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Posts from the ‘Mortgage Co’s’ Category

Thoughts about my investment in New Residential’s and a look at their MSR Pools

New Residential has performed poorly over the last few weeks. Pretty much since the release of their 3rd quarter results, the stock has tumbled.  As I mentioned in my previous post, I think that this move in unwarranted, and I have added to my position significantly at and below $6.

I suspect that the market is lumping in New Residential with all the other mREITs.  They are being compared on standard book value metrics and New Residential trades at a significant premium to its book value (20%) while most other REITs trade at a discount to it.

I wouldn’t be surprised if there are algorithms picking up on the book value discrepancy and automatically shorting the higher price to book companies against longs on the lower ones.  It would seem like a natural trade – short what is expensive, go long what is cheap, and look for opportunities where the dividend of the long exceeds that of the short. Read more

Is the Gain on Sale Boom over?

Earlier this week my portfolio was rolling along nicely, having closed at an all-time high on Wednesday night with me looking forward to further gains ahead.

And then Flagstar reported their fourth quarter results.

I don’t own Flagstar.  I don’t even follow Flagstar.  They are a Michigan based bank that has had some problems in their past and, most importantly for this discussion, run a reasonably large sized mortgage operation. In the fourth quarter Flagstar reported a big decline in their gain on sale margin, from 244 basis points to 153, and the Street took it to mean that the mortgage origination boom was over. In addition to the carnage of Flagstar (down about $2.50 to $15.57 on Thursday), PHH Corp, Impact Mortgage and Nationstar all took it on the chin.

But while the headline decline was steep, there is more to the story.  During the conference call Flagstar provided some clarity. The following exchange between Matthew Kerin, the president of the Mortgage banking division, and Paul Miller of FBR is instructive (via SeekingAlpha). Read more

Impac Mortgage: Where the money comes from

When I first bought Impac Mortgage (back at the beginning of August) it was on the basis of GAAP earnings (which were 50 cents per share in the second quarter), and revenue growth from the mortgage origination business.  Soon after, when I looked more closely into earnings, I determined that much of what was reported in GAAP was obscured by mark to market adjustments and a legacy business that is no longer operating.  Fortunately if I ignored these effects, the resulting picture was even better than the one painted by GAAP.

So I left it alone and went on to other things.

To digress for a minute, this is my process.  Once I feel like I have a clear answer on a stock, I don’t look too much further into the details.  When I look at a stock I look hard, and I usually come up with a fairly accurate picture, but after I feel able to draw a conclusion, I don’t spend a lot more time quibbling over the details.

I don’t have time.  I have time to look into maybe 2 stocks per week.  If I spent week after week evaluating a single security, it is simply inefficient.

Does this lead to mistakes?  Absolutely.  Sometimes I miss a key aspect that changes the equation.  But to mitigate mistakes I have learned to reevaluate when the market tells me I am wrong, and to act quickly when it turns out I am.  And actually, this has been one advantage of starting this blog.  There have been a couple of cases where readers have pointed out something that I have missed.  And I’ve saved money as a result.

Given the amount of time I have to allocate to investing, this remains, in my opinion, my most efficient process.  Study the business, figure out what the key drivers are and where problems are most likely to arise, evaluate those drivers and problems, make a decision and move on to the next one.  Take another look if things start to go amiss.

With respect to Impac, as the stock moved up from $2.50 to $10, I wasn’t that concerned with getting a better grasp on the specifics of earnings.  My initial analysis showed me the drivers, and they led me to conclude that the stock wasn’t even close to reflecting those drivers, and that was enough for me.

But now, with Impac hovering between $10 and $11, further analysis is warranted.  My intent below is to understand how each of the businesses that Impac operates generates earnings, and to compare the earnings generation capacity to GAAP, hopefully eliminating some of the confusion introduced by GAAP. Read more

Further investigation into Impac Mortgage Part I: Non-recourse trusts

I did more research into Impac Mortgage (IMH) over the weekend, and I plan to share my findings in a series of 3 posts.

In this first post I want to focus on the trust assets.  While the trusts are somewhat peripheral to my investment thesis in Impac, an explanation of how they work is central to the following posts I plan to write about earnings, and understanding the trusts helps quantify what potential they might hold for Impac if the housing market recovery becomes robust.

Impac Mortgage was a $250 stock in 2004 (I am including the 10:1 share consolidation that took place).  Obviously it has been a long way down.   The fall in the stock price from then to now has been entirely because of the mortgage market collapse.   This is something to keep in mind while I step through the next few paragraphs.

As I have explained in previous posts, I bought Impac Mortgage because of the growth I anticipate from their origination business.   But while the current business model centers around mortgage origination, it hasn’t always been that way.  Prior to 2008, in addition to originating mortgages Impac created and ran a number of off-balance sheet trusts.  These trusts would buy mortgages, mostly one’s originated by Impac, and pay for those mortgages by selling securitized mortgage obligations to investors.  The trusts would pay interest on their obligations from the cash collected on the mortgages. Read more

Week 65: Doing the work

Portfolio Performance

The turn in housing

– Michael Burry – Scion Capital

The housing market has turned.

Being that it is a huge, lumbering tanker, it takes a long time to slow down and redirect.  The changes happen slowly enough that you can miss them if you are focused on the wrong details (price increases and to a lessor degree sales increases) and not enough on the right one’s (inventory).  All that matters is that prices are cheap, rates are low, and inventory has come down to levels that leave many cities firmly entrenched as sellers markets. Once buyers stop seeing themselves in the drivers seat, their attitude changes from one of waiting for a better buy to that of getting in before its too late.  The vicious circle is replaced by a virtuous one, and sales and price increases will follow.  Nothing lasts forever, and the US housing collapse didn’t either.

Falling inventories had to lead the housing turnaround, and that is what we are seeing now.  Nationwide in August housing inventories fell from 8.2 months of supply a year ago to 6.1 last month.

Read more

More on Impac Mortgage

Yesterday was another big moving day for Impac Mortgage.  I was nervous adding to the stock last week given that it had risen from $2.30 to over $4 in a single day but I’m feeling better about those purchases now.  I’ve been looking at some of the details of the company, trying to fill in the gaps.  Below are some of the answers I’ve found.

On the Business Strategy…

During the year end conference call the company focused much of the discussion on what they were doing to expand the business going forward. They are focused on expanding retail lending activities, their broker network and on purchase money loans.

I had to look up the definition of a purchase money loan:

Simply put, a purchase money loan is a loan used to buy a home. In some ways, it is easier to describe what a purchase money loan is not. It is not a loan that is taken out after you buy a home such as a home equity line of credit or a home equity loan. It is not a refinance mortgage. A purchase money loan is evidenced by the trust deed or mortgage a home buyer signs at the time the home buyer purchases the home.

Impac is developing a business model that is directed at new home loan originations, as opposed to refinancing. I think this is a good strategy going forward. The refinancing business has been a strong business but at some point, probably in the not too distant future, interest rates are going to go up. The whole thesis behind my idea to get into mortgage servicing rights has been premised on rates going up. When they go up the refinancing business is going to dry up. At the same time, the increase in rates is almost certainly going to coincide with an improvement in the resale market, since rates aren’t rising unless the economy improves and the economy isn’t going to improve until housing improves. Impac is positioning itself well for this turn.

Retail volumes were flat in the first quarter but the company guided to higher volumes in the 3rd quarter. Retail volumes have increased significantly over the past year, up from $60.5 million to $132 million in Q2.

The company also restarted their correspondent lending business in January. I’ve written about correspondent lending before, in my write-up of PHH Corporation, and as I point out in an excerpt from that piece below, I really like the prospects of the correspondent business because everybody is running away from it as quickly as they can:

Consider the following. Imagine a mortgage broker who develops significant business volume, earns the confidence of wholesale lenders who will authorize him to approve their loans, and has accumulated some capital. He can now obtain a credit line from a bank that can be drawn against to fund loans, repaying the loans when they are sold to wholesale lenders. Under the law, the broker has morphed into a “lender” – the type called a “correspondent lender”.

This has been a business the big banks have traditionally taken a large piece of. Until now. In August Bank of America reported that they were exiting the correspondent lending business. Ally Financial, who lends through GMAC, retreated from correspondent lending back in December before recently announcing that they would get back into the business on a limited basis. Met Life announced that they were winding down their origination business entirely in January.

This isn’t small potatoes. The above 3 companies were in the top 12 correspondent lenders by volume in the third quarter.

There are rumors others are leaving the business. I thought this quote from a Mortgage News Daily article was spot-on:

One can just hear large lenders talking in their boardrooms. “Do we really want to be in this business, given the regulatory, legal, financial, and public relations issues? Where the value of servicing has dropped dramatically in the market, and could drop further depending on Basel III? Where the mortgage insurance tax deductibility has gone away? Where every week brings a new lawsuit – when will we have more attorneys on staff than originators?”

Its a low margin, highly competitive business. But the opportunity is that it could become less so with some of the big players moving on.

Impac is doing exactly what a small, nimble mortgage originator should do. Get into businesses where the big boys are getting out of. We’ve already seen some of the fruits of that. Correspondent lending volumes were $81.9 million in the second quarter versus only $24.7 million in Q1.

