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Executives

Jim Ballan - VP, IR

Glen Messina - President and CEO

Robert Crowl - CFO

Analysts

Paul Miller - FBR

Henry Coffey - Sterne Agee

Bose George - KBW

Steven Halperson - Compass Point

Ryan Zacharia - JAM Investment Management

Ron Mass - Almitas Capital

Jordan Hymowitz - Philadelphia Financial

Chris Gamaitoni - Millennium

PHH Corporation (PHH) Q4 2012 Earnings Call February 7, 2013 10:00 AM ET

Operator

Good morning ladies and gentlemen. Welcome to the PHH Corporation’s Fourth Quarter 2012 Earnings Conference Call. Your lines will be in a listen-only mode during remarks by PHH management. At the conclusion of the Company’s remarks we will begin the question-and-answer session, at which time I will give you instructions on entering the queue to ask your questions.

Today’s call is also being webcast and recorded for replay purposes. The audio replay can be accessed either on the company’s website at www.phh.com/invest or by telephone at 888-203-1112 or 719-457-0820 and using Conference Id 9254161 beginning shortly after the conclusion of the call. It will be available until February 22, 2013. This access information is also described in the Company’s earnings release and I will repeat it again at the end of our session.

At this time, Jim Ballan, Vice President of Investor Relations will proceed with the introduction.

Jim Ballan

Thanks, Dana. Good morning and welcome to PHH Corporation’s Fourth Quarter 2012 earnings conference call. Please note that statements made during this conference call include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 as further described in slide three of our fourth quarter 2012 investor presentation of supplemental schedules.

Such forward-looking statements represent only our current beliefs regarding future events and are not guarantees of performance or results. Actual results, performance or achievements may differ materially from those expressed or implied in such forward looking statements, due to a variety of factors including, but not limited to the factors under the headings cautionary note regarding forward looking statements and risk factors in our periodic reports filed with the U.S Securities and Exchange Commission including our most recent Annual Report on Form 10-K and quarterly reports on Form 10-Q, which are available in the investor’s section at our website at www.phh.com. Investors are cautioned not to place undue reliance on such forward looking statements.

The earnings release we issued yesterday may be accessed from our website or you may request a faxed or mailed copy by calling our investor hotline. In addition, an investor presentation of supplemental schedules is posted in the Investor’s section of our website under webcast and presentations.

During this call, we may discuss various non-GAAP financial measures including core earnings pretax, core earnings after-tax and core earnings per share. Please refer to our earnings release and accompanying investor presentation of supplemental schedules for description of these and other non-GAAP financial measures as well as a reconciliation of such measures to their respective most directly comparable GAAP financial measures.

Speaking on the call today will be Glen Messina, President and Chief Executive Officer and Rob Crowl, Chief Financial Officer. George Kilroy, President of Fleet and Dave Tucker, President of Mortgage along with other members of the senior management team are also with us and will be available to take your questions.

Glen will discuss the company’s performance in the fourth quarter and our strategic objectives and Rob will review our financial results after that we will take questions. I will turn the call over to Glen Messina.

Glen Messina

Thank you, Jim. Good morning everyone and thank you for your interest in PHH. Overall, I'm pleased with the results for the fourth quarter and the full year 2012. For the fourth quarter we reported GAAP earnings of $1.01 per basic share and core earnings per share of $0.81.

Retail mortgage application volume grew 28% over the prior year of fourth quarter and total loan margin in the fourth quarter was 406 basis points, down only 14 basis points in the third quarter and 120 points basis above the fourth quarter 2011 margin.

For the full year 2012, we reported GAAP earnings of $0.60 per basic share and core earnings for share of $2.96. Fleet delivered 16% growth in segment profit and the high demand for mortgages throughout 2012 and enabled us to achieve approximately 56 billion in total mortgage closings.

We achieved these results despite $251 million in mortgage quality related cost, a significant portion of which were repurchased in foreclosure related charged and $29 million in time charges that Rob will describe shortly.

As I look back on 2012, we spent the year focusing on the execution of our four strategic priorities and I’m proud of the progress we’ve made. In 2012, we delivered disciplined growth in our franchised platforms.

Retail applications were up 36% and retail closings were up 28%. We were awarded the HSBC private label program which includes approximately $50 billion in subservicing UPB.

