After enjoying a big run-up in the last few years, Walter Investment Management (WAC) has been imitating that old party favorite, the limbo, for the past few months. Day after day, investors in the stock have been asking themselves "how low can it go?" With the stock now trading around $28 and change, and likely to have earned a whopping $9+ in core earnings per share in CY 2013 when the stock reports earning in a few months, WAC has to be one of the most perplexing investments out there for value investors. On the surface, the stock should be the steal of the century, and yet it keeps going down. The simple explanation is that investors simply do not believe in the company (or the sector) any more, and sentiment around Walter and its peers can't get more bearish. With the possible exception of the gold miners, I don't think there is a group less loved than WAC and its peers, Nationstar Mortgage (NSM) and Ocwen Financial (OCN).
For those who aren't familiar with Walter, let me take a step back for a moment. WAC and most of its peers have been around since well before the Recession. At the same time though, the Recession is really what super-charged these businesses (most notably Ocwen). Following the Recession, regulators made it more expensive and difficult for banks to service the mortgages they originated by requiring them to hold capital against the mortgages. This was especially problematic for big banks, which often originated mortgages, then packaged them together and sold them in structured product form to investors, while retaining the servicing business on those mortgages. Under new rules promulgated in the last few years, banks have to hold capital in proportion to those mortgage servicing rights (or MSRs), just as they do for any loan. In the face of this new requirement, banks started to sell off their MSRs en masse. Banks sold or are considering MSRs on selling tens of billions of dollars of loans.
Walter has several businesses, as I will discuss in a moment, but the biggest and most core of these businesses is buying these MSRs and then earning a very tiny annual spread by servicing them (usually a few basis points, but it varies based on the deal in question). This spread probably sounds like a very tiny amount, and it is, but WAC is able to make this a big business by literally holding hundreds of billions of dollars of servicing rights. At last report, the firm's servicing portfolio was ~$200 billion in November, with a pipeline of potentially hundreds of billions more than WAC is competing to take on. When the company last reported earnings, its operating EBITDA (~$161 million, EPS of $2.32 per share) was ~41% servicing, 13% insurance, 37% originations, and 9% everything else. So servicing is the biggest part of the profit pie, followed closely by originations.
I think most reasonable investors would agree that the servicing earnings are fairly safe (and low-risk) at this point, given the firm's experience in the area. Walter and its peers know how to run a servicing operation on very thin margins and still make a lot of money. The concern on the servicing side is mainly that the growth in the size of these servicing books is coming to an end. Companies in the servicing industry have grown their combined servicing books from ~$140 billion in the first quarter of 2011 to $1 trillion in the third quarter of 2013. Regulators have begun to express concerns over this growth, as shown by a recent move by New York financial regulators to block an agreement where Ocwen planned to buy the rights to service $39 billion of loans from Wells Fargo (WFC).
Despite this regulatory scrutiny, sell-side analysts are looking for as much as $400 billion in legacy (read: old, junky) mortgage servicing portfolios to be transferred off banks' balance sheets this year, I think WAC will capture a large share of this. With legacy assets, experience in the area and ability to collect on the mortgages while complying with Federal rules matters a lot. WAC is well-positioned here, given its track record (indeed, recent scrutiny on OCN could be to WAC's benefit here). There will also be substantial sales in new, clean mortgage servicing portfolios. In this area, competition is heating up, with some mREITs looking to get into the space. Nonetheless, WAC will still win a healthy portion of these servicing rights, in my view.
Banks have a very strong incentive to get MSRs off their books, given the capital requirements. Thus, short of a complete ban on MSR sales by Federal regulators, the assets are going to keep flowing from banks to companies like WAC. Yet, let's assume for a moment that bears in the space are right. The growth in MSR books may or may not be at an end (WAC is probably less exposed to this risk than Ocwen), but even if it is and all WAC can do is keep the size of its book steady, the servicing rights business alone should generate $0.95 per share in quarterly EPS (41%*$2.32 in EPS from last quarter). This would equate to $3.80 a share in annual EPS. That is assuming that 100% of all other earnings go away completely, which is clearly unlikely.
The second-most important segment for Walter is mortgage originations. The volume here is way down, amid higher interest rates and a dearth of refinancing activity. Walter originates mortgages and then sells them, earning a profit on the sale of the asset. Gain on Sale margins have come down as well, and including gains on paper originated by correspondent lenders. Given this, it's not surprising that investors are concerned about the profitability of this segment. At the same time though, the appointment of Mel Watt as director of the FHFA is a positive for WAC. Watt is pretty firmly pro-homeowner, and as a result, he has already started (and likely will continue) to take actions that benefit consumers, like increasing their ability to get government-backed loan modifications and re-modify their loans as needed in the future. This benefits consumers, but it will also benefit mortgage servicers like WAC. In addition, while higher rates are surely bad for origination volumes, and it is true that a lot of firms have gotten into the origination business, an improving economy should eventually help boost origination levels. At the end of the day, the origination business is important for WAC, but it's not like the firm will go bankrupt even if new originations go to 0. Servicing still gives WAC a lot of value and earnings power for investors.
The other 22% of earnings for WAC are a mixed bag, with some in good shape, and others facing headwinds. Yet, at today's prices, investors seem to be assuming that Walter Investment Management is sure to see an enormous fall in profitability. But even if the company's mortgage origination business, insurance, and other business lines disappeared tomorrow, and WAC could not buy another MSR from anyone, the company would still earn $3-$4 a year in profits for literally at least a decade thanks to its current MSR portfolio. Even the most pessimistic of analysts see WAC earning $5.35 per share in 2014, and of the 11 analysts covering the stock, 7 rate it a buy or strong buy. With the stock at $28 a share, a lot can go wrong and WAC would still be a great investment in the long run. Investors should bear that in mind when dealing with bruins on the sector.