On the preferreds…

The company issued the preferred shares in 2004. The preferred shares paid a dividend of 9.5% and were redeemable at $25 per share. The shares also held precedence in the event of a liquidation over the common shares.

And then Impac changed the rules. In the second quarter of 2009 Impac sent out a proxy  to tender the preferred shares. The tender price, at $1.37 for the series B and $1.43 for the series C, was a small fraction of the redeemable.

About a month later Impac amended the proxy. The amendment rather drastically changed the rules of the preferred. It stripped them of their dividends, stripped them of rights to elect members to the board of directors, and stripped them of almost all other rights that made them senior to the common.

Looking back on the event, it could be interpreted that the preferred holders got a raw deal.  But keep in mind this was the spring of 2009, the stock market had recently hit decade lows in March, and most believed that the rally off those lows was a dead cat bounce.  Many of Impac Mortgage peers were going bankrupt.  The preferred holders were probably happy to getting anything and walk away.   The proxy reached its required minimum tender of 66.7% and along with the shares tendered the amendment was passed.

There are now 665,592 series B preferred outstanding and 1,405,086 series C preferred outstanding. The liquidation value at $25 per share works out to about $52 million. I think you have to consider these shares in terms of the detrimental effect they would have on a takeover bid, because if you wanted to take over the company today you would have to pay something above the current market rate for the common, which would work out to greater than $30 million, plus you would have to pay out the $52 million for the preferred shares.

The weird thing about the preferred is that the only value they is in the event of liquidation.r.   They have no value in a change of control (at least as far as I can tell).  So the preferred’s effectively can be ignored unless you are considering a bankruptcy scenario.  If you are considering a bankruptcy scenario, you also probably should not be considering the common.

So I think its fair to ignore the preferred shares in terms of stockholder equity calculations such as earnings per share and such. Because those earnings are not going to be siphoned to the preferred. It is only if you were buying IMH with the intent of benefiting from a takeover or from the liquidation that you would have to consider them.

There is a lawsuit outstanding with respect to the preferreds.  I haven’t been able to dig up a lot of details on the lawsuit and how much of a risk it is.  The original source of the news release of the lawsuit (not put out by Impac) is not available, but there are reproductions are a few message boards.  The essence of the complaint was explained here:

Silverman says a condition of the tender offer was that at least two-thirds of the holders of the Preferred B and at least two-thirds of the holders of Preferred C shares tender, with the purpose of obtaining sufficient “exit consents” to eliminate the valuable quarterly dividends, preference rights, voting rights and other valuable rights of preferred holders refusing to tender their shares. In this way, the linked tender offer/consent solicitation was deliberately structured to coerce the preferred shareholders into tendering for reasons other than the economic merits of the transaction and into voting for amendments to the terms of the Articles Supplementary of the preferred shares they were selling. Holders of the Preferred B and C shares had to tender or face the prospect of losing virtually all of the economic value of their shares.

This is something I will have to continue to monitor and dig up information on.

A Capital Raise

I think its pretty likely that Impac is going to raise capital here at some point. During the AGM Impac’s CEO,  Joe Tomkinson, said flat out that was part of the plan.

We’ve done a great job on recovery.  When all the competition was declaring bankruptcy, and that quite frankly it would be have been the easiest thing in the world for us to walk away and start a whole new company.  We didn’t do that.  We’ve done everything we can to preserve the shareholders equity.  We haven’t gone out and raised capital, although quite frankly I intend to raise capital which will dilute the shareholders.  I’m told that we’ll get sued for that but my feeling is that its better to have 20% of $100 million dollars than 20% of $20 million dollars.  And so to increase the overall efficiency of the company we’ve got to raise capital.

It was actually a pretty interesting comment.  It was about as blunt of a response as I’ve ever heard to the question of a capital raise.  No fluff about exploring our options or being proactive or some other two-bit turn of phrase to obscure the obvious.   Tomkninson said yup, you bet, we need the cash.

The thing is, they do need cash.  They are growing like a weed and what is beginning to hinder their growth is their warehouse line and the capital required for holding on to servicing.

A warehouse line is a short term line of credit that provides cash for Impac to extend money for the period of time between when the loan is made and the company sells the loan off to Fannie or Freddie.

Warehouse lines are short term and relatively safe so they don’t require a large capital cushion, but they do require some. The main risk is with respect to loans that are made but that can’t be subsequently sold.  This could be because the loans have problems with the documentation (Called scratch and dent), or because the eventual loan purchaser decides not to buy the loan.  A good description of the risks of warehouse lending can be found here.  The article describes the key key evaluation metric for a warehouse lender:

Take any mortgage banker’s financial statement and see how much you need to deduct from loans held for sale to trigger insolvency. Divide that by the average loan amount for that customer. That’s the number of unsaleable loans it will take to put the customer in the tank, and it is typically not going to be a large number.

Tomkinson said that if they raised capital, they could increase their warehouse lines by $70 million for every $700K they had. Right now warehouse capacity is about $140 million (top of my head) and so you could raise $1.5 million and double that.  $1.5 million at $5 per share would be less than 5% dilution.  Even if they doubled that amount, the dilution would not be significant and the money raised would allow the business to continue to grow.

The company has also been growing its servicing portfolio.  I have talked extensively about how I feel the servicing business is a great business to be in, including this article I published on SeekingAlpha. As I wrote in that article:

Mortgage servicing rights are one of the most attractive opportunities in the market right now. There is the potential for returns as much as 30-40% IRR for the companies involved.

I believe the opportunity is being ignored by a market for three reasons:

  1. The market lumps mortgage servicing rights in as just another housing play, and housing is still 2-3 years away from recovering
  2. Mortgage servicing rights are complicated and most market participants don’t want to take the time to understand them
  3. Mortgage servicing rights have traditionally been a crappy business and over the past 5 years they have been a really crappy business

If the company uses capital to grow its servicing business at 30% returns, I would be ok with that.  This is a case where a little dilution may not be such a bad thing.

Limitations on acquisition and change in control ownership limit

The last item that I have been researching but have not had much success in understanding is whether there are obstacles to a potential take over.  With the 10-K risk factors was the following statement:

Our Charter and bylaws, and Maryland corporate law contain a number of provisions that could delay, defer, or prevent a transaction or a change of control of us that might involve a premium price for holders of our capital stock or otherwise be in their best interests by increasing the associated costs and timeframe necessary to make an acquisition, making the process for acquiring a sufficient number of shares of our capital stock to effectuate or accomplish such a change of control longer and more costly. In addition, investors may refrain from attempting to cause a change in control because of the difficulty associated with such a venture because of the limitations.

Unfortunately I have searched and cannot find any clarification on this.

Impac Mortgage: Out of Nowhere

Sometimes you have to act before you know the whole story.

I’ve been on holidays all week and have had pretty limited access to the internet.  I’ve checked my emails maybe once a day at most.  On Tuesday night I checked and I noticed the following google alert (by the way I would highly recommend using google alerts for all key words and company names.  Its an invaluable tool).

I had never heard of the company but I’ve been looking for other ways of playing the origination and servicing industry, especially through smaller companies.   So I read the earnings release.

50 cents per share earnings in the second quarter. Most of the earnings appear to be coming from plain vanilla mortgage origination (same business as PHH).  The company almost doubled origination revenue year over year.  They also hold on to their servicing rights and appear to be growing their servicing portfolio.

Then I check the stock price on yahoo.  The stock had a $2.30 close before the earnings release.

Wait a minute.  This company just earned 50 cents in the quarter and its trading at $2.30 per share?

Well before I went to bed I thought about what I needed to clarify before the market opened the next day if I were going to buy the stock.  I needed to make sure that the share structure was what it appeared.  I needed to make sure that the earnings were legitimate (that they were coming from mortgage origination and not from a one time mark to market valuation change).  And I needed to make sure that there wasn’t some sort of debt or financing issue (for example some sort of GSE putback overhang) that would put the company close or perhaps over the precipice.

I read through the 10-Q, which was released with earnings, and I read through the 10-K risk factors. I didn’t see any red flags.  So I took the optimistic attitude that maybe this stock was simply mispriced.  Maybe it was like all the other mortgage related stocks and the mortgage industry itself and it was just hated to the point where it no longer reflected reality.

First thing in the morning before everyone woke up and I had to get off the computer (it was a vacation after all) I bought some stock.  I took a 1% position in each of my portfolios, including the one followed here:

By the end of the day, the stock was trading over $4.

I give this history in part because I hate to write up a stock after its had a run like Impac has.  I’m sure its going to sound to some like a pump and dump or an unlikely piece of luck.  Yet this blog is about the stocks I’ve bought so that’s what I have to write about and that’s what I’m doing.

As well, specifically regarding the outlook of Impac Mortgage, even though the stock has run up a rather ridiculous 100+ percent in the last 4 days, I think it may go a lot higher.  If I’m reading it right and not missing anything (which keep in mind I very well could be), the stock has room to run.  After all this was a $250 stock in 2005 and even after the run up, the market capitalization is a miniscule $30 some million dollars (though there are additionally some preferred’s outstanding). I’m not just talking the talk.  I doubled my position on Friday at $4.26.