Fleet delivered 3% growth in leased net investment as well as growth in average service units and we successfully negotiated price changes in certain key client relationships to offset increased cost so, we can continue to invest in these relationships for the long term. In some cases we took the tough actions necessary to separate client relationships with lower profitability.

We delivered on operational excellence. We made defect reduction our priority in mortgage and Fleet. In particular in 2012, we reduced our Fannie Mae new originations defect rate by approximately 80% and reduced our defect rate for critical processes in Fleet by more than 30%.

We delivered our commitment to customer service. Customer satisfaction scores increased by as much as 10 points for certain key clients in mortgage and as much as 13 points in Fleet and Fleet also won seven awards recognizing our leadership and innovation, and customer service.

And we delivered on generating liquidity and cash flow and deleveraging. We entered 2013 with $829 million in cash, up $415 million from year-end 2011 and with a $183 million left of unsecure debt.

We improved our unencumbered asset ratio from 2.3 times at the beginning of the year to 2.8 times at year end, approaching our goal of three times or better. And we demonstrated access to multiple debt capital markets. We put in place multiyear revolving credit facilities, renewed or extended more than $6 billion of mortgage related funding arrangements, issued $1.2 billion in fleet term ABS debt and renewed $2.3 billion in fleet lease conduit financing facilities.

We paid off our 2012 and 2013 unsecured debt maturities in 2012 and our next unsecured debt maturity is not until September of 2014 when we have $250 million in aggregate principle amount of convertible debt maturating.

Our solid operating performance reflects our commitment to our four key strategies and we believe the continued implementation of these strategies while maximize value for shareholders by positioning us for growth and making us more competitive, more profitable, and more capital efficient company.

Now I would like to turn the call over to Rob to discuss our results, after which I'll discuss our outlook for 2013.

Robert Crowl

Thanks Glen. On a GAAP basis net income attributable to PHH Corporation for the fourth quarter 2012 was $58 million, or $1 per basic share, which included a $29 million positive mark-to-market adjustment on MSR asset, partially offset by $10 million in MSR hedge losses. Core earnings, which excludes the net MSR mark were $46 million on an after tax basis or $0.81 per share.

For the full year 2012, on a GAAP basis net income attributable to PHH Corporation was $34 million or $0.60 per basic share, which included a $223 million negative mark-to-market adjustment on our MSR assets, primarily from elevated pre-payment rates as interest rates declined throughout the year, and $5 million on MSR hedge losses. Core earnings were $168 million on an after tax basis or $2.96 per share.

Core earnings per share would have grown 30% in 2012 as compared to 2011 if you adjust for $0.31 per share in losses in 2012 related to debt prepayment and mortgage reinsurance termination costs, as well as a $0.72 per share gain in 2011 related to the sale of our interest and our appraisal services business.

Core earning pretax for the combined mortgage production and servicing segments was $45 million in the fourth quarter, down from $59 million in the previous quarter. Production segment was down $23 million, due primarily to lower gain on mortgage loans and increased investments in compliance and quality related initiatives.

The servicing segment was $9 million better than last quarter due primarily to lower quality related costs. Retail applications in the fourth quarter were $14.8 billion, down 5% relative to last quarter reflecting seasonal trends but up 28% compared to the fourth quarter last year, driven by the expansion of our retail platforms. Fourth quarter retail locks expected to close were $4.6 billion versus $4.8 billion last quarter, also unseasonal fluctuation.

Fourth quarter correspondent closings were down 65% from last year, consistent with our strategy to focus on business partners we believe will consistently deliver high quality results. Our correspondent channel represented 13% of total closings in the fourth quarter and 18% for the full year, in line with our 15%$ to 20% expectation.

For 2013 we expect the correspondent channel to represent approximately 10% to 15% of total originations. Competition for volume in this channel has increased and margins in the fourth quarter tightened significantly more than what we experienced in our retail channel.

Our capitalized loan servicing portfolio of $140 billion in UPB at year end is down 5% from the end of 2011, as our replenishment rate continued to be below a 100% in the fourth quarter, primarily from the scaling back of our correspondent channel and higher prepayment rates.

