Posts tagged ‘phh corporation’

Feb 20

PHH, Newcastle Investments, and mortgage servicing rights

In my week 29 letter I began to talk the opportunity I was seeing in mortgage origination and servicing.

While an uptick in new home building may still be some time away, mortgage origination should benefit over the next year from the refinancing associated with HARP II and from less competition due to the exodus of originators from the ranks brought on by the dismal market conditions.

Mortgage servicing, meanwhile, has been hurt by falling interest rates (remember that as a servicer you get paid as long as the loan is being paid, so refinancing can hurt your business if you can’t reoriginate the refinancing), by uncertainty in the regulatory environment, and by the regulatory capital concerns of banks. But valuations on mortgage servicing rights are low and with loan quality standards currently high and with interest rates unlikely to go lower, new servicing rights should be a good investment.

I want to delve a little deeper into the mortgage servicing rights (MSR) part of the business this week.

What is a mortgage servicing right?

A mortgage servicing right is a somewhat complicated little piece of paper of conditions, responsibilities and payments. For the basic definition I will defer to investopedia:

An MSR is a contractual agreement where the right, or rights, to service an existing mortgage are sold by the original lender to another party who specializes in the various functions of servicing mortgages. Common rights included are the right to collect mortgage payments monthly, set aside taxes and insurance premiums in escrow, and forward interest and principle to the mortgage lender.

In return for these responsibilities, the servicer is entitled to a small piece of the recurring interest payments made by the borrower, usually around 25 basis points (0.25%).

A more investment oriented definition of an MSR comes from kamakuraco, who published an interesting paper on estimating the risk of an MSR, and who define the mortgage servicing right in the terms of a security:

One can approach the valuation of mortgage servicing rights as the valuation of a fixed income (broadly defined) security subject to default risk and prepayment risk.

There are two risks implicit to an MSR; either the mortgage is paid off, or the borrower defaults. In both cases the payments to the holder of the MSR are no more.

The collapse of the MSR

There was a great discussion two weeks ago on the Lykken on Lending mortgage banking podcast. Lykken had on Austin Tilghman and David Stephens, CEO & CFO respectfully, both with United Capital Markets. These fellows are industry experts in the mortgage servicing market. The discussion begins about a half hour into the podcast.

To take an aside for a second, I have to say that listening to the discussion brought about one of those exciting moments that make investing fun. I was biking home from work, had my ipod on listening to the broadcast. The roundtable discussion with the UCM execs came on and the second question, put forth by Alice Alvey, asked why are company’s beginning to retain their own servicing rights when traditionally most originators just sold those rights off for the cash up front? Austin Tilghman (I think. He didn’t identify himself) replied with the following:

Prior to the meltdown the price paid for an SRP [servicing release premium] was generally 5x or more of the [mortgage] service fee. That multiple dropped to 4x a few years ago and we are hearing that its dropped to 0x in some cases today.

Andy Schell, Lykken’s partner, then went on to say that he had recently done an analysis of SRP’s and MSR’s and, in his words, “I couldn’t believe the numbers are so low.” He reiterated that the SRP’s are in some cases approaching zero.

Wow.

When I hear that kind of disconnect I immediately think opportunity. And then I think how can I capitalize on that opportunity.

Defining SRP’s (there are too many acronyms in this industry)

But first of all, another definition. When a company originates a mortgage, along with that mortgage comes the right to service the mortgage. That’s the mortgage servicing right.

As an originator you have the option to keep the MSR on your book and service the mortgage through its life in return for the 25 basis point (or thereabouts) premium.

Alternatively you can capitalize the MSR up front by selling it. In return for selling the MSR you get cash. The cash you get is referred to as the servicing release premium (SRP).

The acronyms MSR and SRP get used all the time in discussions without definition so its good up front to understand what these two concepts are.