So with a word of warning that any stock that has risen 100% in less than a week should be carefully considered before buying, let’s take a look at what the company does.

On to the company…

The story here is a simple one. Impac is a mortgage originator that has been growing it origination volumes substantially for the past year, and that growth has finally reached the inflection point where it has become profitable.

The company originates mortgages through retail, wholesale and correspondent channels.  A breakdown of origination volume by channel for the second quarter is illustrated below:

The company has developed a significant retail platform.  Retail lending is when the company deals directly with the borrower, as opposed to wholesale and correspondent lending where they are acting through independent brokers and correspondents who are originating the actual loans which are then sold to them.

The retail business is more often the higher profit business (because there is no middle man taking a cut) but it also requires more up front capital and fixed costs as you have to develop the infrastructure, the marketing, the people and the relationships required to interact with the borrower directly.  These higher start-up costs were at least partially responsible for the losses incurred in previous quarters.  The company made the following statement with respect to this in the year end 10-K:

 In 2011, the mortgage lending operations has been successful in increasing its monthly lending origination volumes to be in excess of $100 million. However, although the mortgage lending revenues increased in 2011, expenses associated with the mortgage lending activities significantly increased also. The increase in expenses was primarily due to start-up and expansion costs with opening new offices, hiring staff, purchasing equipment, investing in technology and the supplemental default management team as discussed above. Specifically, as the Company attempts to build a purchase money centric platform with a significant amount of retail originated loans; the related start-up costs for this type of origination platform will be higher than a wholesale refinance focused mortgage operation. In addition, the Company has made small investments in proprietary technologies that will further support our expansion of retail originated purchase money mortgages along with more competitive recruitment of realtor direct loan officers. The Company believes this is the right strategy in the long term as interest rates on mortgage loans are expected to rise in the future, which will greatly reduce the percentage of refinance transactions to more historical percentages. In order for the mortgage operations to achieve profitability, we will need to (i) increase overall origination volumes, (ii) improve lending revenues by originating a higher percentage of retail loans and products with wider margins and greater loan fees and (iii) reduce lending operating costs through increased operational efficiencies, or some combination of them.

While in the second quarter most of the growth was from the wholesale channel, future growth is expected to be driven from retail.

Second quarter volumes in the wholesale and correspondent lending channels led to significant volume increases over the first quarter; however, retail expansion during the second quarter is expected to lead to a corresponding increase in retail production during the 3rd quarter. Retail production is also expected to increase from the opening of the previously announced Reverse Mortgage operations.

Moving on to margins, Impac’s margins on mortgage lending look comparable to other companies I follow.  The company booked mortgage lending gains and fees of $15.1 million on $531.9 million of loans originated.  That is a total gain of 283 basis points.  To compare, PHH recorded a total gain on loans of 308 basis points in the second quarter.  Nationstar meanwhile recorded gain on sale of 306 basis points.

The company also earns money from mortgage servicing, and they have been growing their servicing portfolio every quarter.  I appreciated the company’s comments that they saw opportunity in holding on to the service rights of the mortgages they are originating given the ultra-low rates and high quality loans that are being written.

Excel expects to continue building its mortgage servicing portfolio as management believes a servicing portfolio of agency loans during a period of low interest rates and high credit quality focus is a good investment for the Company.

It’s the same line I’ve been saying for months now.

The company hasn’t been reporting the total balance of loans serviced for very long, but below the increase over the last 3 quarters is illustrated:

The company hires a subservicer to perform the servicing activities.  Assuming 25 basis points for the servicing fee and 7 basis points going to the subservicer, the company stands to pull in around $2 million in servicing revenues per year.

All of the loans originated and serviced are conforming, meaning they are being sold to Fannie Mae, Freddie Mac, or Ginnie Mae.

Things to be concerned about…

With this all said, the company does have some hair.

For one, they do not do a very good job of explaining their mortgage lending revenues.  While PHH and Nationstar both provide enough information to determine what they are valuing the capitalized servicing rights at, I can find no way of doing that with what Impac provides.

Second, the company appears to mark to market just about everything, including their long term debt. As noted in the 10-Q:

…long-term debt had an unpaid principal balance of $70.5 million compared to an estimated fair value of $12.0 million

Huh?  I don’t know if I am misunderstanding this or what because I have never seen a company mark to market their own debt and I didn’t even know you could do that.  Nevertheless, it seems to be what they do and its something worth contemplating the implications of.

Potential upside from The Long Term Mortgage Portfolio

An interesting sort of call option that Impac has embedded into its value comes from their residual interest in a number of securitization trusts.   Before 2007 the company originated and packaged mostly sub-prime loans and sold them off to investors through non-recourse trusts.  The company kept a residual interest (the equity) in these trusts.  The residual interest was the lowest rung on the ladder, being the first to not receive payment in the event of defaults within the trust.

These trusts are basically securizations of mostly Alt-A loans (meaning loans where the borrower does not have full documentation of income or net worth or some other metric that Fannie Mae and Freddie Mac requires).

Probably the most important thing about these trusts is that they are non-recourse to the Company, so the economic risk is limited to the residual interest only.

A break-down of the current fair value estimate of residual interest in the trust by year (taken from the 10-Q) is shown below:

These trusts are carried at fair value and the debt associated with them is also carried at fair value.   The difference between the expected fair value of the trusts (which is $5.469 billion) versus the debt (which is $5.446 billion) is $23 million.

While Impac seems to point to this number in its 10-Q I don’t think its terribly relevant.  For one, the future value of the trust assets (the mortgages within each trust) are based on a lot of assumptions, including future default rates, prepayment rates, interest rates, and so on.

Probably more importantly, at maturity the debt associated with each trust has to be paid in full, not at fair value.  While the overall fair value of the trust assets is a little less than $5.5 billion, the outstanding principle balance of the debt is $9.1 billion.  So clearly the debt outstanding outweighs the trust assets.  Nevertheless, the trusts are clearly not all a worthless asset.  In the second quarter the company collected $4.4 million in cash from the trusts, representing residual interest payments from those trusts that are presumably in a strong enough position to meet the collateral requirements that must be met before cash is paid to the residual interest holder.   Value is being realized and the potential for more value to be realized exists.

What I think is worth highlighting is that the future cash flow potential of these residual interests is basically a pure play on the US housing market.  Less defaults, stronger cash flow performance from the underlying mortgages, and Impac stands to take in a decent amount of cash from these trusts.  If housing goes down for a triple dip, well then you can probably write them off to something pretty close to zero.


The stock is a bit of a flier, no question about it.  The market capitalization is miniscule, the analyst and brokerage following is non-existent, and the disclosure is not as complete as I would like it.

Nevertheless, the industry is right and, if my thesis about the housing market bottoming and potentially surprising to the upside pans out, the timing is right.  The company, if you ask me, is doing exactly the right thing at the right time by building its origination business and retaining as much servicing as cash flow will allow.  I’ve taken a position and added to it once.  If it continues to play out as it appears to me it could, I will continue to add on the way up.

Adding more Mortgage Insurers

I have already written about how I stumbled upon MBIA Inc. (MBI) as I was researching mortgage insurance companies and in particular MGIC.  My interest in the mortgage insurers has been brought about by my desire to seek out companies that might benefit from a turn in the housing market.

I am not looking for a hockey-stick-like turnaround in housing.  I don’t expect to see prices or new constructions having a significant rise any time soon.  But I do think its  plausible that we are at a point where things no longer get worse.

How to play the bottom

Thus far, I’ve looked to play this bottom in a couple of different ways.

My foray into the servicers has been an attempt to capitalize on the premise.  Nationstar Mortgage (NSM), Newcastle Investment Corp (NCT), Home Loan Lending Services (HLSS), PHH Corp (PHH); all are examples of companies that should benefit from a stabilization in the mortgage market.  So far the thesis has paid off and I am up (since my purchases at the beginning of the year) well over 50% on Nationstar, about 30% on PHH Corp, and 15% on Newcastle (not counting the dividend).

I have also been able to capitalize on the trend by jumping into select regional banks that had exposure to the mortgage market turnaround.  Both Rurban Financial (RBNF) and Community Bankers Trust (BTC) have been big winners for me here, returning thus far 50%+ since the beginning of the year.

I now have have a third business for playing the housing bottom.  The insurers.  In addition to MBIA, last week I bought a fair position in Radian Group (RDN) and a lessor position in MGIC (MTG).  I also added a little to my position in MBIA (MBI).  In the case of Radian I unfortunately didn’t catch the bottom in the stock, but at least was fortunat enough to have gotten in well before the week long run ended, and I am actually seeing quite a profit on the position already.   Trades in my practice account that I track here are shown below:

Why Insurers?

I tend to have a lot of significant thoughts on my bike ride home.  It must be something about the state of semi-awareness that biking down major thorough fares in rush hour does to one’s brain.  On the one hand, what with cars whizzing by you and changing lanes and pulling out you are always on alert.  On the other hand, its the same ride you have done hundreds of times and so it is easy to day-dream yourself into a whole other world of thoughts.

