Ocwen Financial has developed a reputation among mortgage bond investors for ripping off the band aid.
The Atlanta company’s rapid expansion into mortgage servicing by acquiring the rights to portfolios, mostly from banks, has recently generated some backlash, as stock investors and analysts question its ability to integrate the new business.
Mortgage bond investors are just as concerned about Ocwen’s practice of aggressively modifying troubled loans, often by writing down the principal balance, which not only reduces the value of the collateral in these deals, but also interrupts interest payments on the bonds.
In August and September, Ocwen assumed the rights to servicer approximately $30 billion of unpaid balances (UPB) related to Freddie Mac and Fannie Mae loans. Most of the bank’s $42 billion of UPB non-agency portfolio is scheduled for transfer and close on November.
On July 1 and September 1, Ocwen respectively completed the boarding of $3.0 billion and $2.0 billion in UPB representing the non-prime subservicing from a large financial institution.
Ocwen isn’t alone; rivals Nationstar and Walter Investment have also been snapping up mortgage servicing rights from banks eager to exit the business. But Nationstar and Walter haven’t been writing down the principal of troubled loans at the same pace.
“The big game in the market today is trying to figure out which of these loans might get transferred to Ocwen,” said the head of active taxable fixed-income at a major East Coast money manager. This person said that prices on residential mortgage backed securities (RMBS) can drop as much as 10 points when the news is first reported, so a bond already trading at a discount of 80 cents on the dollar could see its price drop as low as 70.
Paul Nikodem, executive director and head of RMBS research at Nomura Securities, said it’s difficult to isolate one factor among the many impacting RMBS prices when servicing rights on the underlying loans change hands. However, news about MSRs moving to Ocwen likely results in investors revising their cash flow assumptions to be more conservative, in anticipation of payments on their bonds taking longer to arrive or never arriving at all if the servicer writes down principal, he said, and that’s bound to exert downward pressure on prices.
Nikodem added that affected securities typically experience cash low disruptions when Ocwen reimburses itself from the payment “waterfall” for fees earns for modifying loans, as well as from the past advances it recoups as the result of modifications. In addition, the significant loan-principal reductions that Ocwen pursues lower payments to RMBS bondholders, at least in the short term, although payments could later improve because borrowers have greater incentive to pay. The impact of the servicing transfer varies depending on where bonds are in the capital structure. “Junior bondholders and current cashflowing senior bondholders are much more negatively affected by lower advances,” he said.
Although Ocwen and Nationstar have experienced similar growth in MSRs, it is Ocwen that prompts investors to bite their fingernails when they first learn it will service the loans backing their bonds. Modifications of loans increase soon after they’re transferred to both Ocwen and Nationstar and advances of payments to bondholders decrease, but Ocwen has been far more aggressive on both fronts.
According to Nomura, the servicer writes down principal in 80% of its subprime loan modifications, compared with 67% for the overall subprime sector and 55% for Nationstar. A similar deviation from the norm holds true for advances, which mortgage servicers have traditionally provided to facilitate payments to investors when borrowers are delinquent, at least until it becomes clear those advances can no longer be recovered. Nomura said Ocwen’s advance rate is 20% to 30% of delinquent balance in subprime, compared with an average of 35% to 40% for most other servicers.
“On average for previous Ocwen transfers, certain bondholders could see up to six or eight months of cashflow cut offs,” Nikoderm said, adding, “We have not seen anything nearly to this magnitude for Nationstar-transferred deals.”
Ocwen’s strategy is undoubtedly aggressive. However, it claims that its business model serves the interests of investors as well as borrowers. A company spokesperson pointed to an Oct. 4 report by Moody’s Investors Service ranking the servicer among the best the rating agency has analyzed.
“We believe that report reflects our successful efforts to both reduce investor losses through NPV positive resolutions, including those involving principle reductions, and help thousands of families remain in their homes,” the spokesperson said. “In addition, our advance model is strong; we have outstanding advances of over $8.5 billion, which we believe is industry-leading.”