Why SRP’s have collapsed

As David Stephens alluded to above, the value of an SRP has collapsed of late. A few reasons why this is the case:

There is concern about a regulatory change to make MSR’s a fee for service as opposed to a tacked on percentage of the loan interest (this is preventing new participants from getting into the market but it appears that it is not going to happen)
There is a more nebulous concern about the regulatory environment in Washington in general and what the “unknown unknowns” of future legislation might be
You only get the cash flow stream of an MSR over time whereas you get cash right now by selling the SRP and has of course been a liquidity problem in the industry since 2007
Its a long term commitment to get into servicing. You can’t just jump in overnight without getting approvals as a servicer from the regulators and developing the infrastructure to do the servicing
The market for buying and selling servicing is thin at the best of times and especially thin now (because of all the folks getting out of the business)
And that is because… no bank wants to have anything to do with the mortgage industry

The opportunity

The basic investment premise here was well put on the broadcast by Joe Farr, who asked the following question:

With rates at 3.5% or 4% and quality never being better, why is it that that servicing values are close to zero in some cases?

To which Austin replied:

Its the aggregation of the aggregators. In 2007 an originator might have 20 take outs for the loan they produced. After the spectacular failures of 2008 and the combination of large companies into even larger ones there may have been 10 takeouts. Recently we’ve seen BoA and Citi getting out of the market and you can count on one hand the number of people that account for 50% of the market. And they have their own capacity limitations. It just gets tougher and tougher to find a takeout and then those that are left are becoming more selective about what they buy.

And there you have it. A simple supply and demand imbalance where demand for SRP’s has been decimated by the housing collapse have caused a disconnect in servicing valuations.

Who is going to benefit?

So I own a bunch of PHH now. They are big time servicer and the MSR’s on their books are valued at about 2.7x. Clearly from a book value perspective PHH has some upside to that servicing valuation if interest rates begin to rise and they can value that servicing at something closer to 5x. Servicing values have had to take major writedowns over the past 3 years as defaults have increased and more importantly, as interest rates have fallen, raising the possibility of refinancing. I found that really interesting table of the writedowns taken by some of the major banks over the past 3 years in the Kamakura report that I mentioned earlier:

That is nearly $30B in writedowns over the past 3 years for the 8 major banks. Wow.

Remember that the writedowns are being taken in part because the current MSRs are expected to refinance at a faster rate. PHH has, in the past, managed to retain most of their servicing rights that get refinanced by being the originator on those refinancings. So its perhaps a little misleading to value those servicing rights at 2.7x.

To get an idea of impact of a revaluation of those MSRs on teh PHH books to a 5x servicing fee multiple:

Ok, so that’s a pretty big impact on the accounting end.

As I already mentioned, PHH has proven that they can produce more MSR’s then they lose even during times where a large amount of the MSR’s are refinancing. The new MSR’s replacing the old MSR’s are of a much higher quality. By high quality I mean that these MSR’s are connected to mortgages that are being financed at extremely low rates (and therefore where the chance of early repayment is low) and within a market where credit quality is extremely restrictive (meaning the chance of default is low). This doesn’t seem to be reflected anywhere in the books.

So PHH has some upside as MSR come back into favor. That’s good. But there are two problems with using PHH as the vehicle to play the MSR disconnect:

They don’t have the cash right now to take advantage of the disconnect in price and buy up MSR’s on the cheap. What I really need is a company with lots of cash and a savvy management team that recognizes that there is an opportunity in the market and you have to jump in.
They are an originator, so when the MSR’s begin to recover their value its going to be on the heels of rising interest rates which will hurt the PHH refinancing business. In other words, PHH will never have all cylinders firing at once.

What I really need is a company with lots of cash and a savvy management team that recognizes that there is an opportunity in the market and you have to jump in.

Enter Newcastle Investment

I have owned Newcastle investment in the past. In fact, I owned them as recently as last summer, but I sold them in one of my “sell everything because who the hell knows what is happening in Europe” moments. At the time, I owned Newcastle because they, much like Gramercy Capital, had a large disconnect between the NAV of their managed CDO portfolio and the share price.

