MSRs Redux (HLSS, OCN, ASPS)

The new year did not start out so well for one segment of my portfolio - those related to mortgage servicing rights (MSRs). Beginning with a general sell-off in January, non-bank servicing companies took a beating:

I was far from immune, though my risk-management stops did force some reduction late in January. However, the value in ASPS and OCN in particular led to me to slowly re-add in early February. This was premature:

• New York Department of Financial Services blocks Wells Fargo sale of MSRs to Ocwen
• Ocwen may be sued by multiple large investors

If the above were short-seller reports, this would have been a classic "bear-raid", especially given the black-out period prior to earnings (Feb 27/13th,  for OCN/ASPS). The first news item came out in the middle of the HLSS earnings call (Feb 6th), requiring management to deflect questions until the upcoming Ocwen call. Rumors of the above may indeed have been circulating previously, though the exact reason for the market reevaluation may be tough to see and moot at this time.

However, how does this affect Ocwen (OCN) and its related entities as a whole?  Buffett describes value as simply the discounted cash flows of a company, so the question, does this materially change those cashflows?

1) OCN's future prospects remain bright - New York's regulatory action should be temporary because OCN's best-in-class cure rate and delinquency trends make it the best for both investors and homeowners.

The principal reason for the growth of Ocwen is the competitive disadvantage that bank servicers now have in light of Basel 3. I detailed this in a previous post and showed how banks take capital charges if they service mortgages themselves.

This fundamental fact (which shows no signs of changing) has not changed - what may have is the rate of portfolio growth for OCN and others. The principal reason behind the government block is concern over the ability of OCN to service the mortgage. OCN, which outsources most of the work to india, has indeed be dogged by consumer complaints about improper/slow processing and related errors which may lead to excess fees and delayed payments. Given the sub-prime focus that OCN has, it can be difficult to figure out how much of this is simply from the sub-prime consumers' own mistakes and how much is legitimately OCN's fault. It may indeed be more of the latter, but industry data suggest that out of other servicers, OCN remains first-in-class when it comes to final outcomes.

OCN's cure rate - the rate at which it turns delinquent loans into current ones, remain the best in the industry. A higher metric for benefits both investors and homeowners, as it means that fewer foreclosures occur and more principal is repaid.

Source: December 2013 presentation by Ocwen

2) Investor lawsuits by PIMCO/BlackRock are also temporary and on weak footing. Both pushed for the ResCap's sale to OCN and have only recently turned against it. I believe that they are upset possible errors which occurred during the on-boarding process and/or lower investor returns than they anticipated due to foreclosures, etc. The above arguments apply to this as well, although detailed rebuttals will depend on the actual lawsuits filed.

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Portfolio-wise, I've focused on the highest conviction names and have therefore exited less direct exposure to this trend, namely HLSS.

Disclosure: long OCN/ASPS 

-Stanley