairly treated as a cyclical, high-risk stock due to its sub-prime core. As regulatory issues fade and its new servicing platform is successfully integrated, its role in the servicing industry will again be legitimized, making it “mainstream.” Industry-wide margins are being squeezed due to servicing costs, but its post-PHH scale along with lower legal/compliance expenses will offset these concerns. Credit ratings and “screenability” should improve with resolution of current legal issues, paving the way for more institutional buyers to boost the stock price. Overall, mortgage servicing is a niche market, but current industry dynamics necessitate Ocwen’s existence as a company.  

Catalyst

• Legal and regulatory tensions dissipate
• New MSRs at fair value vs. amortized cost
• Credit rating improvement