I’m not going to go through that CDO valuation right now because I want to talk about the MSR business that Newcastle is branching out into. I probably will in the next few weeks, just to get a better idea of the value proposition here. In the mean time the best places to find a comprehensive analysis of Newcastle’s CDO business are on the Gator Capital blog and the analysis by PlanMaestro on variantperceptions here and here.

The essence of these analyses is that if you add up the CDO business and cash at corporate, subtract out the preferred’s and other debts, you get a company with an NAV of about $5-$5.50 per share. So your net asset value is something pretty close to the current share price.

Here’s the crux then. Of that $5-$5.50 per share net asset value, about $205M (or a little less that $2 per share) was cash at the end of the third quarter. The potential upside exists if Newcastle can turn that cash into a cash producing asset that has a value greater than the face value for which it is purchased.

NCT gets into the MSR business

On its third quarter conference call Newcastle made the announcement of the change in direction. The company was getting into the mortgage servicing business. The company said it would be making major investments into MSR’s over the next few quarters (one of which they have already since announced). The reasons that they decided to make the switch in strategic direction was:

They felt the MSR business offered the best risk adjusted returns out there
The existing core business of CDO creation was basically dead

Interestingly, Derek Pilecki, who writes the Gator Capital blog, dumped NCT when the news was announced. While I am of the mind that getting into the servicing business right now is a savvy move, I recommend reading his final analysis of (and reasons for selling) Newcastle here for a contrary point of view.

Newcastle believes that there are significant returns that could be realized from MSR investments. From the SeekingAlpha Q3 conference call transcript:

We are still very optimistic that the returns on an unleveraged basis will be kind of mid-teens even mid-20, so very compelling in any environment but in particular with all the certainly in the world if we get something that is a big deal for us.

Newcastle went on to describe something that the fellows from UCM pointed out on the Lykken broadcast; how banks are basically dumping their servicing business on the cheap. Again from the transcript of the 3rd quarter conference call:

Banks in the U.S. are very focused on regulatory capital, on regulatory risk, on just the perception of headline risk, [and this has] made them more likely to be source [of MSR supply]

To get into the business Newcastle is partnering with an originator and servicer (Nationstar) and Nationstar will be performing the actual servicing. I think that Newcastle can be thought of as a silent partner that is putting up the cash. Again, the problem with MSR’s is that you have to have the cash to put up, and while most originators are running a tight cash flow, Newcastle has ample cash to take advantage of the investment.

Newcastle has also received approval from the IRS that MSR’s can receive the same favorable taxtreatment as other REIT assets.

That they had to clarify approval demonstrates the “first mover” status that Newcastle holds. Newcastle is early on in the game, being one of the first REIT’s to take advantage of this opportunity. As one of the analysts put it on the Q&A, Newcastle is “leading the way”.

What’s the upside?

The upside to Newcastle is a big increase in the free cash flow that the REIT can generate. Before getting into the MSR business, Newcastle was generating around $80M of free cash flow (FCF). At a 20% return on the $200M of unrestricted cash (using the assumption that the company puts all its free cash into the MSR business), you are looking at FCF of another $40M. Given the current market capitalization of $600M that puts NCT at a 5x free cash flow multiple. The company paid about a $60M common share dividend in the third quarter, so clearly another dividend hike would be likely.

The company announced their first MSR deal with Nationstar in a December 13th news release. In it the company reiterated the return metrics:

“I am very pleased to announce our first investment in Excess Mortgage Servicing Rights. This is a watershed investment for us in this sector. We expect this investment will generate approximately a 20% unleveraged return and total cash flows of over 2 times our investment. I am excited to be investing alongside Nationstar, a premier mortgage servicer and originator. Residential mortgage servicing is a large market and we currently see a strong pipeline of similar investments at very attractive returns.”

The deal was for $44M.