We anticipate returning to a replenishment rate in excess of a 100% in 2013 with the addition of HSBC. A greater than 100% replenishment rate generally should coincide with growth in our capitalized loan servicing portfolio.

Our total loan servicing portfolio of a $184 billion at the yearend 2012, edged up during the year reflecting growth in our subservicing UPB. We also expect to more than double our subservicing UPB from the yearend level with the assumption of approximately $50 billion in subservicing from HSBC.

We view this growth in subservicing as positive because it is less capital intensive than owned servicing and has more limited rep than warranty risk. The credit quality of our servicing portfolio continues to be strong as our delinquency rate remains less than half the level reported for large residential mortgage servicers.

Our total delinquency rate at yearend excluding foreclosure and real estate owned was 3.15%, up from 3.04% at the third quarter of 2012, but down from 3.29 at the beginning of the year.

We continue to make progress in clearing the backlog of GSE repurchases, which have declined 44% since the first quarter of 2012 and 27% from last quarter. We recorded $37 million in repurchase and foreclosure related charges during that quarter, a slight decrease from the $41 million in the third quarter.

Our repurchase and foreclosure related reserves at quarter end was a $191 million; up from a $176 million, at end of last quarter. We have also updated our estimate for reasonably possible future losses related to repurchase and indemnification requests to $40 million, which is down $30 million, from our $70 million estimate at the end of the third quarter.

The reasonably possible loss estimate continues to assume that repurchase demands remain at elevated levels through the end of 2013 and that our success rate in defending against these claims is lower than what we have historically experienced. I want to remind you that the estimate for reasonably possible losses above and beyond are recorded repurchase and foreclosure related reserve.

At year end we valued our MSR at 73 basis points of our capitalized loan servicing portfolio, representing a 2.4 times capitalized servicing multiple. These valuations are up from 69 basis points and 2.3 times respectively at the end of the third quarter, but down from 82 basis points and 2.7 times at year end 2011. The valuation increase during the quarter was primarily driven by slight increase in mortgage rates as the yield curve steepened.

Our fleet business continued to provide consistent segment profit and operating cash flow in the quarter. Fourth quarter segment profit for Fleet was $20 million, down $1 million from the third quarter of 2012, but up $1 million in the fourth quarter of 2011.

Customers displayed hesitation in the fourth quarter for new vehicle orders and syndication volume was lower than anticipated, highlighting some lingering economic uncertainty in the sector. For the full year Fleet earns $87 million, 16% better than 2011 with growth in net investment and leases and average service units.

As Glen said we are also pleased with the significant progress we made on our liquidity objectives last year. We closed out the year with $829 million in unrestricted cash and cash equivalents. The $152 million increase from $677 million at the end of the third quarter includes $79 million received from counterparties related to cash collateral postings as well as cash flow from operations.

And now I will turn it back over to Glen.

Glen Messina

Thanks Rob. Our fourth quarter performance was a solid ending to year in which we made significant progress from both an operating and financing standpoints. We believe 2013 will be another year change for the mortgage industry. While interest rates remain at historically low levels and residential mortgages remain a cornerstone consumer financial product for U.S. banks, both the MBA and the GSE forecast for 2013 project re-financing volume to decline while purchase financing demand is expected to increase.

Our reduction at industry volume levels could cause prices to margins to narrow and so far in 2013 total loan margin has continued a downward trend. In January, total loan margin remained at historically wide levels but averaged approximately 40 basis points below the fourth quarter 2012 average, similar to our average for the first quarter of 2012 and well above our margins for 2011.

2013 could also be a year of increased clarity for the mortgage industry. The CFPB has already promulgated seven new regulations that should take some uncertainty out of the industry but likely will change the way in which mortgage originators and services operate and increase the cost of loan origination and servicing.

We also have the FHFA’s three year strategic plan for the GSEs that suggest GSE support for the U.S. mortgage market will likely continue for the next several years.

For Fleet, a number of economic forecasts suggests only a slight growth in 2013 in corporate investments and equipment including trucks. Additionally, the number of new vehicle acquisition and vehicles coming off lease could decline as customers postpone new vehicle acquisition due to concerns about the U.S. economy and how the U.S. budget challenges our resolve.