Moody’s compared the status of the approximately one million loans that were delinquent 60 days or more or in foreclosure as of December 2008, finding that 31% of the loans servicers modified at least once performed much better than those that weren’t modified. The analysis found Ocwen’s modification program to be “best in class,” although it added that “the better performance of Ocwen’s modified loans may well be the result of Ocwen’s propensity to re-modify loans more often than the other servicers do.”
William Fricke, a senior credit officer at Moody’s and one of the report’s authors, said that, given foreclosure periods stretching four or five years in judicial states, and the likelihood that fees and other costs could lead to high losses upon liquidation, loan modifications may result in lower losses. Consequently, multiple modifications may make sense from a net-present-value (NPV) perspective, he said.
“Ocwen considers how much it will recover if the loan is eventually foreclosed versus the borrower’s propensity to pay if the loan is modified, given his or her past history,” Fricke said, adding that comparing the NPVs under those scenarios determines which is the better approach currently. “If the foreclosure period shortens, then Ocwen’s strategy would change.”
Ocwen not only applies more modifications to loans, it also tends to cut much more deeply into principal than other servicers, sometimes by more than 50%, according to RMBS investors. Frick said the servicers’ Shared Appreciation Modification (SAM) program may allow it to forgive principal more readily, although that assumes a continuing housing market recovery and rising home values. The program writes down the principal of the loan to 95% of the property’s current value, and then forgives the written down portion in one-third increments over the next three years, as long as borrowers share 25% of any future appreciation with lenders.
Successive modifications can also work in servicer’s favor. Sue Troll, a credit analyst at T. Rowe Price whose analysis helped limit her firm’s exposure to the subprime mortgage crisis, said that “each time a loan is modified it is considered current,” improving its loan-performance rate. In addition, she said, the servicer collects a fee for doing the modification and can recoup any prior advances made to the trust.
“In terms of multiple modifications, Ocwen definitely leads,” Nikodem said.
In many cases Ocwen continues to reduce principal on subsequent modifications, Nikodem said, adding that “it is hard to imagine that these modifications are NPV positive for bondholders.”
A short sale or foreclosure sale might be a better option in such instances. Nikodem said the short-sale rate for the loans Ocwen services is slightly lower than for other servicers. “If you think about servicers’ incentives,” he said, “They are incented to keep the loan alive and collect fees as long as possible.”
Nikodem said that a business strategy driven by recurring modification fees and advance recoveries will be less incented to point borrowers in the direction of short sales or liquidations. And although servicers recoup advances when loans are eventually foreclosed, they are capital intensive in the meantime, requiring the servicer to finance advances without being reimbursed for them.
“That rubs investors the wrong way because there’s the suspicion that Ocwen is doing modifications in its own self-interest, to recover advances and fees. But the modifications may not be in best interests of investors or borrowers,” said the managing director and head of residential mortgage credit another major money manager headquartered in the South.
On the other hand, alternatives to writing down principal, such as waiting to foreclose on a property, may be even worse for RMBS investors. “The cost to foreclose has not abated at all,” said Sharif Mahdavian, lead analytical manager for U.S. RMBS at Standard & Poor’s. “That would suggest the servicer may claim that even very aggressive principal modifications are better than foreclosures.”
And Moody’s Fricke said that all servicers determine whether to pursue foreclosure or modifications based on the NPV they calculate. So as long as modifications result in a higher NPV, they’ll choose that option over foreclosure.
While such an approach may be difficult to refute, servicers tend to omit critical information about how they carry it out, unnerving investors. “I understand the [NPV] argument, but the servicers never disclose the results of their NPV tests,” Troll said, adding, “It’s hard to imagine a situation where forgiving substantial amounts of principal that result in immediate, large losses to the trust, are actually producing higher cash flows than if the loan was liquidated through a normal liquidation channel or a short sale.
Fricke said that successive modifications can be generally positive for the securitization trusts, because the loan continues to generate cash, but other options such as short sales can be equally effective. Ocwen lags the industry in short sale rates, Fricke said.