In my opinion, apart from the basic cash flow expected there is unrealized value in these MSR assets. For one, because Newcastle is partnering with an originator in Nationstar, there is a good chance that a decent percentage of the MSR’s that the company is investing in will be refinanced through Nationstar. Newcastle was quick to point out that refinanced mortgages remain in the portfolio and continue to cash flow to Newcastle. The refinanced value is not included in the value of the MSR. Newcastle estimated the following refinancing rate on the Q3 call (from the SeekingAlpha transcript again):

So our experience at Nationstar on our agency pools that we service which is a material amount of loans is that we’ve had recapture rates in the kind of low-to-mid 30% (inaudible) over the past six months, and that’s obviously significant, we think and we’re hopeful that with a little bit of focus, we could increase that to 40%, 50% at the extreme end of it, not that I’m predicting this, because it wouldn’t be prudent, but at the extreme end of it, you can capture a 100% of the loans that prepays, then you would have really the perpetual money machine right, as the IO would stick around, the extra service will stick around forever, but even at recapture rates at 20%, 30%, 40%, 50%. It has a terrific impact in terms of the volatility of the MSR and that’s (inaudible) investment profile looks like.

Second, as I already pointed out, recent and new MSR’s are being collected from mortgages that have been financed at historically low rates and in an era of extremely strict lending criteria. There is little chance that these mortgages are going to default and little chance that they will be refinanced any time soon. In other words these are high quality assets.

Its kind of a weird perfect storm here; you have a situation where the asset quality has never been better at a time when nobody wants the asset. While I suppose its not clear exactly what the quality of the MSR’s Newcastle is investing in are, if one presupposes a little faith in the management team (which has after all had the foresight to see an opportunity that many others have not yet seen), you might draw the conclusion that Newcastle is getting into high quality assets at a fraction of their underlying value.

Anyways if you add it all up I think NCT is on to something here. I bought a position in the stock and plan to add to incrementally as the stock moves up and my thesis is proven right.

Feb 19

PHH and one way to bet on a turn in the US economy

PHH is one of those stories where the more I look at it, the more it makes sense to me, and the more it makes sense to me, the bigger the position I am willing to take.

I love to add to a rising stock. I think its truly the best way to make money. You buy a start position, the stock begins to move up, you add to that position, it moves up again, you add again. The market is telling you that you are right and so you listen to the market, and to use a phrase of Dennis Gartman’s “do more of what is working”.

In the last week I basically doubled my position in PHH:

I wrote my basic thesis on PHH 3 weeks ago. I love that the company is involved in mortgage origination and servicing. I think that mortgage servicing rights represent one of the best investments you can own right now (I’ll put out a post a little later where I’ll discuss the upside of the mortgage servicing business along with another new investment I just made; in Newcastle Investment). I also love that the company trades at about half of tangible book and at around 4x a core earnings number that truly does represent the core earnings metric that should be used to evaluate the company.

What I had kind of ignored up until this this week was the company’s Fleet business. It seemed like it was making money, it wasn’t really a core part of my reason for owning the company, so I just disregarded it as something that wouldn’t necessarily hurt the investment thesis but was not really something I wanted to focus on.

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.

So what’s so great about that?

This week I ran a quick set of earnings numbers on the PHH Fleet business:

If you average earnings over the last 6 years you get average earnings of $0.83 per share of PHH.

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. What would you value such a business at? 10x earnings? 12x earnings? 15x earnings?

If you start running the numbers at those kind of multiples on the average and peak earnings numbers, you realize pretty quickly that the Fleet business could be worth something pretty close to 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 I am right about my previous speculation that the US economy is improving, the Fleet business could turn out to be a cash generating machine for PHH.