It was about a month ago that I was biking home from work and thinking about what other businesses could benefit if the housing market in the United States just stopped getting worse when it occurred to me that I really should be looking at the mortgage insurers.   If ever there was a business whose livelihood was dependent not on a robust recovery in housing but instead an end to the continual decline, it was the insurance business.  As a mortgage insurer, you are less concerned if prices rise or new sales increase than you are that people don’t default on their loans.  Clearly, people not defaulting on their loans is  the necessary condition to any housing recovery.

This appears to be happening.

The most recent Home Price Index (HPI) report, put out by CoreLogic,  said the following:

“We see the consistent month-over-month increases within our HPI and Pending HPI as one sign that the housing market is stabilizing,” said Anand Nallathambi, president and chief executive officer of CoreLogic. “Home prices are responding to a restricted supply that will likely exist for some time to come—an optimistic sign for the future of our industry.”

Meanwhile, according the CoreLogic Shadow Inventory report, serious delinquencies in some of the hardest hit areas are showing big year over year declines:

Serious delinquencies, which are the main driver of the shadow inventory, declined the most in Arizona (-37.0 percent), California (-28.0 percent), Nevada (-27.4 percent), Michigan (-23.7 percent) and Minnesota (-18.1 percent).

A look at charts of new home sales and existing home sales (taken from CalculatedRiskBlog) show a pretty clear bottom.

My thesis was echoed by Radian management on their Q1 conference call.

We believe our core mortgage insurance business is attractive with strong returns, outstanding credit quality and sound pricing.We continue to capture a much larger share of new mortgage insurance business today than ever before in our history in an extremely competitive but high quality market.

Radian further echoed the sentiment that defaults are declining at the KBW Mortgage Finance conference:

You saw our press release this morning. In addition to the strong level of NIW, delinquencies continued to decline. So in May they declined again. Primary delinquencies fell below 100,000 for the first time in quite some time. In addition, the new default line, which really drives the incurred losses, was down 25% from May 2011. So year-over-year on a monthly basis down 25%, and that is a greater reduction than our projections have shown.

Insurers like Radian and MGIC stand to benefit from another trend that I called out in my post Pounding the Table on Mortgage Servicing Rights a few months ago.

Now we have the opposite scenario.  Lending standards are so tight that only the most fool-proof borrowers are able to get loans.  The risk of default should be greatly reduced.  The result again is for the MSR to stay on the books, paying out cash, for longer.

When I had looked at Radian and MGIC last year, one thing that made be skeptical was that they weren’t writing enough new business.  The same can’t be said any more.  In particular in the case of Radian,they are writing significant new insurance:

In fact, our market share of this profitable new business is double what it was in the challenging underwriting years of 2005 through 2008 and this increased volume is improving the overall credit profile of our MI portfolio. In the first quarter, we again wrote $6.5 billion of new mortgage insurance business and our pipeline remains strong with new insurance written (NIW) reaching approximately $2.6 billion in April.

Again at the KBW Mortgage Finance Conference, Radian provided at update that in May saw an additional $2.7B of NIW.  They also put some numbers to the exposure to the legacy book of insurance, versus the newer insurance written:

With our increasing market share we have grown the composition of the higher-quality books 2009 and subsequent at a much greater level than some of the other MIs that have legacy exposure. So as of March 31, we are up to 31% of our risk in force. That is from the 2009 and subsequent books. And, importantly, the 2006 and 2007 vintages, those poorer vintages, are down to 31%. By the end of 2012 at the rate we are going, the 2009 and subsequent are likely to be in the 40% range of our risk in force.

More to Come

These are complicated businesses and it is going to take me some time to fully wrap my head around the potential.  My positions thus far are reasonably small because of this.  As is often the case for me, my initial investment provides the incentive  to investigate further, and if I like what I see I buy more.  I just hope that the stocks don’t run away from me before that happens.  I expect to come up with more detailed write-ups  about both Radian and MGIC in the near future.

Stepping through the Nationstar Mortgage Income Statement

I have spent the last couple of nights reviewing the first quarter (and first ever) Nationstar Mortgage financial statement.

While the statement is not overly complex, it does have a few tricks.  At the end of the day, I am trying to determine an earnings estimate for each business segment.  To do that, need to make sense of the each of the line items that constitute the GAAP earnings, and then decide which are legitimate revenues and expenses, and which are just accounting items that need to be excluded.

What is the Business of Nationstar?

Nationstar operates three businesses:

  1. Mortgage Servicing
  2. Mortgage Origination
  3. Legacy Business

Through the mortgage servicing business Nationstar services a portfolio of loans.  The portfolio consists of loans that they have originated, loans for which they have bought the servicing rights from another party, and loans that they have agreed to subservice for a set fee.  Nationstar collects principal and interest payments and generates ancillary fees related to the mortgage loan.  In return Nationstar receives a fee, usually defined as a percentage of the unpaid principle balance of each loan.

The mortgage origination business originates residential mortgage loans.  Most of the loans that Nationstar originates are qualifying loans, meaning that they are eventually bought by and securitized through one of the GSE’s (such as Fannie Mae or Freddie Mac).  Nationstar runs this business as as feeder for their servicing business.  The vast majority of the loans originated are refinancings of existing loans that Nationstar previously serviced.

The legacy business consists of a number of legacy portfolios.  The portfolios  of what are basically pools of mortgage loans whose cash flows pay interest and principle to note holders sit on balance sheet and are in run-off.

Why you can ignore the legacy Business

Each portfolio of loans and its related outstanding notes under the legacy business segment constitute what is called a variable interest entity (VIE).  According to the GAAP accounting rules, Nationstar has to carry VIE’s on its balance sheet and consolidate the profits and losses of on its income statement.

According to GAAP, the rules for consolidating a VIE is such that if Nationstar is the primary director of activities of the entity and if Nationstar holds a beneficial interest or obligation to the entity, they must be consolidated on the books.  Nationstar meets these criteria and so the entities go on the balance sheet.

Yet in Nationstar’s case, the liabilities are non-recourse to the company.  Thus Nationstar is not liable for any losses that these entities incur.   This makes the consolidation somewhat misleading. The losses experienced by the VIE’s are not transferrable to Nationstar, even though they pass through the income statement like they are.

I decided to take a bit closer look at these VIE’s to understand exactly what they are and make sure they weren’t boogey men in the closet.

Nationstar accounts for the VIE’s with the following assets and liabilities on its balance sheet.

The VIE’s are of two types.

  1. Securitizations of residential loans transferred to trusts
  2. Special purchase entities (SPE)

In both cases, Nationstar is considered the director of activities because they are the servicer of the mortgages that make up the assets of the entity.  So that’s the first criteria met.  In the case of the securitizations, Nationstar has retained one or more of the subordinate securities from the securitizations, and so this qualifies them as holding a beneficial interest.  In the case of the SPE, because Nationstar remains in control of the mortgages transferred.  The result is that in both cases these entities must stay consolidated on the books as per GAAP.

But the key point is that the debt holders do not have recourse to Nationstar.  The assets within the VIE’s structure are the only assets that can be used to repay debt.  So in reality, the VIE is quarantined from the rest of the balance sheet.

The other side of the coin is that Nationstar may be able to see income from the interests they do retain in these entities.  However this is unlikely.  That’s because the entities are full of a lot of non-performing mortgages that were originated before the mortgage market blew up.  Nationstar says the following about their prospects in the last 10-Q:

As a result of market conditions and deteriorating credit performance on these consolidated VIEs, Nationstar expects minimal to no future cash flows on the economic residual

With no likely benefit from the VIE’s, and with all losses experienced by the VIE non-recourse to Nationstar, there is basically no reason to consider the VIE in any evaluation of the company.  And that is what I plan to do here.

The Mortgage Servicing Business

I’m going to start the analysis of servicing by providing the segments income statement and then going through each item in the statement line by line.

Servicing Fee Income:  This is the base fee that Nationstar receives.  A servicing fee is generally a percentage of the unpaid principle balance of the mortgages being serviced.  The unpaid principle balance averaged  $96,107,000,000 in Q1.  Nationstar earned fees of 60,707,000 off of that.  That puts the average servicing fee at 25 basis points, which is the typical fee received for servicing Fannie Mae and Freddie Mac qualified mortgages.

Loss Mitigation and Performance Incentives:  Fannie and Freddie compensate servicers if they successfully complete a repayment plan or loss mitigation on a loan that is 60 days or more delinquent.  The guidelines Fannie has set out for this are:

  • The mortgage loan must be 60 or more days delinquent when first reported with a Delinquency Status Code 12 – Repayment Plan – by the servicer.
  • The mortgage must be brought current upon the successful completion of the repayment plan.
  • Once a repayment plan incentive fee has been paid, a 12-month period must elapse from the date the related mortgage loan became current before another repayment plan incentive fee will be paid on that mortgage.

Nationstar receives fees when they mitigate a loan meeting these guidelines.  I didn’t look for Freddie’s guidelines but a imagine they are similar.