So, what should you expect from PHH in 2013? First and foremost, you should expect us to stick to the four strategic priorities we implemented in 2012. We believe these strategies enhance the ability of our business model to adapt to this rapidly changing environment and should enable us to focus on creating long term value for our borrowers, clients and shareholders.

We intend to focus on discipline growth in our franchise platforms, which are our private label services and real estate channels in mortgage along with our fleet business.

We believe our best growth opportunity in mortgage in 2013 is the penetration of our existing clients. Our mortgage clients are promoting greater volumes from the employees and we are working with them to educate their financial advisors.

We have access to more than 45,000 financial advisors through our PLS channel and we believe we have significant opportunity to increase the number of financial advisors through whom we actively source mortgage loan originations.

We also have a significant pipeline of prospective private label client and our PLS sales force is focused on demonstrating to them the unique value proposition we offer. We believe increased regulation and increasing complexity in the mortgage business will continue to drive these institutions to outsource the mortgage operations to PHH.

In 2013, we will assume approximately $50 billion of UPB of subservicing from HSBC and will begin operating as HSBC’s outsourced mortgage services provider for U.S. operations.

HSBC is expected to come online at the beginning of the second quarter and once fully ramped, HSBC as expected to be among our top PLS clients. Our Realogy joint venture positions us to see an estimated one out of every four home sales transactions in the U.S. and gives us the benefit of a front row seat in the recovery of the housing market. We are focused on driving increased capture rate in this segment as well as increasing and signing new clients.

With the transition of our mortgage business to a great emphasis on retail and as the overall mortgage market transitions to a purchase driven market we would expect organization volume going forward to more closely follow the seasonality of the purchase market.

Typically purchase market volume is highest in the second and third quarters of each year. Although mortgage total loan margins tend to be highly volatile, we believe there are four key factors that should cause our margins to remain at higher levels than in past cycles.

First, the cost of organization for residential mortgages has increased substantially since the credit crisis due to increased documentation and underwriting requirements, more stringing regulation and increased GFE guarantee fees. As a result originators may attempt to recoup these increased operating costs for pricing.

Second, the recently released Qualified Mortgage Rule standardizing mortgage origination procedures should limit lenders ability to subsidize margins on prime mortgage loans with high margins from subprime mortgages.

Third, we have increased the mix of retail organizations, which provide higher total gain on loans and correspondent loan production from 69% of total organization volume in 2011 to an expected 85% to 90% of total organization volume in 2013.

And finally, we believe our reduced level of origination defects should result in fewer repurchase requests and could lessen the negative impact of scratch and dent mark-to-market adjustments on our margins.

I would also point out that a decline in refinancing related prepayments and rising interest rates would likely cause earnings in cash flow for our mortgage serving segment to improve and the book value of our MSR asset to increase. This should help offset the impact to earnings and cash flow from lower margins and volumes in our mortgage production segment.

In Fleet, we are staffed to very active in marketing our unique value proposition in the Private Truck Fleet market. This includes detailed maintenance and usage analysis, vehicle specifications, a number of restructures and optimal replacement scheduling. Also during the first and second quarters of 2013 we will be on boarding new services and lease clients won in late 2012. These efforts should contribute to our growth.

Regarding operational excellence and customer service, you should expect us to continue to invest in our business to reduce origination defects and simplify our processes and to anticipate and address fundamental changes in the industry.

We are investing in people systems and processes to create a long term viable platform that will perform as the mortgage industry continues to evolve. This investment includes operating and capital expenses related to the expansion of our retail presence, enhancement to our compliance structure to meet new regulatory standards, continued modernization of our information systems and the achievement of requisite quality and customer service objectives.

We believe our investment in operational excellent and our commitment to continually raise the bar on the quality of customer service should lower future operating cost and improve the quality of our product and service offerings. Ultimately, we believe it’s essential for the success of our business model to be the industry leader in compliance, quality and customer service.

While we remain committed to investing in our business, the increasing cost of origination and servicing over the past few years has pressured the profitability of some of our outsourcing relationships. We are committed to operate our business profitability, and we will continue to work in partnership with our clients to address the fundamental changes in the industry to ensure our programs on meeting our mutual objectives.

Where we cannot adequately recover the cost and risk of service delivery, we will make the difficult choices of which contracts we can remain in and which we cannot.