One last point. When you see the value that appears to be unrealized in Fleet you have to wonder whether there could be a spin-off of Fleet from the rest of the company at some point. There was a question on the Q4 conference call that alluded to this possibility. Management did not deny it, saying only that it wasn`t an appropriate topic for a public forum. Meanwhile, what better way for a cash strapped company to raise cash then to spinoff a somewhat unrelated business that isn’t being realized at fair value anyways. For those of you not familiar with spin-offs I would recommend Joel Greenblatts excellent and terribly titled book, How to be a “Stock Market Genius”. While there is no guarantee that a spinoff of Fleet will occur, the cards are all aligned.

Jan 22

2 Comments

Week 29: Conviction and Humility, Investigating PHH, Don’t forget about Atna, Buying Midway

Portfolio Performance

Portfolio Composition:

On Conviction and Humility

I find that investing in stocks is a constant antithesis/synthesis (to use a couple of terms from philosphy) between conviction and humility. Never is this more evident than when things aren’t going your way.

While the market has been up the last couple of weeks, and my portfolio has been up somewhat as well, it is not doing as well as I would like, not as good as the market even, and that makes me want to reevaluate.

Part of me wants to just get out and start all over again. Right now there are things of which I am wrong. Wrong about some of the gold stocks I own (while Atna continues to do well, Aurizon is not doing well, Lydian is not doing well, and a couple of my more recent purchases, Esperenza and Canaco, have stalled out). Wrong about some of the oils I own (I probably should have sold out of Reliable Energy at 30 cents) that aren’t doing much of anything. Certainly wrong about my big bad bailout bank short bet, which went quite far south last week.

The other part of me, pushing just as strongly, wants to stay the course and, more exactly, to ignore what the market might be telling me because the market is wrong and I am right and in time I will be vindicated.

It goes without saying that this last attraction is a dangerous one. Surely we all have listened to the expert that held his conviction against all evidence to the point where his credibility was lost forever.

The truth between these two extremes lies, of course, somewhere in the middle. The difficulty is figuring out exactly where that is.

The basic long term investment theses on which I am currently holding stocks (and shorts) are as follows:

Europe is on an inevitable course to dissolution, with a collapse in Japan not far behind
Gold is the only asset that is no one’s liability and it will gain respect as a store of value as these events unfold
The US, while troubled, is muddling through, and the US housing market has likely had, as Kyle Bass has put it, the pig go through the python
Oil is harder to find and harder to get out of the ground then most people appreciate, and its price will prove sticky to the upside
The hz-multifrac is a revolutionary technology and so you want to own oil companies that can take advantage of that technology

I think its helpful to review these basic points on occasion, particularly when things are not going my way. If I can still stand by these tenants then the rest is just a matter of evaluating if the individual stocks themselves are decent businesses (or perhaps more importantly good stories) in their own right.

And, having thought about it over the weeked, I wouldn’t stand away from any of the above.

Two weeks of a market moving up with many of my stocks doing nothing can seem like an eternity. Sitting with as much cash as I currently have (though I have reduced that cash level somewhat, mostly in response to specific opportunities and a recogntion that the deterioration of Europe no longer seems imminent) while the market rises, can be tough to bare. But I can’t just abandon what makes sense because of a few tough weeks. If the facts change, certainly I have to change with them. No doubt about that. But when the main fact that has changed is that the market is not going down any more, I think it is wise to respect that fact (no sense doubling down and some sense in lightening up with what doesn’t work) but not so wise to change course entirely. Better to move as a big ship might, slowly inching it way towards a new course, ever on the lookout for signs on the horizon that might make the destination more clear.

Wading into the Mortgage Market

On Tuesday this week a 13-G was issued that Hayman Investments (the hedge fund run by Kyle Bass) had purchased over 7% (4,448,751 shares) of PHH Corp. I got a google alert on the news almost immediately. It still wasn’t soon enough. The stock was up 10% within minutes and closed up 12% on the day.

I sat down on Tuesday night with the intent of understanding what Bass what was up to.

I don’t think this is just Bass buying a cheap company (which they are) and hoping for the best. I think there is more to this story, as I will explain below. But first, lets talk a bit about where I think we are in the housing cycle.