Modification fees:  These are special fees that Nationstar earns through modifying loans that qualify through the government sponsored HAMP and non-HAMP Modification programs. As per the FHFA servicing paper:

In certain instances and programs, servicers can also earn revenue in the form of incentive fees available under proprietary modification programs (generally in accordance with the Enterprises’ Servicing Guides) and through federal government modification programs (e.g., the Home Affordable Modification Program (“HAMP”)).

Late Fees and other Ancillary Charges:  According to FHFA, “servicers are also entitled to certain ancillary fees under the Servicing Guidelines, which include, among other things, late fees assessed on delinquent payments, charges for issuing payoff statements, fax charges, biweekly payment fees, and advertising supplement fees.”  That sums up what these are.

Reverse Mortgage Fees:  These are fees from their reverse mortgage portfolio of servicing right.  In terms of the servicing fee structure, the fees accrue to Nationstar but I’m not sure if Nationstar actually gets paid in cash until the property is  sold and the mortgage (and all its accrued interest) is paid off.

Change in Fair Value on Excess Spread Financing:  This has to do with the Newcastle deal.  Nationstar and Newcastle have entered into a couple of servicing arrangements whereby Nationstar performs all the servicing for a base fee (usually 7 basis points) and Nationstar and Newcastle share in the excess servicing right (with Newcastle getting a cut because they put up a substantial portion of the capital to purchase the rights). When Nationstar sells their partial interest in the excess servicing right (usually 65%) to Newcastle they treat that on the balance sheet as a financing.  So they book a liability associated with the loan and an asset associated with the underlying servicing rights.  The loan liability is recorded at fair value so Nationstar has to mark the value up and down each quarter.  In my opinion this is a pure accounting item and shouldn’t be included in earnings.

MSR Fair Value adjustment: This one is tricky.  The MSR fair value adjustment is comprised of 3 parts:

  • Actual prepayments of the underlying mortgage loans
  • Actual receipts of recurring cash flows
  • Market-related fair value adjustments

The fair value of the mortgage servicing portfolio is affected when the loan is repaid because the value associated with that particular mortgage servicing right gets written off.  The value of actual receipts of cash flows could be considered to be the basic amortization of the mortgage servicing right.   The Market-related fair value adjustment is the adjustment to the value of each servicing right based on the likelihood it will prepay in the future or not.  It’s the market-related fair value adjustment that we want to remove from the earnings calculation. Unfortunately Nationstar doesn’t break out the fair value adjustment between these items so its impossible to know how much of the adjustment is market related and how much is due to prepayments and recurring cash flow and how much is the fair value adjustment.

To give an example of what each of the three components might look like, PHH breaks them out into separate items.  Here is an excerpt from their first quarter 10-Q.

The reason that its important to deduct actual prepayments and actual receipts of recurring cash flows is because Nationstar is capitalizing the servicing portion upon origination.  So they are booking the earnings at the start, and that is only legitimate if they are amortizing that capitalized servicing right over the life that they receive fees.  If you ignore the amortization but not the capitalization you would be double counting earnings.

Given that Nationstar does not break out the items, I think that the only way I can properly handle this is by deducting the capitalized servicing from the origination segment and ignoring the entire fair market adjustment.  If I ignore the capitalization of the servicing and the fair market adjustment, then I don’t have to worry about its amortization over time.

Expenses and Impairments:  In the 10-Q Nationstar doesn’t breakout what the individual expenses and impairments are.  However, in the prospectus they do.  They reported the following expenses and impairments for the last 2 years:

I do note that none of these items are impairments so I’m not sure what that’s all about.

Interest Income:  It looks like the main source of interest income for Nationstar comes from the reverse mortgage servicing that they hold.  To be honest I am not sure what aspect of the reverse mortgage this interest income is coming from.  I know that Nationstar  receives a fee in return for servicing the reverse mortgage, but it’s not clear to me whether some of this fee is defined as interest as opposed to just being a fee.  My guess on this is that when a reverse mortgage is created Nationstar collects interest on the as of yet unadvanced amount.  But I don’t know for sure whether this is the case or not.  If its not I don’t know how they are are collecting interest.  In the end it’s a small sum.

Interest Expense:  As a servicer you are responsible for payment of late principle and interest amounts.  You are also sometimes responsible for taxes and insurance if the escrow funds set aside for the borrower aren’t sufficient.  All of these funds will eventually be paid back, but in the mean time you have to get the money from somewhere.  Nationstar sets up servicer advance lending facilities with banks and draws on these funds.  The cost of funds is generally a LIBOR plus arrangement.  Interest expense also includes interest from the senior unsecured notes that the company has outstanding.

The Mortgage Origination Business

Following in the same vein as servicing, here are the numbers for the origination business, followed by a description of the items involved.

Gain on Sale:  According to the prospectus, “transfers of financial assets are accounted for as sales when control over the assets has been surrendered by Nationstar”.  So unlike PHH, which books revenues when the interest lock commitment is made, Nationstar does not book revenue until the mortgage is transferred.  Margins were high in the first quarter, at 369 basis points.  PHH also recorded extremely high margins in the first quarter, so Nationstar was not the only one.  In the PHH 10-Q the company suggested that these margins are expected to remain high for the remainder of the year, and that they may stay high for longer as the increased risks associated with the industry are being realized through higher margins.

Provision for repurchases: I can’t be positive because Nationstar doesn’t provide any details about this line item, but I suspect that it is a provision taken for repurchase requests from the GSE’s.  Nationstar originate the vast majority for their loans for the GSE’s and there have been notable putbacks by them on originators for poorly originated loans during the boom.  PHH took a $65M provision in the first quarter.  Given that Nationstar was a fairly small originator until just recently, the $3M provision by Nationstar seems comparable to me.

Capitalized Servicing Rights: I already discussed this item to some extent in the servicing segment.  Nationstar capitalizes the expected profit from the servicing cash flow stream and books that as profit up front.  Changes to that capitalization are realized in subsequent quarters on a mark to market basis as part of the MSR Fair Value adjustment.  The important point to note is that Nationstar capitalized its servicing at 110 basis points.  This means that Nationstar is capitalizing servicing at roughly 4x the servicing fee.

Fair value mark-to-market adjustments: These are adjustments that are made on the mortgage loans held for sale.  Nationstar originates mortgage loans and there is always a pipeline of these loans that have yet to be sold to a GSE or other securitization.  The changes in the value of this pipeline from quarter to quarter is recorded as this line item.  I don’t think this item should be considered in earnings.  The loans will eventually be sold and at that time will be recorded as gain on sale. Until that time the marking up and down of the unsold loan portfolio is really just an accounting fiction.

Mark-to-market on derivatives/hedges:  There are 3 types of hedges/derivatives that Nationstar uses:

  1. The first type of hedge that Nationstar has is an interest hedge on the Interest Rate Lock Commitment (IRLC).  The IRLC is a commitment by Nationstar to provide a particular interest rate to the borrower for a certain amount of time. We have all gotten these when we went to a lender for a loan.
  2. The second type of hedge that Nationstar enters into is one that de-risks changes in value of the mortgage that will eventually be originated and sold from the IRLC.  Nationstar enters into forward sales of MBS against IRLC’s in an amount equal to the portion of the IRLC expected to close, and against mortgages held for sale in amount of the mortgage to be sold.
  3. The third type of hedge is a interest rate swap that it will use to hedge the interest payments on its debt.  Nationstar always has short term warehouse lending facilities drawn upon to fund its origination pipeline.  These lending facilities are typically variable rates and base on LIBOR.  Nationstar will enter into a swap to essentially fix that rate.

Origination Segment Operating Costs: According to the prospectus, the originations segments operating costs include staffing costs, sales commissions, technology, rent and other general and administrative cost.  Pretty basic stuff.  Making a comparison again to PHH, Nationstar had operating costs that were about the same on a per origination dollar basis.  Expenses and Impairments for Nationstar were 239 basis point of Total Originations.  For PHH costs were 246 basis point.

Interest Income: This is income that Nationstar earns on originated loans prior to selling them to the GSE’s.

Interest Expense: Similarly to interest income, interest expense is the cost of funds required to originate a loan.  Nationstar taps warehouse funding to bridge the gap between the day the loan is signed off and when the loan is eventually delivered to the GSE or other third party who will ultimately securitize the loan.

Adding it all up to Earnings

The point of going through all of the above was to determine which of the line item revenues and expenses should be included as part of operating earnings.  To review, I concluded that I would ignore the expenses due to the Newcastle arrangements, the fair value adjustments to the servicing portfolio, the capitalized portion of the origination, and the fair value adjustment to the originated loans that have yet to be sold to the GSE’s.

I also have to come up with a tax rate.  In the 10-Q Nationstar said that they expect a tax rate in the range of 20-28% for the period ending December 2012.  I have chosen the midpoint, 24% as the rate I will use here.

Igoring the items and applying the tax rate results in the following first quarter earnings for the company

Its not bad.  These earnings would put the current share price at a little under 10x earnings.