With respect to the New Jersey Attorney General and Multistate Mortgage Community Regulatory matters that we have previously disclosed, we have no material updates to report at this time.

PHH is the largest residential mortgage outsourcer in the U.S., serving many of country's wealth management firms and regional community banks along with our direct real estate channel, which is principally Realogy relationship. We are also the third largest vehicle management services provider in the U.S. and Canada combined.

We believe our scale, specialized expertise, and customized service offering gives us a strong competitive position in our franchise platform. We take limited credit risk; have a high quality asset base from our focus on prime mortgage originations and from our well diversified fleet lease portfolio and high credit quality lessees.

As I said in the past we believe our mortgage and fleet businesses should be able to achieve, low to mid teen core returns on equity. We are working hard to achieve our target ROEs as prudently and as expeditiously as possible and we believe we are well positioned for continued success in 2013.

I want to recognize and thank my colleagues of PHH for the hard work and enduring commitment over the last year as we look forward to 2013 and I also want to thank our customers for their business and confidence in us as a service provider.

And with that we're ready to take questions. Dana.

Question-and-Answer Session

Operator

(Operator Instructions). And we'll go first to Paul Miller with FBR.

Paul Miller - FBR

Expenses, the $29 million, that's one time in nature. So we weren't looking modeling this out and I guess that's flowed through the other expense line items. Should we take it out of there going forward?

Glen Messina

Paul, I think you're referring to the line other operating expenses for 2012 the fourth quarter from fourth quarter 2011?

Paul Miller - FBR

Yes.

Glen Messina

Yes, the increase roughly $30 million and here's the way it’s at, if you look at that breakdown here's how it is. $27 million of the $30 million is related to repurchase, foreclosure and OREO related expenses. The drivers of that certainly are the economy and as we work through the legacy books of business we believe that those expenses would decline.

$3 million of increase in production direct expenses, that's a variable with volume and relates to the build out of our retail channel. We incurred about $8 million in quality and compliance related costs, focusing on defect reduction and preparing for the changes proposed by the seven new regs from the CFPB.

About half of that is one time in nature, the other half is probably going to be run rate, and we experienced a $5 million decline in cost of goods sold at Fleet, which is timing of syndication transactions fourth quarter year over year.

Paul Miller - FBR

So you talked about in here, don't you talk about $29 million of onetime and nature related to compliance costs. Am I missing something?

Robert Crowl

Paul, I think you're referring to the debt retirement.

Glen Messina

And the loss on the commutation of the Atrium reinsurance.

Paul Miller - FBR

Okay I must have got confused. And then I wanted to touch base real quick on the comments you make about your reps and warrants. You made a comment that you reserved roughly $37 million. Then the guidance of $70 million of future reserves, comes down to $40 million, but then you make, in your Press Release you talk about, you expect reps and warrant costs to remain elevated.

So can you just clarify this a little bit, is $40 million the rest of the reserves that you think you're going to have to allocate to this give or take some noise and then at that point you're going to be adequately reserved for there is reps and warrant cost?

Glen Messina

So Paul, I'll get back to you here. We have been talking about this, pretty consistently throughout the past year. The $40 million are estimated for reasonably possible additional losses over and above the reserve that we have on our boat of $191 million. That reasonably possible loss estimate assumes that our repurchase demands remain elevated throughout the and to 2013, that our success rate in defending claims declines and that the loss severities on those repurchased claims remains at elevated levels as well.

Paul Miller - FBR

Okay, so if, I don’t want to put words in your mouth, but if you go out and you reserve another $40 million, what you have been reserving relatively, consistent since a year ago when you started making this commentary about this, does that mean that your reps and warrants cost would drastically go down in the third quarter?

Glen Messina

The $40 million is again, that I would assume that the rep and warrant claims remain elevated for the balance of this year. Now the timing of how that gets recognized for quarter is really dependent upon the timing and flow of the repurchase demands coming from the GSEs.

Operator

And we will go next to Henry Coffey with Sterne Agee.

Henry Coffey - Sterne Agee

I know it is difficult to quantify this item, but focusing back on Paul’s question, there is obviously a turning point as that unreserved expected loss figure goes lower and lower and the reserve balance goes higher and higher, where suddenly you don’t need to keep adding to that, it’s a legacy cost. Is there any way you can help us quantify when that turning point is coming? Obviously it’s moving in the right direction?