First of all, I am no blind optimist here. I don’t think for a second that housing is about to make a robust 180 with rising prices and robust new builds. That’s not happening for a long time yet.

But that does not mean that all housing company’s should be left in the trash bin. No I think that those that rely more on volume then price may find themselves doing better this year, and may be ripe for a move.

Why? Because I think prices have fallen enough in many markets. Most of the damage in terms of declines appears to have been done. There was a great graph provided by Core Logic a couple weeks ago that showed prices both including and excluding foreclosures.

Illuminating! If you ignore foreclosures, prices nationwide are on the verge of going positive. If you look at the regional data, prices are actually up in many locales. And while some areas are still bogged down in foreclosures, many have worked through the worst of it. Those are going to be the areas where we start to see a turn.

So it makes sense to look for companies that stand to gain from these first signs of stabilization.

And with that, onto PHH…

PHH is in the business of mortgage origination. They are in the business of mortgage servicing rights. Tthey are also in the business of commercial vehicle fleet management but I don’t think that’s the story here so I’m not going to dwell on that. Lets talk for a minute about the two former businesses.

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, and then processing the loan through (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%. In the third quarter the company said that their “pricing margin also expanded by more than 47 basis points as compared to the second quarter.”

Mortgage Servicing

Mortgage servicing happens after the loan is made. The servicer is responsible for calculating 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.

PHH refers to these 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 with 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. Those refi’s mean that the mortgages that PHH has the rights to service no longer exist. Now ideally PHH originates the refi and thus takes on the servicing rights for that refi so the old mortgage servicing right (MSR) is replaced with a new one. But there’s no guarantee of that.

Rates go up and the opposite situation occurs. Origination suffers, no one is refinancing at the higher rates, but that also means the MSR’s are not being lost either.

As it is, PHH has proven to be pretty good at holding on to more MSR’s then it loses. Forthe 9 months ending in the 3rd quarter the company had a replenishment rate on MSR’s of 167%.

Ok, back to Bass. There are a number of things happening in the mortgage business right now from which PHH stands to benefit. Let’s go through them one by one starting with Harp II.

HARP II

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 total 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 probablythe 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,”

The two tiers of HARP II

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 can capture business up front without the competition.

There is more interesting information on the new HARP program here.

What’s it going to mean?

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.

I was listening to this week’s Lykken on Lending and they were talking about Harp II. Lykken said that listeners (brokers and third party originators) needed to gear up for the “mother of all refinancing booms”. In another segment a couple of weeks earlier Lykken and his guests spoke quite excitedly about the impact of no LTV limits. The one guest talked about how common it is to have to turn away borrowers because they are too far under on their home. HARP II should help with that.

BOA and correspondent lending – another tailwind

So first of all, what is a correspondent lender?

Consider a broker who develops significant business volume, has earned 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 taken a large piece of. Until now. In August BoA reported that they were exiting correspondent lending.

This isn’t small potatoes. It accounted for”47 percent of Bank of America’s mortgage originations, or $27.4 billion, in the first quarter of 2011, the Wall Street Journal said citing Inside Mortgage Finance.”

There are rumors others are leaving the business. Its a low margin, highly competitive business but it could become less so with some of the big players moving on.

In comparison, for PHH total mortgage closing volumes for 2011 so far were $36.3 billion of which approximately 70% were retail and 30% were wholesale/correspondent. Here is what management said on the Q3 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. Luke, do you want to add anything?

The company made a total of $95M off of mortgage production, meaning off of fees for new originations of that $36.3B of loans they processed. The company doesn’t break down the margins between the retail and the wholesale/correspondent. Total revenue from the segment was $264M, which suggests that the fees on average are around 0.7% of total loan value.

Tailwind 3: Signing up new partners

The last tailwind for PHH is that they are having success 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.

They also lost one significant client in Charles Schwab but over all the company expects to gain significant production:

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.