The key point for putting this valuation in perspective is to not that Nationstar is growing at a phenomenal rate.  The company grew their servicing portfolio at 50% last year, after having grown it at 100% the year before.  The Aurora transaction will expand the unpaid principle balance of the servicing portfolio from $97B to $160B, or about 60%.   The deal that Nationstar is negotiating with ResCap is even bigger.  The Rescap deal is for an unpaid principle balance of $374B.  Now Nationstar is splitting this between themselves, Newcastle and Fortress Investment Group.  Presumably though Nationstar will be doing all the servicing work, with the other parties just stepping in to provide capital and take a piece of the excess servicing fees.  Obviously, such a large deal would represent tremendous growth to Nationstar, upwards of 300%.  While one has to wonder if Nationstar can pull off the logistics of such quick growth, there is little doubt that the earnings potential of the company will increase exponentially if this deal goes through.   And you get that potential for about 10x their operating earnings.  The bottomline with Nationstar is that you get to participate in an impressive growth opportunity without having to pay up for that growth.

You can be a Stock Market Genius… by Buying PHH Corp

I swear its the name of a book, not the punchline of an infomercial

You Can Be a Stock Market Genius was written by Joel Greenblatt in 1999.  It is an oft recommended book by value investors.  The recommendations, however, generally come with the following caveat, or something similar in effect:  “Now I know the title is awful but…”

If you can get past the cheesy title and into the meat, the book provides an investor with a wealth of knowledge, focusing on areas of the stock market that are overlooked by the most investors, and explaining how you can find value there.

One opportunity that is discussed at length in the book is the spin-off. A spin-off typically occurs either when the company feels that the sum of the parts is greater than the whole, or when a bad business is overwhelming the perception of a good business.  Usually a spin-off involves two or more businesses that are mostly mutually exclusive from one another.

The basic premise of the spin-off is that the underlying businesses will be realized for a higher value separately then they are being realized for together.  In his book, Greenblatt focuses on the inefficiencies with the spin-off process.  In many cases investors of the original security will be more interested in one of the resulting securities than the other.  In some cases the spin-off will result in one entity that is far smaller than the other, and institutions with size limitations on what they can hold will be forced to sell.  These reasons lead to a lot of selling pressure over a short amount of time, which can depress one of the spin-off companies and lead to a good value situation.

I want to focus here on the basic premise of a spin-off; that the businesses that underly the parent company are undervalued as a whole, and that often there is money to be made simply from the recognition of value brought about by their separation.  The intent of the spin-off is to create value, and often times it works.  There are plenty of examples of company’s whose stock popped on the announcement of a spin-off or divestiture.  With investors being more able to focus on the simpler business structures of the resulting spin-off companies, the value is more readily perceived.

The Spin-off Potential of PHH Corp

I believe that PHH Corp is an ideal candidate for a spin-off or a divestiture that would create significant value for shareholders.  Moreover, even if a spin-off never happens, the value is there to be realized and the market appears to be in the process of reevaluating its worth.

PHH is involved in two businesses that, from what I can tell, have very little efficiencies with one another apart from the fact that both involve money.

  1. Mortgage Origination and Servicing
  2. Fleet Management Services

When I became interested in PHH Corp a few months ago it was because of the Mortgage Origination and Servicing segment.  PHH is one of the few large originators out there that trades publically.  I learned about the company while reading a 13G filing from Hayman Capital, the investment management firm run by Kyle Bass.  Bass took a 7.9% stake in the company.

My initial investment analysis focused on the servicing and origination segment of the business.  I was pretty sure I could see the value that Bass saw, and I will get to that in a minute.  I bought the stock soon after and watched it do well for a couple of weeks.

Well at some point my procrastination was overridden by my curiousity and I thought I better take a look at this Fleet Management business.  To be honest, I didn’t even know what Fleet Management was.  What I was shocked to learn was not only that Fleet Management is a solid, growing business, but that an argument could be made that its value alone could be worth a large percentage of the PHH market capitalization.  I can imagine a scenario where the Fleet Management business is spun off or divested from the mortgage business, with the result being a significant realization of shareholder value.

What is Fleet Management?

The best definition I could find as to what the business of fleet management is all about came from wikipedia:

Fleet management is the management of a company’s vehicle fleet. Fleet management includes commercial motor vehicles such as cars, vans and trucks. Fleet (vehicle) management can include a range of functions, such as vehicle financing, vehicle maintenance, vehicle telematics (tracking and diagnostics), driver management, speed management, fuel management and health and safety management. Fleet Management is a function which allows companies which rely on transportation in their business to remove or minimize the risks associated with vehicle investment, improving efficiency, productivity and reducing their overall transportation and staff costs, providing 100% compliance with government legislation (duty of care) and many more. These functions can be dealt with by either an in-house fleet-management department or an outsourced fleet-management provider.

Its a fairly simple business, and one that has proven to be consistently profitable even through one of the worst recessions ever.

The hidden consistency of Fleet

I went back a few years and looked at the earnings numbers on the PHH Fleet business:

Average earnings from Fleet over the past 6 years have been $0.83 per share of PHH.   Even in the depths of the 2008-2009 recession Fleet delivered respectable earnings.

The Fleet business continued its operational performance in the first quarter of this year and looks ready to break above a $1 per share in earnings for the first time since 2007.

Think about that for a second.  Here you have a business that has shown the ability to earn money consistently, even through what was probably the worst recession of our generation.  It could quick likely earn $1 per share of earnings this year.  Earnings have grown in the high teens for the past 3 years.

What would you value such a business at?  12x earnings? 15x earnings?  Maybe more?

If you use either of those multiples on the average and peak earnings numbers, it becomes clear that the Fleet business is worth something not too far away from the current stock price.  Or in other words, when you are buying PHH you are buying the mortgage business for very little.

Moreover, as one would expect, the Fleet Management business is going to improve along with the economy.  As per last year’s 10-K:

The fleet management industry continues to be impacted by the relative strength of the U.S. economy. As the U.S. economy improves, we expect to see continued improvement in the industry. We believe that improvement in the economic conditions will be reflected in continued growth in our service unit counts.

If the US economy is indeed improving, the Fleet business could turn out to be a cash generating machine.

This all leads to the speculation of whether there could be a spin-off or sale of Fleet from the rest of the company at some point.  A sale of Fleet would provide the cash needed by the servicing business to grow and allow PHH to continue their correspondent lending business at higher levels.  A spin-off would most likely realize value for shareholders, as the value of each individual business would be more easily identified.

There was a question on the Q4 conference call that alluded to the possibility of some sort of divestiture.  Management did not deny it, saying only that it wasn`t an appropriate topic for a public forum.   On the fourth quarter conference call the CEO, Glenn Messina, was asked about the possibility of bidders to the Fleet business (as well as the mortgage servicing business).  His response was:

As it relates to anything regard to Fleet or Mortgage, this public forum is not the place to have any discussions about anything like that. I’m focused on maximizing shareholder value. We’ve laid out our four strategies and that’s what we are going to be pursuing.

That certainly is not a no.

But wait, there’s more!

So a spin-off or sale of Fleet is certainly a possibility.  But that is the not the only source of value hidden within PHH.  PHH is in the business of mortgage origination and mortgage servicing.  The company breaks origination and servicing up into two distinct segments.

Mortgage Origination

Mortgage origination basically consists of finding a person that needs a loan to buy a home, showing that person a list of mortgage options of how they could finance that loan, qualifying the borrower for loan guarantees such as those from the GSE’s, processing the loan (doing all the paperwork) and passing it through to the eventual lender institution (usually to Fannie, Freddie or a bank that will either keep it on their books or sell it to another investor).  PHH takes a cut in the process, or an origination fee, that is typically between 1/2% and 1%.

Mortgage Servicing

Mortgage servicing happens after the loan is made. The servicer is responsible for determining how much the borrower owes and collecting that amount.  If a loan is not being paid then the servicer takes on additional responsibilities such negotiating a workout upon default, looking after the foreclosed property and such.  There are also other contingent responsibilities such as taxes and insurance, depending on the specifics of the servicing agreement.

The natural hedge of servicing and origination

PHH refers to the servicing and origination businesses as a natural hedge of each other.  Why?  Because they are inversely correlated with respect to interest rates.

Let’s say interest rates fall.  What happens?  People that have mortgages at higher rates refinance those mortgages.  That’s great for the origination business.  They are writing up refi’s and taking in the fees.

Not so great for the servicing business. When a mortgage is refinanced the right to service that mortgage no longer exists.  Of course this can be mitigated if PHH is able to originate the refinance and thus takes on the servicing rights for that refi so the old mortgage servicing right (MSR) is replaced with a new one.  PHH has proven to be quite good at “recapturing” loans in this manner.  But there’s no guarantee.

When rates go up and the opposite situation occurs.  Origination suffers, no one is refinancing at the higher rates.   But mortgage servicing rights are not being lost either, and PHH is collecting cash on these rights for longer.

There are a number of developments happening in the mortgage business right now from which PHH stands to benefit.

Origination: Generating consistent earnings, but needs to grow

Since 2008 PHH has had a steady stream of earnings from the mortgage origination business.   However, probably not surprisingly in the current environment, they have not been able to grow the business substantially.  Below are earnings of the business over the past 5 years, as well as for the first quarter of this year.