Glen Messina

So, Henry, I think the way you are thinking about it is correct. So assuming repurchase demands trail off at the end of 2013 as our reasonably possible loss estimate would expect or projects, then you come to a point where your on balance sheet reserve does reflect an appropriate reserve level to cover normalized repurchases out of the portfolio and then we would continue to book a repurchase reserve upfront as we sell new production to the GSEs and that reserve should be sufficient to cover future repurchase demands over the life of that business.

Henry Coffey - Sterne Agee

So turning point, it sounds like a flatter into sort of call it late 13 or maybe early 14?

Glen Messina

Again Henry, as I said to Paul, the timing of repurchase demands, we can really predict that from the GSE. We think it’s going to be elevated through the end of 2013; it may be lumpy by quarter. 2013 will have to play out to see how the timing plays out by quarter.

Henry Coffey - Sterne Agee

I appreciate the complexity there. Just two more questions, debt levels you’ve get about $1 billion as a corporate debt, some of that is converts. What is the sort of GAAP effective cost on that debt and what would be the dynamic or refinancing all of it. I noticed one of your single B rated competitors just did a very large issue with 6%.

Glen Messina

Yes, the GAAP effective cost on the debt is about 13%. Obviously, we would expect to be able to go-to-market today given the amount of capital markets or the fact that we may establish access to the capital market in 2012 and get substantially lower rate than that, but I think you should know, Henry, there cost benefit that needs to be done associated with that.

So if we want to tender and take out some debt we are going have to pay, there is a true cash cost, economic cost of paying tender premiums. You might not get all the debt tendered. So clearly as we have said before, continuing to de-lever the business and looking to restructure the maturity ladder of our unsecured debt is a critical priority for the company and will continue to be and we are evaluating those alternatives year on quarterly basis and working with our banks and investment bankers to determine what the optimal structure is but whatever we do, it ultimately has to create value for our shareholders and we don’t want to give up economics that could reap to the shareholders just for GAAP benefits.

Henry Coffey - Sterne Agee

That $829 million as cash how much of that is kind of cash that you need in the business and how much of that is sort of excess cash that you could use to pay down that debt?

Glen Messina

So Henry, we have talked about before. We keep cash on hand to cover a number of different things. Certainly there is operating cash needs to manage the timing of loans sales and loan purchase. We are trying to reserve cash for the 2014 convertible maturities. We have got reasonably possibly losses that we want to reserve for and our objective continues to be the same which is, we want to continue to de-lever the business.

So consistent with those objectives, we are going to continue to evaluate opportunities to de-lever the business and we want to make sure we have got sufficient cash and liquidity to be in a position of strength to capitalize on any opportunities that may avail themselves in the market while we continue to pursue our objective of de-levering the business.

Henry Coffey - Sterne Agee

And on a completely unrelated question, I have noticed mortgage rates have obviously started to move a little higher. They seemed to be sort of holding pace with at least what we see when we look at the cash market in terms of the spreads you’re going to be allowed whether that’s Fannie rates or the securitization yields.

When you look at that dynamic and you look the mortgage banker index which seems to actually be holding up fairly well, how should we think about your own gain on sale margins and your own, are we likely to see a high degree of stability or how can we use that sort of public market data to interpret where PHH is going?

Glen Messina

Yes, Henry I’ve said before it’s tough for anybody to predict and forecast where exactly margins are going to be but the difference between the primary and secondary mortgage rates I think is a good indication of where generally cash spreads are or cash price and margin is for loan production.

As I said before on average in the fourth quarter, we saw about a 14 basis points decrease in average margin but there was some pretty good movement during the fourth quarter of margins.

If you look the beginning of the fourth quarter where actually margins continue to be at record levels and they subsequently backed off towards the end of the December but throughout the month of January, even though compared to the average priced in margins would be down about 40 basis points, if you look at endpoint to endpoint, endpoint of December to endpoint of January, pricing margins have held relatively flat.

Operator

And we’ll go next to Bose George with KBW.