Twisting in the (tail)Wind

The Donald Coxe conference call this week was very good, and it produced one particularly enlightening graph.

Long term rates, both treasury and mortgage, are at all time lows. When the Fed embarked on operation twist, it was with the intent of bringing down the long end of the curve, and by doing so, propping up and ideally pushing ahead, the housing market.

I would say this was a success.

When you add to the fact of HARP II that interest rates are at all time lows and really, given the decline in house prices in many markets, are basically creating the conditions where you would be crazy not to buy a house, you just have to think that this is going to help origination activity in 2012. I think the point that is sometimes forgotten is that the downard spiral of housing is really caused by the foreclosure mess. Its the lynchpin. If you could create the conditions to stem that flow, I think the situation would right itself a lot faster than is appreciated.

When core earnings matter

A lot of the time when a company is reporting some sort of non-GAAP earnings, its in order to hide something. A good example of this is Salesforce.com. They report non-GAAP earnings that exclude certain costs (particularly stock options) that they would rather ignore.

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

The problem with the GAAP number is that it is obscured by changes in the mark to market value of the MSR portfolio. PHH has to write up and down their mortgage servicing rights with changes in interest rates and to a lessor degree credit quality. When rates go down they have to write down the value of the rights and when rates go up they have to write up the rights.

The fluctuations on the income statement caused by these mark to market moves are huge. Up to $400M in some quarters. If you look at quarterly GAAP earnings over the past couple years they look like a scatter chart.

The reality of the MSR’s is that as long as the company is replenishing the existing pool with more rights from new originations then its losing to payoffs of its existing pool, its all good. As I already noted, PHH is doing that.

The core earnings number takes out that effect. And if you look at that core earnings number you see a pretty cheap looking company.

All that, and discount to book…

The last point I would like to make about PHH is the discount relative to book value. You can get the shares at a pretty substantial discount, even after the post-Bass run up:

What’s even more interesting is that this discount exists even after the valuation of the MSR portfolio has been clobbered by falling interest rates. It is not impossible to imagine a scenario where the MSR’s add book worth $500M plus, or another $10 per share.

So what does Bass see?

To sum it up, with PHH you are getting a cheap company that has earned decent money of late and that should benefit from the tailwinds of HARP II, weary competitors and a rebounding housing market.

The negative with PHH is the debt they have coming due, and whether they will have the cash to pay it off. That debt is an issue I believe is worthy of a post in itself, and I will try to get around to that next week.

Europe is still a problem

…it just doesn’t seem like it right now.

I have a few other things I was hoping to talk about this week but I’m running out of time and this letter is getting quite long already. But I do want to talk a bit about some of the reading I have done on Europe the past week.

It seems what with the stock market rising every day that Europe is old news now. Yet I think that to ignore the risk of Europe right now, to go all in, is still at best a gamble. It may turn out, you could do it and cash out big in 6 months. But to say you knew it would turn out that way would be kidding yourself. We could just as easily wake up tomorrow in crisis mode again as in the happy-happy-risk mode that we’ve been in the last couple weeks.

Europe hasn’t gone away.

The S&P downgrade of a number of European countries been widely reported already so I’m not going to dwell on it, but I do want to point out that the language used. In particular:

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU’s core and the so-called “periphery”.

This strikes at the basic point that I have made in past posts. Austerity measures are not going to fix the problem with Europe because the problem is not a one time spending binge that just has to be paid off. The problem is much deeper, relates to inherent inequities in the productive abilities of the economies, and is quite possibly not solvable without a break up.

As John Maudlin said in his piece “End of Europe”:

For most of the past two years, European leaders have tried to deal with the problems as though they were short-term liquidity problems: “If we just find the money to buy some more Greek bonds, then Greece can figure out how to solve its problems and then pay us back. Given enough time, the problem can get solved.”