I believe there are a few opportunities in the origination space that could change the growth profile of the business  The first is if the company could take advantage of the pricing opportunity that exists in correspondent lending.

Correspondent lending

So first of all, what is a correspondent lender?

Consider the following. Imagine a mortgage broker who develops significant business volume, earns the confidence of wholesale lenders who will authorize him to approve their loans, and has accumulated some capital. He can now obtain a credit line from a bank that can be drawn against to fund loans, repaying the loans when they are sold to wholesale lenders. Under the law, the broker has morphed into a “lender” – the type called a “correspondent lender”.

This has been a business the big banks have traditionally taken a large piece of.   Until now.  In August Bank of America reported that they were exiting the correspondent lending business.  Ally Financial, who lends through GMAC, retreated from correspondent lending back in December before recently announcing that they would get back into the business on a limited basis.  Met Life announced that they were winding down their origination business entirely in January.

This isn’t small potatoes.  The above 3 companies were in the top 12 correspondent lenders by volume in the third quarter.

There are rumors others are leaving the business. I thought this quote from a Mortgage News Daily article was spot-on:

One can just hear large lenders talking in their boardrooms. “Do we really want to be in this business, given the regulatory, legal, financial, and public relations issues? Where the value of servicing has dropped dramatically in the market, and could drop further depending on Basel III? Where the mortgage insurance tax deductibility has gone away? Where every week brings a new lawsuit – when will we have more attorneys on staff than originators?”

Its a low margin, highly competitive business.   But the opportunity is that it could become less so with some of the big players moving on.

In the 4th quarter PHH announced that they would be reducing their own correspondent lending business.  But even at the time of the announcement they hedged their bet, saying they would remain opportunistic and take advantages of periods of high margins.  With so many other large lenders cutting back or completely exiting from the business, its a good time to be opportunistic.

Here is what management said about the correspondent business on the Q3 2011 conference call:

Yes I’m going let – yes the answer to the question is yes, we think there are better opportunities but once again we’re really pretty opportunistic in that channel. So we pay close attention to margins in that channel. As you know it’s probably the most cost competitive channel, it is the most cost competitive channel that we operate in and we’ve seen some really strange behavior in that market in terms of where margins are being priced. Some of our competitors are in the market, when they are in the market they’re very aggressive in terms of their pricing and then they back off and they’re out of market and that’s why we stay really opportunistic in that market.

On the Q1 2012 call, when questioned about the outlook of the correspondent business going forward, management began to change their tune.  CEO Glenn Messina said the following:

Right now we think by year end we’ll probably ramp it down to about 20% of the total, but yes, I do want to caution everyone. Last quarter I talked about managing the correspondent operations to a cash budget, and given where margins are today, cash cost origination tends to be very low.

So within the right quality parameters, and we’ve established defined quality parameters around who sells loans to us and the quality of their originations, we may flex up or down depending upon what the cash cost originations is.

So basically what Messina is saying is that margins are so good right now that while we originally figured to be ramping down correspondent lending,we would be crazy to do that in this environment.  Analysts have already ratcheted down estimates for the origination business as a whole based on expected declines in the correspondent segment.   PHH is in a good position to now beat those estimates.

Signing up new partners

The second possible growth vehicle for the origination business is a continuation of the success they had in the latter half of last year in signing up some big partners for their origination business.  From the Q3 CC:

We also made significant progress in growing our nationwide sourcing footprint over the past two quarters signing five new private label accounts. The new relationships include Barclays which we mentioned on last quarter’s call and today we’re pleased to announce that we’ve added Ameriprise and Morgan Stanley Private Bank along with two other financial institutions all as new PLS partners.

PHH did also lose one significant client in Charles Schwab last year, but overall the company expects to gain significant production from the new clients over and beyond the lost ones:

We expect the five new PLS accounts in the aggregate based on their 2011 production and taking into account ramp up time and anticipated launch schedules to produce about 7 billion in closing volume in 2012, about double what we predicted for Schwab.

There haven’t been any further announcements of major partnerships since the third quarter.  I imagine that these relationship get reviewed close to year end, so we will just have to wait and see.  Given the propensity for the big banks to scale back and outsource their mortgage business, it seems reasonable to me that PHH will be able to grow its book through further relationships.

HARP II could provide some short term support to origination

HARP stands for the Home Affordability Refinance Program.  HARP II is the name that has been coined for the new version of HARP.  It supersedes the original HARP.  HARP I was a total failure.

The HARP program has helped far fewer borrowers than its proponents estimated — roughly 894,000 borrowers since Aug. 31, 2011. — and many less than the estimated 11 million U.S. homeowners who owe more than their homes are worth.

Why was it a failure?  A few reasons:

1. Put back risk: Basically when a bank participated in the original program they were worried that they would get stuck with the original mortgage.  I think what happens here is that to rewrite the original loan to new terms, the loan is going to be scrutinized.  The banks and other underwriters know that the quality of many of those original documents are sketchy at best and they would rather not have to pull out the skeletons.

2. LTV Limits: This is probably the biggest problem.  The original HARP program dealt with current loans with LTV’s of 80-105.  That was expanded to 125 in 2009, but that still wasn’t enough.  I was surprised by that until I read this:

This should have a big impact in certain parts of Nevada, Arizona, and Florida where many borrowers owe more than 125% of the value of their homes. In Nevada, for example, two thirds of all loans backed by Fannie Mae are underwater, and half of all loans are above the 125% loan-to-value cut-off.

3. Appraisal costs: the borrower had to have an appraisal done to qualify for the original program.  That appraisal could cost $400.  Borrowers were reluctant to take this cost on when there was no guarantee they would be accepted by the program

HARP II aims to correct these mistakes.  The LTV limit is gone.  Appraisals are no longer required.  And banks are protected against the put backs.Says Brian Ye, analyst at J.P Morgan Chase & Co:

“We are of the opinion that there are enough changes to the program that bank servicers could really change their behavior, and this could be one of the first times that the administration has under-promised and over-delivered,”

There is one particular element of the new program that helps out PHH is that servicers get a head start over third party originators.   I confess I don’t know just what of impact this is going to have, but it is interesting and potentially significant, so I think its worth mentioning.  Servicers like PHH have been writing borrowers up for the program since the beginning of the year.   A third party originator cannot submit any documents to Fannie or Freddie until March.   This was done to entice the banks into the program, but the corrollary is that a company like PHH has been able to capture business up front without the competition.

More information on the new HARP program can be found here.

Will HARP II work?

This is, of course, the big question. The program is aimed to attract two million borrowers by the end of 2013.  This would be a little more than twice what the original program attracted.

However if the program works, and if JP Morgan turns out to be right and the administration “under-promised”, there is certainly a lot of room for upside.  According to CoreLogic:

10.9 million, or 22.5 percent, of all residential properties with a mortgage were in negative equity at the end of the second quarter of 2011.  Eight million borrowers with negative equity, or nearly 75 percent of all underwater borrowers, have above market rates. The disparity is even greater for those with severe negative equity. More than 40 percent of borrowers with 125 percent or higher loan-to-value (LTV) ratios have mortgages with rates at 6 percent or above, compared to only 17 percent for borrowers with positive equity.

Apart from the obvious fact that these numbers show just how staggeringly bad housing has become, if you prefer to see the glass half full those numbers also suggest that there are a lot of borrowers out that could benefit from a program like this.

Mortgage Servicing Rights and the Mortgage Servicing Disconnect

I wrote a long article on Seeking Alpha (The Opportunity in Mortgage Servicing Rights) describing the factors that have caused the mortgage servicing industry to fall into disarray.  I am not going to repeat that thesis in detail here.  To summarize its conclusions by way of analogy, the opportunity in the mortgage servicing industry right now is similar to the opportunity in correspondent lending.   Many of the traditional big players in the industry are getting out of the business and that has left a void.  The void has caused servicing valuations to collapse and has opened up the potential for servicers like PHH to take on new business.

PHH Corp is perhaps not the best way to play the valuation gap in servicing rights.  There are other companies like Newcastle Investments, Nationstar Mortgage Holdings, and Home Loan Servicing Solutions that are actively purchasing 3rd Party portfolios of servicing rights on the cheap, and in my opinion stand to gain substantially from their eventual reversion to historical norms.

PHH, on the other hand, does not buy servicing rights outright from 3rd parties.  They do, however, keep the servicing rights of the mortgages they originate, and they do perform subservicing of portfolios owned by others. It is perhaps in the subservicing business where PHH can take advantage of the exit of other large players, developing new relationships as subservicer.  Right now the subservicing business is a fairly miniscule component of the overall servicing revenue (a little less than 3% of total fee revenue in the first quarter) so I am going to leave this as a possibility, but not one to count on.

The other potential opportunity for PHH lies with the effect rising interest rates will have on its existing servicing portfolio.

Interest rates have done nothing but fall for more than 20 years.