Bose George - KBW

First just the question on the MSR hedge. You guys had $29 million mark and looks like $10 million offset, I was curious if your hedge ratio has increased and in terms of like you see more meaningful moves up, can we extrapolate from this or would it be different?

Glen Messina

Bob, you want to handle it?

Robert Crowl

Yes. Now I think our coverage has remained roughly the same. We have not made any material movements in hedge since the end of the third quarter. We continue to have a position in both mortgages and swaps, I'm sorry, the swaption, the swaption position going to decay a little bit overtime and to the extent that we don’t or decide not to replenish that, our coverage would decline all else equal, but we continue to maintain roughly the same coverage.

Bose George - KBW

And also if the rates move up more meaningfully, can we just extrapolate from this where about a third of it gets offset by hedges, is it going to be somewhat asymmetric?

Robert Crowl

I wish it was that easy. I would say that’s probably a good starting point. Again, some of the time decay on the swaptions probably would lessen that all else equal, and then what’s really going to also drive it is the mortgage swap basis, which did not necessarily move in our favor during the fourth quarter, but that could be something that then negates to the extent that it tightens, some of effectiveness of the hedge or the opposite to the extent that it widens..

Bose George - KBW

Okay. And then actually switching to the dilution on the convert, when you guys calculate that do you pull out the effective interest expense from the earnings number, so there is an offset that’s going through as well?

Glen Messina

We do not deduct the effective interest expense.

Bose George - KBW

Okay, I guess presumably that’s not required under GAAP to do that.

Glen Messina

No, it does not.

Bose George - KBW

Okay. Great. And finally just the repurchase demands number went up a little bit in November, I am just curious of those concern in any way or just kind of a blip?

Glen Messina

Yeah, so I think you are referring to the private investor portfolio because GSE related demands continue to decline throughout the fourth quarter. In the private investor portfolio, it’s actually related to one of our private label clients who has been a customer of ours for several years. They had not performed a loan quality review since the inception of the program. They did a live-to-date program review and asked us, or they made a repurchase for about 40 or so loans, that are performing loans but they believed didn’t meet our credit quality standards and their underwriting guidelines. So, we are in a process of negotiating with them now. I don’t think it anything that’s systemic. It really was just a onetime event from one client.

Operator

Now we will take our next question from Kevin Barker with Compass Point.

Steven Halperson - Compass Point

Hi, this Steve Halperson from Kevin’s team. Most of my questions have been answered, but I had a question regarding the HSBC contract. Could you provide some color on incremental servicing fee revenue, origination volumes and expenses that are related to this contract?

Glen Messina

Steve, I think as I said before on some prior calls, we do have confidentiality provisions baked into our private label services agreements where we are bound to not share pricing terms, conditions and things like that. What I would say though is that the HSBC relationship was priced using a structure that’s consistent generally with our other private level services arrangements to include both our owned portion of production as well as our subservice and fee for service arrangements.

Operator

We look next to Ryan Zacharia with JAM Investment Management

Ryan Zacharia - JAM Investment Management

I just wanted to delve a little bit into the indirect expenses within mortgage production, and the expenses line item. This might have been addressed, but there was a pretty material rise, kind of a 57% sequential increase but originations didn't move that much and I just want to understand what drove that and what we can expect in the future?

Glen Messina

So for indirect expenses, if you look year-over-year, you want to focus on the quarter or year over year, Ryan?

Ryan Zacharia - JAM Investment Management

The quarter.

Glen Messina

So for the quarter, the other expense line was the big mover there and I think as I mentioned before in my discussion with Paul, the other expenses really was a function of our investments in quality and compliance. Part of our plan is to invest in operational excellence, to reduce defects and be ready for the regulatory changes that have come through with the CFPB. So we have increased our compliance and quality related expenses. About half of that is one time in nature and the other half is probably going to be run rate.

Ryan Zacharia - JAM Investment Management

Half of the increase or half of what I think you said was $8 million.

Glen Messina

Half of the increase.

Ryan Zacharia - JAM Investment Management

So $6 million should come out on a go forward basis.

Glen Messina

Roughly.

Operator

We'll take our next question from Ron Mass with Almitas Capital

Ron Mass - Almitas Capital

I had a question relating to recapture rate on the loans that prepay and also if you could talk a little bit about the prepayment rate on the loans in your servicing book that you saw in the last quarter and how that would compare to your future projections?