They have now arrived at the understanding that it this not a short-term problem. Rather, it’s a solvency problem of the various governments, which of course creates a solvency problem for their banks. They are now addressing the problem of solvency and providing capital until such time as certain countries can get their budgets under control and the bond market sees fit to provide the capital they need.

But they are completely ignoring the third and largest problem, and that is massive trade imbalances. Germany exports products to the peripheral European countries, which run trade deficits. As I have shown in several letters, a country cannot reduce private-sector leverage, reduce public-sector leverage and deficits (balance its budget), and run a trade deficit all at the same time. That is simple, unavoidable math, based on 400 years of accounting understanding. Ultimately, there must be a trade surplus if leverage and debt are to be reduced.

There is a great model that Maudlin creates in the post that summarizes the situation of Greece, Portugal et al to a tee. I would recommend reading the piece in its entirety. One last point from the piece:

Prior to the euro, the imbalances would be handled by currency exchange rates. The value of the drachma would go down relative to the value of the deutschmark. Things would balance over time. Now, all of the eurozone countries are effectively on a gold standard, with the euro standing in for gold this time. Britain, the US, and Japan print their own currencies. Their currencies can rise or fall over long periods of time, based on national accounts and the desires of foreigners to buy goods or invest in their countries.

He is retreading the old Jane Jacobs idea that I brought up a couple weeks ago:

What Europe has embarked on with the Euro is the exact opposite of what is needed. Currency regimes need to evolve to produce better feedback, not worse. The Euro currency feedback mechanism is skewed by the strength of the German economy (actually more exactly the economy of its one or two prime export replacing cities, Berlin and Frankfurt). Peripheral countries like Italy, Greece, Spain and Portugal are doomed to receive faulty feedback rather than the natural “export subsidy” that would occur if those countries had (lower value) currencies of their own.

To think that all is well is to mistake the calm eye of the storm for the end of it.

Meanwhile, I’ll end my Europe talk with this: There seems to be a growing recognition that Greece needs to exit the Euro. The chief executive of Germany’s natural gas firm Linde’s chief executive Wolfgang Reitzle was quoted as saying the following in Reuters:

“In the medium term Greece needs to exit. And the writedowns on Greek debt will not be between 50 to 70 percent, but in the end will be written down by 100 percent,” Reitzle said.

Asking Germans to pay more than 50 percent taxes to help fund other euro zone countries will erode the will of the German electorate to support rescue measures, Reitzle said.

Although this scenario is not desirable, he felt that German industry would survive working in a new currency.

Atna’s jump in reserves (and share price)

I haven’t spent as much time as I should writing about Atna. I tend to ignore the stocks that I am right about. This is perhaps not the best way to self-promote, but since I’m not really in that ballgame anyways, who cares. I learn more from my mistakes.

But don’t take that for disinterest. I watch Atna like a hawk every day. As I pointed out a month ago, I think that if Pinson works out the stock is worth somewhere between $3 and $6. I know that there is some skepticism around Pinson, that there may be rock stability issues, but I’m of the mind that the current stock price is more than pricing in that risk.

It feels to me like a stock being accumulated before a break-out. Perhaps we got a taste of things to come this week when the stock popped over $1 and up to as high as $1.05.

On the news front, Atna released an updated resource at Briggs on Thursday.

There is not too much to get too excited about, though it is nice to see that they managed to move about 50,000oz to measured and indicated, basically replacing production. Overall they showed a slight increase of about 14,000 oz all in. At the current production rate (45,000 oz), Briggs is good for another 10 years. That alone is probably good for the current share price.

Buying Midway Energy (Again)

The other move I made this week was to reinitiate a position in Midway Energy. I decided to pull the trigger here because the other Swan Hill players showed signs of moving up towards the end of the week.

I already own positions in Second Wave and Arcan (though the Second Wave position didn’t get taken in the practice account due to an unfortunate glitch in the order fill). I did not own Midway and it had not moved higher and it seems a reasonable presumption that it will follow suit eventually.