At some point this trend is going to reverse.  Rates are going to head upwards.  David Einhorn published an interesting opinion piece this week in the Huffington Post.  He argued that the Federal Reserves policy of zero interest rates and quantitative easing is counter-productive; that it is not enticing risk adverse investors into stocks.  He goes on to argue that if the Federal Reserve were to allow interest rates to rise, you would see investors begin to shy away from the bond market, as what has been a one way winning trade for 20+ years would show signs of waning.

Falling interest rates have been a plague on the mortgage servicing industry.  Every time a borrower refinances, the servicing right associated with the original mortgage ceases.  This has put companies like PHH on a treadmill of generating originations to replenish their servicing pipeline, and forced them to work hard to recapture the borrowers that are looking to refinance.

When interest rates begin to head back up, the opposite scenario is going to prevail.   PHH is going to be left with a servicing portfolio that is chaulk full of low interest rate loans that will not refinance for years.  Everyone who can refinance their mortgage will have already done so.  Meanwhile, the quality of the loans being originated since 2008 is some of the highest it has ever been.  No one has dared make a risky loan in the current environment.

There are 3 risks associated with holding a mortgage servicing right.  The first risk is the risk of refinancing.  The second risk is the risk of default.  The third risk is the risk that the house is put up for sale.  We are in an environment where the first two risks are likely to be lower going forward than they have been for quite some time.  A rise in the risk of the house simply being sold implies an economy that is recovering.   Thisis probably a positive for PHH, as higher home sales will drive it origination business.

The end result is that the servicing portfolio that PHH owns is going to be generating cash for longer than it has in the recent past.  This is going to help PHH grow its portfolio further, for the simple reason that the portfolio won’t have as much turnover.

A brief look at the effect of mortgage servicing rights on tangible book

Another effect of rising interest rates is that which it will have on the book value of the servicing assets.

PHH provides an estimate of its tangible book value every quarter as part of its investor supplementary material.  Below is the estimate at the end of the first quarter as well as at year end 2011.

The company is trading at a reasonably significant discount to tangible book, which in itself says something about the unrealized value.  But if you look at the book value a bit closer, you realize that there is a lot of hidden value within the assets on the books.

Baked into shareholder equity is the value of the mortgage servicing assets that PHH carries on their balance sheet.  The servicing asset was carried at $1.3B at the end of the first quarter.  As I already explained, this asset is marked to market every quarter based on interest rates and the perceived threat of prepayment and default of the mortgages underlying the asset.   The asset represents the future value of servicing an unpaid principle balance of $149.6B in mortgages.  According to the latest earnings release, the average yearly fee that PHH receives for servicing those mortgages is 30 basis points, or about $450M of servicing fees per year.  A simple ratio comparing the current value of the servicing right ($1.3B) to the expected income of that portfolio ($450M) tells you that PHH is valuing their servicing portfolio at about 2.9x its yearly servicing income.

I’ve done a bit of research into the matter, and while right now mortgage servicing rights are selling at multiples of anywhere from 1x to 3x the yearly income, in the past servicing rights sold at 4x to even 6x yearly income.  Once servicing rights return to the mean, the book value of PHH will rise substantially.  At 4x servicing book value would rise byapproximately $450M to $34 per share.  At the high end of 6x book value would be $50 per share.

Another way that higher rates help servicing revenues

There is another rather obscure way that higher interest rates are going to improve earnings at PHH.  As part of the mortgages that PHH services PHH is charged with managing escrow accounts that are used to hold funds designated for taxes and inusurance.  PHH receives a benefit for these services by way of receiving the interest on these accounts.  The interest benefit is recorded under the Mortgage Servicing segment accounting item Mortgage Interest Income.

Beginning in 2008 mortgage interest income collapsed.  Since then it has fallen to a fraction of what it was pre-2008.

Taking a look at the PHH 10-K for 2008, when the collapse began, PHH said the following about the reduction in mortgage interest income.

Mortgage net finance income decreased by $86 million (89%) during 2008 compared to 2007, primarily due to lower interest income from escrow balances. This decrease was primarily due to lower short-term interest rates in 2008 compared to 2007 as escrow balances earn income based on one-month LIBOR.

As interest rates rise, the interest associated with these escrow accounts are going to rise substantially.  In 2007 one month LIBOR averaged around 5.3%.  In 2011 it averaged around 0.3%.  When (perhaps if) the economy finally begins to show some strength, LIBOR rates will rise.  To give a sense of this affect on PHH, in 2007 PHH was pulling in almost $3/share worth of revenue from these escrow accounts.  In 2011 that had dropped to $0.30 per share.

The Fannie put back

Since 2007 PHH has had a continual drag on its mortgage servicing income caused by the put-back of mortgages from Fannie Mae.  Over the past couple of years Fannie Mae has been reviewing their loan book for the periods from 2005-present and looking for any breaches in contractual terms, poor underwriting or defective documentation.  When it finds a mortgage that has one of these flaws, it puts it back on the lender.

PHH can fight these repurchase requests, but only up to a point.  Bank of America has been probably the most vigilant in fighting Fannie, and in return Fannie decided not to renew their contract to buy loans from BoA.  Fannie holds the trump card in this battle, and so PHH is going to be pretty much stuck with paying up for many of the repurchase requests put back to them.

Since 2008 PHH has been taking significant writedowns due to the repurchase requests including a big charge at the end of the most recent quarter.

The topic was discussed in depth on the first quarter conference call.  Messina had the following comments:

Based on our ongoing discussions with the GSEs, we believe that by the end of 2012, they may be substantially complete with their review of our seriously delinquent and defaulted related to origination years 2005 and prior, and by the end of 2013, they may be substantially complete with their review of our seriously delinquent and defaulted loans related to origination years 2008 and prior.

Almost 78% of our standing repurchase requests at quarter end are related to the 2005 through 2008 origination years. Given the results of the first quarter, our ongoing discussions with the GSEs, we believe it’s reasonably possible that future losses related to repurchase and indemnification requests may be in excess of our recorded foreclosure-related reserves.

Assuming that the elevated level of repurchase demands that we have recently experienced continues through the end of 2013, and the company’s success rate in defending against such requests declines, and that loss severities on repurchases remain at current levels, the estimated amount of possible losses in excess of our foreclosure-related reserves is $140 million.

The bottom line is that repurchase requests are likely to be a drag on earnings for the next two years.  The company is outlining $140 million in addittional charges, presumably broken up over the next 7 quarters.  This works out to about $20 million a quarter, which is fairly consistent with the level of charges over the past 3 years.

When core earnings matter

Whenever a company publishes core earnings you have to look good and hard at why they are doing so.  You never know what they might be trying to gloss over by eliminating some of the more unsavoury elements of the income statement.

PHH reports core earnings every quarter but they do so for a very good reason.  Core earnings are a far better representation of the company’s profitability than are GAAP earnings.

The problem with GAAP earnings is that they are obscured by changes in the mark to market value of the mortgage servicing right portfolio.  The accounting nature of the servicing right is such that PHH has to write up and down the mark to market value of each right with changes in interest rates.  A servicing right is in many ways no different than an interest only mortgage security.  The biggest risk is the prepayment of the security and with most mortgages this risk is closely tied to interest rates. When rates go down mortgage servicing rights have to be written down in value to reflect this increased risk of prepayment.

The fluctuations on the income statement caused by these mark to market moves are huge.  Up to $400M in some quarters, which for a company the size of PHH (there are only 55M shares outstanding after all), leads to massive moves up and down.  If you look at quarterly GAAP earnings over the past couple years they look like a scatter chart.  Below is a chart of earnings from the mortgage servicing segment that includes the effects of the mark to market adjustment.  With interest rates having fallen so precipitiously in the last few years, PHH has had to take pretty massive GAAP writedowns on their servicing portfolio.  Below are the before tax earnings per share from the mortgage servicing segment.  Much of the swing is the result of the mark to market adjustments to the servicing portfolio.

The reality of the mortgage servicing right is that as long as the company is replenishing the existing pool with more rights from new originations and recaptured refinances then its losing to payoffs, its all good.  As I already noted, PHH is doing that and then some.

The core earnings number that PHH reports is quite simply GAAP earning less this mark to market effect. And if you look at that core earnings over the last few years you can see that they have have been growing consistently and that the current stock price of $17 is not expensive relative to earnings.

So what did Bass see?

Let’s review the core elements of the thesis with PHH:

  1. The company is trading at about 65% of a tangible book value that perhaps undervalues the servicing assets by 25-50%
  2. Core earnings, which are a relevant metric of company profitability, are over $3 per share and growing
  3. The Fleet business itself has the potential to earn $1 per share in 2012 and provides a reasonably steady earnings stream even during recessions
  4. There is upside potential for PHH to take advantage of the current disconnects in the mortgage market, both in servicing and in originations
  5. The potential of a divestiture or spin-off of Fleet from Mortgage or vice versa

The downside is that the stock has moved well off its lows and that because of the sensitivity of the mortgage business to overall economic activity, the share price is volatile.  Bass bought his shares at around $10 and in full disclosure I bought most of my shares in the $12 range, though I have added recently with the break-out above $16.  While I can’t say for certain that PHH will eventually divest the Fleet business, I think that the story has enough elements that even if they don’t, there is plenty of room for upside appreciation in the share price.


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