Glen Messina

Yes, so, as it relates to recapture rate, we have not historically disclosed our recapture rate and just if you look at our business model versus the industry in general, because we originate through our private label services clients, we don't necessarily use the same framework for recapture, having a dedicated recapture unit that makes loan calls to solicit the portfolio, those type of things. Loans are actually recaptured through the financial advisors, that through we originate loans. As Rob said, overall replenishment rate had averaged below a 100%. So it did see higher level of prepayments or early payments of mortgage loans throughout the course of 2012 and the fourth quarter remained elevated.

And our recapture rate ended up being below a 100%, primarily because we have narrowed our focus in correspondent to high quality partners and are of course as a result our correspondent volume declined fairly substantially. Now we would expect as we go forward into 2013, that as we bring on HSBC and we continue to rebuild or build out our retail production and as the market shifts more towards a purchase market, we will continue to improve our recapture rate and drive back over a 100%.

Operator

We’ll go next to Jordan Hymowitz with Philadelphia Financial.

Jordan Hymowitz - Philadelphia Financial

Of the 40 basis points gain on sale compression in the first quarter, how much would you say is related to the Fannie Mae or GSEP’s (ph) going up?

Glen Messina

Jordan, none of it. When you think about the GSEP increases, the reality is, if GPs go up, generally for the industry, typically you may have some loans caught in your pipeline that, you’re price assuming one GP and yes, they are going to be sold into a security that has the higher GP into it and you are going to end up at a temporary margin compression as a result of that but generally the industry has been pretty disciplined at pushing GP increases back to the consumer. We didn't have any margin compression related to guarantee GP increases.

Jordan Hymowitz - Philadelphia Financial

Okay, second thing is, did you disclose what percent was HARP?

Glen Messina

Historically we have, we didn’t talk about it in this call. Just given the high credit quality nature of our portfolio, we don’t have as much HARP production as others had during in the industry. If you look at it our pipeline, our closings, HARP loans account about 6% of our pipeline and are closing throughout 2012.

Operator

(Operator Instructions) .We will go next to Chris Gamaitoni with Millennium.

Chris Gamaitoni - Millennium

I just wanted to dig in the economic hedge results on the gain on sale. It’s been elevated for a few quarters, and could you just walk me through the kind of the give and takes and why that’s elevated, is that going to be sustained in the future and what could cause it to go down or up?

Glen Messina

Obviously we do, we hedge our pipeline as most mortgage originators do. One of the key variables there is what we call fill through performance. So as loans are being locked into our pipeline we make an assumption as to how many of those loans are actually are going to pull through to a closed loan and to the extent that more loans close or pull through to closing than we have assumed in our calculation of how we hedge the portfolio, that generally tends to be a positive effect and we do get some positive impact as a result of pull through.

That ends up being one of the bigger movements. As well, here we do tend to see, that number does tends to be volatile, it does change back and forth on quarters. It is pretty lumpy. That does depend upon market movement, quarter-per-quarter and where your rates actually end up relative to your mortgage portfolio at quarter end, vis-à-vis the average coupon in your pipeline.

Chris Gamaitoni - Millennium

And then just a question on the rep and warrant. We have seen some other similar originators who sold into larger Wall Street conduits during the 2005 - 2007 period get indemnification requests. Have you started to see any of those?

Glen Messina

The answer is no. We report our repurchase requests, or repurchase indemnification requests as part of our investor supplement or supplemental package under the section of private investors. There has been a lot of talk in the industry that that’s been elevated for some originators and sellers. A lot of that activity has to do with loans that were considered “subprime” but we’ve never been a subprime originator. So we are fortunate we don’t have that challenge.

Operator

And we have no further questions in the queue at this time.

Glen Messina

Thank you operator and for shareholders thank you very much for continued interest in investment in PHH and look forward to talking to you at the end of the first quarter.

Operator

This concludes the PHH Corporation fourth quarter 2012 earnings conference call. Once again ladies and gentleman, the replay will be available beginning later today at the Company’s website at www.phh.com/invest or by dialing 888-203-1112 or 719-457-0820 and using conference Id 9254161. It will be archived until February 22, 2013. You may now disconnect.

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